IRS Issues Final Regulations on the Business Interest Expense Deduction Limitation by Heath Standorf, CPA
Posted on October 20, 2020
The IRS recently published final regulations regarding the business interest expense deduction limitations introduced in 2017 by the Tax Cuts and Jobs Act (TCJA) and recently updated by the CARES Act. Included in the final regulations are guidance to help taxpayers identify and calculate their interest deduction limitation and FAQs to help them understand if they may qualify for a small-business exemption. The latest package of regulations also includes proposed rules for applying the interest expense deduction limitations to partnerships, S corporations, regulated investment companies (RICs), U.S. shareholders of controlled foreign corporations (CFCs) and foreign persons with U.S. federal income tax filing obligations.
For tax years beginning in 2018, the TCJA called for taxpayers to limit the deductibility of their business interest expense to the sum of:
- the taxpayer’s business interest income for the taxable year,
- 30 percent of the taxpayer’s ATI for the taxable year, and
- any floor plan financing interest.
However, with the COVID-19 health crisis and the subsequent enactment of the CARES Act, the recently issued final regulations grant taxpayers the option to deduct as business interest expense as much as 50 percent of ATI for tax years 2019 and 2020 (and only in tax year 2020 for partnerships). Moreover, taxpayers may use their 2019 ATI to calculate their business interest expense deduction limit for 2020. This would allow for higher interest expense deductions for taxpayers during the economic recovery from the pandemic. Because taxpayers may have earned significantly less income in 2020, the larger interest expense deduction could help generate or add to a net operating loss (NOL), which the CARES Act allows taxpayers to carry back five years.
The final regulations also open the door for taxpayers computing ATI to add back to taxable income all depreciation, amortization and depletion incurred in tax years beginning before 2022, even when they are capitalized to inventory and included in cost of goods sold. This is especially welcome news to manufacturers and other businesses with significant inventory that capitalize certain expenses under the Uniform Capitalization rules (UNICAP).
Another key provision included in the final regulations is a slightly narrower definition of business interest expense. For example, while it is confirmed that floor plan financing is an interest expense, commitment fees and debt issuance costs may be excluded and potentially result in a larger expense deduction for certain taxpayers. Clarification is also provided for the treatment of other interest expenses, including guaranteed payments and substitute interest payments, and anti-avoidance rules are introduced to prevent taxpayers from engaging in certain transactions that could artificially reduce the amount of their net business interest expense.
The original language of the law provides an exception to the interest expense deduction limitation for small businesses with average annual gross receipts of $26 million or less for the prior three years (a threshold that will be annually adjusted for inflation). It also allows farming businesses and real estate businesses to elect out of the interest expense deduction limitation, which consequently would also disqualify them from claiming the additional first-year 100 percent bonus depreciation deduction for certain types of property they hold. Real estate businesses with activities that do not rise to the level of a trade or business or that qualify for the small business exception from section 163(j) can now make a protective election to be treated as an electing real property business.
To help businesses with affiliated companies under common ownership determine whether their combined receipts fall below the average annual gross receipts threshold of $26 million, the IRS, as part of its final regulations, posted to its website a series of frequently-asked questions (FAQs). Here, taxpayers can find examples and answers to such questions as what aggregation rules should apply when multiple taxpayers are structured as corporations and how parent-subsidiary or brother-sister controlled-groups may determine ownership.
Included with the final regulations are proposed regulations that would allow controlled foreign corporations (CFCs) with common ownership the option to calculate interest expense deduction limitations on a CFC-by-CFC basis or by applying consolidated group rules to calculate a single limitation for all commonly owned CFCs. These proposed regulations also address the determination of deduction limitations for partnerships and their partners, including specific guidance for tiered partnerships, and the allocation of interest expense in pass-through entities. Taxpayers may rely on these proposed rules until the IRS issues and publishes its final regulations in the federal register. Consequently, it is critical that taxpayers seek the counsel of experienced advisors.
In addition, taxpayers should work closely with their professional accountants and CPAs to determine whether the final and proposed regulations may warrant the filing of an amended return for a previous tax year. The issuance of the final regulations may also offer taxpayers unique opportunities for more tax efficient planning for the future.
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.