Changes to Business Interest Expense Limitation
The Tax Cuts and Jobs Act (“TJCA”) significantly limited business interest expense deductions
In 2017, the Tax Cuts and Jobs Act (“TCJA”) made major changes to the rules regarding federal income tax deductions for business interest expense. The new rules generally applied to all business interest payments for taxpayers with annual gross receipts more than $26 million. They limited business interest deductions to the sum of 1) business interest income 2) floor plan financing interest and 3) 30% of adjusted taxable income – see additional information below.
Calculation of adjusted taxable income - and important change for 2022. The calculation of 30% of adjusted taxable income is a major component of the business interest deduction limitation for affected taxpayers. Fortunately, prior to 2022, depreciation and amortization expense were added back in the calculation of adjusted taxable income. This addback rule allowed capital-intense or highly leveraged businesses to avoid the business interest expense limitation.
However, beginning in 2022, depreciation and amortization expense will NO longer be allowed as an addback in the calculation of adjusted taxable income for purposes of calculating the business interest deduction limitation. Therefore, it is likely that in 2022 the amount of business interest expense that businesses can deduct may decrease significantly.
Note that any interest disallowed in the current year can be carried forward to future years.
Effect on 2022 business income taxes and planning considerations
A decrease in deductible business interest expense would increase business taxable income and related income taxes payable for affected businesses. As a result, the following are possible recommendations to consider:
- Incorporate the effect of this change in current tax planning and cash flow modeling.
- Evaluate whether to settle intercompany debts or restructure them to take advantage of self-charged interest exceptions, since self-charged interest is not included in the calculation of the business interest expenses limitation
- Potentially restructure lease agreements between related parties to reduce interest expense components
- For real property and farming businesses electing the ADS depreciation rules to reduce current year depreciation and opt out of the interest expense deduction limitations
Small Business Exception / Final Thoughts
It is important to note that the business interest expense deduction limitation does NOT apply to businesses that qualify as a small business. A qualifying small business is generally a business having less than $26 million of annual gross receipts. However, an important caveat and possible trap for the unwary is the “tax shelter rule” which disqualifies a business for the small business exemption if it considered a “tax shelter.” The definition of a “tax shelter” generally includes:
- Non-C corporation “pass-through” entities
- In which over 35% of losses flow to limited partners or similar owners that do not actively participate in the management of the entity.