BUSINESS INTEREST DEDUCTION LIMITATION: THE NEW CODE SECTION 163(j) JORDAN D. AUGUST practices in the areas of taxation, estate, and business planning with the Tampa offjce of Carlton Fields. Mr. August advises individuals and businesses on a variety of federal income, gift, and estate taxation and state taxation planning and controversy matters. His practice focuses on providing tax advice and long-term planning to individuals, closely-held companies, including partnerships, S corporations, and C corpora- tions, limited liability companies, tax-exempt organizations, and trusts. He counsels high-net worth individuals regarding their wealth preservation, estate planning, business succession planning, and charitable and family gifting needs, including multi-generational transfers of wealth. Mr. August has experience in the areas of probate, estate and trust administration, federal gift and estate taxation, and representation of fjduciaries and benefjciaries of estates and trusts. Mr. August represents businesses and non-profjt organizations on organizational and corporate governance matters, mergers and acquisi- tions, restructurings, and other business transactions. As a business and non-profjt advisor, Mr. August counsels clients on lifecycle events, including entity formation, reorganizations, both taxable and non-taxable, and liquidation events, and drafts corporate governance docu- ments, including limited liability company operating agreements, partnership agreements, and bylaws. He also advises and assists clients with the preparation of rules, terms, and other contractual arrangements regarding product and branding promotions and charitable fundraisers, including raffmes, sweepstakes, contests, and other games of chance and games of skill. With the enactment of the Tax Cuts and Jobs Act them with a new set of rules limiting the deduction (“Act”), 1 Congress created a new set of rules limit- of business interest expenses under amended Code ing business interest deductions that is expected to Section 163(j). 2 Unlike the earnings stripping rules, the impact many taxpayers with outstanding debt obliga- new business interest deduction limitation is appli- tions. Historically, these businesses enjoyed the ben- cable to all types of taxpayers involved in a trade or efjt of deducting all of their interest expenses paid or business, including partnerships, S corporations, trusts, incurred during the taxable year, subject to certain and sole proprietorships, subject to several exceptions exceptions or restrictions. The Act efgectively put a cap described below. on many of those business interest deductions, par- Efgective for tax years beginning after December 31, ticularly for highly leveraged mid-to-large sized busi- 2017, a taxpayer’s business interest deduction for a par- nesses, and will require businesses to reevaluate both ticular tax year is limited to the sum of: their business needs for debt fjnancing and the poten- tial additional after-tax cost of securing such debt. • Business interest income of the taxpayer; Moreover, as interest rates are forecasted to gradually rise, this cost-benefjt analysis will have particular sig- • Thirty percent (30%) of the taxpayer’s adjusted tax- nifjcance in the coming years. This article covers the able income; and basic mechanics of the new business interest deduc- • The fmoor plan fjnancing interest of the taxpayer. 3 tion limitation and describes certain planning consid- erations businesses will face under the Act. Thus, to the extent that a taxpayer’s business inter- est expense exceeds its business interest income and I. GENERAL RULE fmoor plan fjnancing interest, the deduction for the net Prior to the passage of the Act, Internal Revenue Code interest expense is limited to 30 percent (30%) of its (“Code”) Section 163(j) included earnings stripping adjusted taxable income. 4 rules denying certain interest deductions for “disquali- This limitation applies at the taxpayer level. For a group fjed interest” paid by a corporation to a related per- of affjliated corporations that fjle a consolidated return, son who pays no U.S. tax such interest income. The Act repealed the earnings stripping rules and replaced the limitation applies at the consolidated tax return WINTER 2018 THE PRACTICAL TAX LAWYER | 25
fjling level. 5 As discussed below, there are also special year. 9 This exemption eliminates the concern of most rules applicable to pass through entities. small businesses regarding the deductibility of their interest expenses, notwithstanding any other inter- Any amount of business interest deduction disallowed est limitations that could otherwise apply under the under Code Section 163(j) is treated as business interest Code. 10 paid or accrued in the following tax year and may be carried forward indefjnitely, subject to certain restric- B. Electing Real Property Trade or Business tions on partnerships (as discussed below). 6 In this way, The Act also permits certain real property trade or interest deductions limited under Code Section 163(j) businesses otherwise subject to the business inter- are generally deferred until the taxpayer has suffjcient est deduction limitation rules to elect to avoid their business interest income, adjusted taxable income, application. Under Code Section 163(j)(7)(B), an “elect- or fmoor plan fjnancing interest to take the deduction. ing real property trade or business,” which is defjned As a result, a leveraged business that sufgers through by reference to Code Section 469(c)(7)(C) as any real a series of unsuccessful fjnancial years may see their property development, redevelopment, construc- interest deductions limited throughout the down- tion, reconstruction, acquisition, conversion, rental, turn, an unfortunate outcome for some struggling operation, management, leasing, or brokerage trade businesses. or business, may make an irrevocable election to be exempted from the business interest deduction limi- Example #1. Basic Application of the General Rule 7 tation rules. 11 The election is available to any taxpayer In 2018, Taxpayer A, a calendar year corporation, has involved in such a real property trade or business, $30,000 of adjusted taxable income, $6,000 of business including a corporation or real estate investment trust interest income, $30,000 of business interest expense, (“REIT”). 12 and no fmoor plan fjnancing interest. On its 2018 Form 1120, A may deduct only $15,000 of its business interest However, there is a cost to a taxpayer making such expense. That amount is equal to the sum of A’s $6,000 election: it must thereafter depreciate its nonresiden- of business interest income plus thirty percent (30%) of tial real property, residential rental property, and quali- fjed improvement property (certain improvements its adjusted taxable income (30% x $30,000 = $9,000). The $15,000 of disallowed business interest expense is to nonresidential real property) under the alternative carried forward indefjnitely. depreciation system (“ADS”) rather than the general modifjed accelerated cost recovery system (“MACRS”) In 2019, A has $100,000 of adjusted taxable income, of Code Section 168. 13 This will require the electing real $12,000 of business interest income, $40,000 of busi- property trade or business to depreciate such prop- ness interest expense (including the $15,000 in disal- erty on a straight line over a longer period rather than lowed interest carried forward from 2018), and no fmoor under an accelerated method of depreciation. In some plan fjnancing interest. A will be permitted to deduct cases, the depreciation trade ofg may be a rather sig- all $40,000 of the business interest expenses, which nifjcant after-tax cost to the electing taxpayer. includes interest carried forward from the prior tax year, since the that amount is less than the sum of A’s Therefore, eligible real estate businesses with gross receipts in excess of $25 million during previous tax $12,000 of business interest income plus 30 percent of its adjusted taxable income (30% x $100,000 = $30,000). years 14 should consider whether the election to avoid the business interest deduction limitation rules pro- II. EXCEPTIONS TO THE DEDUCTION LIMITATION 8 vides suffjcient benefjt in non-deferrals of interest deductions to ofgset the opportunity cost of depreciat- A. Small Business Exemption ing their subject property under ADS rather than gen- Under the Act, certain small businesses are exempted eral MACRS. This analysis will depend upon the types from the business interest deduction limitation of of assets the real estate business holds (i.e., whether Code Section 163(j). A taxpayer with average annual they are a type that would be subject to ADS upon an gross receipts of $25 million or less for the three-year election), the amount of debt and interest outstand- period ending with the previous tax year are exempt ing, and the taxpayer’s current and projected gross from the interest deduction limitation for such taxable receipts and adjusted taxable income. 15 Furthermore, 26 | THE PRACTICAL TAX LAWYER WINTER 2018
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