CARES Act Eases Limitation on Business Interest Expense Deductions, Special Rules Apply to Partnerships by Heath Standorf, CPA
To help businesses improve cash flow and manage rising debt in the wake of the COVID-19 pandemic, the CARES Act allows certain taxpayers to deduct more business interest expense than was previously allowed under existing law. This, combined with other provisions of the government’s $2.3 trillion coronavirus stimulus package CARES Act, can provide businesses with immediate financial relief.
The CARES Act modifies Sec. 163(j) of the tax code by allowing taxpayers to deduct business interest expense up to 50 percent of adjusted taxable income (ATI) for tax years 2019 and 2020, an increase from the 30 percent limit introduced in 2018 under the Tax Cuts and Jobs Act (TCJA). For partnerships, the 50 percent ATI limit applies to 2020 only, which is discussed in more detail below. Any limited interest expense is carried forward to future tax years.
The COVID-19 crisis will likely lead to many companies seeing a reduction in their net income or a net loss in 2020. Accordingly, the CARES Act introduced an election for taxpayers to use their 2019 ATI for the purpose of calculating the 50 percent limitation in 2020. The intention is to reduce tax liabilities and quarterly estimated tax payments for the current year. In addition, considering that Net Operating Losses (NOLs) can now be carried back five years, the deduction of additional interest expense can increase those carrybacks. This can go a long way to helping businesses improve liquidity.
What is Adjusted Taxable Income (ATI)?
For tax years 2018 through 2021, the TCJA defined ATI to be a taxpayer’s earnings before interest, taxes, depreciation, amortization and depletion (similar to EBITDA). It can be calculated by taking a business’s net taxable income and then adjusting for the following:
1) add back business interest expense; depreciation, amortization, and depletion deduction; capital loss carrybacks or carryovers; and any deduction or loss not properly allocable to a non-excepted trade or business; and
2) subtract business interest income; the lesser of (i) gain realized on sale or disposition of property or (ii) deductions for depreciation, amortization or depletion taken for such property during a tax year beginning after 2017; and any income or gain that is not properly allocable to a non-excepted trade or business.
Beginning in 2022, the ATI calculation will not adjust for depreciation, amortization or depletion.
To Whom Does the Business Interest Expense Deduction Limitation Apply?
In general, the business interest deduction limitation applies to most taxpayers. However, there is an exception for small taxpayers with average annual gross receipts of less than $26 million for the three preceding tax years. This exception does not apply to tax shelters, regardless of their size.
Additionally, qualifying real estate and farming businesses may elect to opt-out of the Sec. 163(j) interest expense limitation. Because this election has other tax ramifications, consultation with professional tax advisors is recommended.
New Guidance for Certain Real Estate and Farming Businesses
The IRS recently issued guidance for the Sec. 163(j) provisions of the CARES Act (see Rev. Proc. 2020-22). With regards to the opt-out election for certain real estate and farming businesses, those taxpayers are now eligible to make a late election or withdraw a previous election for tax years 2018, 2019 and 2020. Taxpayers now have until October 15, 2021, to amend 2018 and 2019 returns to reflect the change in elections.
Special Rules for Partnerships Under the CARES Act
Under the CARES Act, partnerships may apply the higher 50 percent ATI limit to 2020; the 30 percent limit still applies for tax year 2019.
For 2019, any interest expense that is limited under Sec. 163(j) will pass through to the individual partners. Subsequently, the partners will have the ability to deduct half of that interest in 2020 without limitation. The remaining 50 percent of excess business interest expense from 2019 will continue to be subject to the 163(j) rules.
Taxpayers will be well-served to meet with their accountants to help navigate the complexity of the Sec. 163(j) limitations and apply the provisions of the CARES Act in order to yield the most tax-efficient results for their unique circumstances.
About the Author: Heath Standorf, CPA, is a senior manager of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where he helps high-net-worth entrepreneurs and real estate developers structure their businesses and manage complex transactions for optimal tax efficiency. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or at firstname.lastname@example.org.