IRS has released final regs for business interest expense deduction: What are the options for businesses and who qualifies for the small business exemption?
On July 28, the Internal Revenue Service (IRS) released final and proposed regulations regarding the provision of the Tax Cuts and Jobs Act (TCJA) that limits the deduction for business interest expense and temporary revisions to that provision made by the Coronavirus Aid, Relief, and Economic Security (CARES) Act. On September 3, Treasury and the IRS officially filed the regulations for publication in the Federal Register.
What does this mean for you?
Under TCJA, as revised by the CARES Act, many businesses with business interest expenses will have their interest expense deduction limited to 50% of their adjusted taxable income (ATI) for tax years beginning in both 2019 and 2020 for C and S corporations. Also, in some situations, taxpayers can elect to keep the limitation under TCJA, which was 30% of ATI for a taxable year, but would need consent to revoke such an election for the taxable year once made.
In addition, for partnerships, the CARES Act increases the ATI limitation to 50% only for taxable years beginning in 2020. For partnership taxable years beginning in 2019, the ATI limitation remains at 30%. The disallowed portion of the business interest expense are carried forward until offset by income from the same entity in future years.
It is important to note that there is a small business exception to these interest deduction limitation rules – generally, the rules to not apply to a business with average gross receipts of $26 million or less for the 3 preceding years. However, as explained below, there is potential trap for certain partnerships.
Below are some of the highlights of the proposed and final regulations:
Proposed Regulations – the old rules – however businesses can still elect to use these:
- Expanded definition of interest expense – the amount of interest expense included debt issuance cost, loan commitment fees and certain hedging costs
- Unfavorable treatment of cost of goods sold depreciation – taxpayers could not add back depreciation, amortization, or depletion capitalized to inventory under the uniform capitalization rules causing some manufacturers to be subject to the limitations on deducting business interest expense.
- Option for some businesses to elect out if less depreciation is deducted – real estate trades or businesses exempt under the small business rules could not make an election out of 163(j). When electing out, depreciation for real property is converted to ADS and bonus depreciation is not allowed.
- No clarification for nursing & assisted living – did not address qualified nursing and assisted living facilities.
- Individual reporting for owners in pass thru businesses – partnerships and S corporations exempt from 163(j) were required to report business interest expense to owners for further testing on the next tier of taxpayers returns.
Final Regulations – the new, generally taxpayer friendly, rules:
- Narrowed the definition of interest expense – eliminated debt issuance cost, loan commitment fees and certain hedging costs from the definition of interest expense
- Favorable treatment of cost of goods sold depreciation - Taxpayers can add back cost of goods sold depreciation when calculating ATI which results in a larger interest expense deduction. This is a big taxpayer win.
- Protective claim for certain rental real estate – a protective 163(j) election can be made by certain rental real estate taxpayers regardless if the activities are deemed a trade or business. However, there was no change to depreciation from the proposed regulations if the election is made.
- Safe harbor for nursing and assisted living – issued Notice 2020-59 providing a safe harbor for nursing and assisted living facilities the ability to elect out of 163(j) by treating them as real property trades or business.
- No individual reporting for owners of exempt pass thru businesses – removed the obligation for testing interest expense from exempt pass-through entities to the partner or shareholder level.
New regulations clarify effective dates for the rules and provide options
The final regulations generally are effective for tax years beginning on or after Nov. 13, 2020. However, under the clarified effective date provisions, businesses have these options if they feel that the proposed regulations may be more beneficial for tax years beginning after Dec. 31, 2017, and before November 13, 2020:
- Adopt the final regulations for all tax years after Dec. 31, 2017, amending or adjusting returns for years for which returns already have been filed.
- Adopt the final regulations for some but not all tax years beginning after Dec. 31, 2017, amending or adjusting returns for years for which returns already have been filed.
- Continue to use the 2018 proposed regulations for tax years beginning after Dec. 31, 2017, and before Nov. 13, 2020.
- Continue to use the 2018 proposed regulations for tax years beginning after Dec. 31, 2017, and before Nov. 13, 2020, but with early adoption of the change in the final regulations that allows cost of goods sold depreciation to increase ATI. This may be desirable option for many businesses.
Unresolved issue regarding the small business exception for some partnerships and S corporations
These final regulations are generally good news. However, unfortunately, the final regulations failed to address an issue that could affect the ability of certain partnerships to benefit from the small business exception. A partnership that is considered a “tax shelter” will not qualify as a small business exempt from the interest limitation rules, even if average gross receipts for the 3 preceding years are $26 million or less.
The IRS definition of a tax shelter includes a partnership or S corporation, if more than 35% of its losses are allocable to limited partners or limited entrepreneurs (persons who have an interest in the enterprise but do not actively participate in managing the enterprise.) Therefore, under this definition, many small business partnerships and S corporations may not be exempt from these interest limitation rules if there were losses allocated to limited or not active owners. This is something that needs to be monitored until when the rule is changed.
How Herbein can help
The 163(j) final and proposed regulations are technical and nuanced. However, they apply to most businesses, so it is important to gain an understanding of how these rules apply to the specific facts and circumstances of your business. We can help you determine their applicability and discuss planning opportunities, including options regarding which rules to apply, to minimize the impact of this limitation on your business.
For additional information contact the author at email@example.com. Article contributed by Neil Winter.