Taxpayers filing their tax returns for tax years beginning after December 31, 2017 will need to adhere to the business interest deduction limitation imposed by the Tax Cuts and Jobs Act. The business interest deduction limitation disallows all net business interest expense in excess of 30% of the adjusted taxable income of a business. Any amount subject to this limitation may be carried forward to a future tax year indefinitely until it is able to be applied.
The 30% income limit only applies to net business interest expense based on the respective business’ adjusted taxable income. Net business interest expense is the excess of business interest expense over business interest income. For tax years beginning after December 31, 2017 and before January 1, 2022, adjusted taxable income will be computed with the exclusion of depreciation, amortization, depletion, or business interest expense. For tax years beginning after December 31, 2021, the calculation of adjusted taxable income will be amended to include depreciation, amortization and depletion, but will still exclude business interest expense.
For most entities, business interest income and expenses are limited to interest earned on trade or business accounts and do not include investment interest. However, C Corporations do not differentiate between different interest classifications. For C Corporations, all interest is considered to be business-related when calculating the business interest deduction limitation. This principle applies to any net investment interest income that has been allocated to a C Corporation partner by a partnership.
Deduction rules for other entity structures are more restrictive. Both S corporations and partnerships must first calculate and apply the business interest limitation at the entity level. For S corporations, any disallowed business interest expense shall remain at the S corporation level and not be passed through to shareholders. Any disallowed business interest expense at the partnership level will be passed through to the entity’s partners.
The excess business interest expense allocated to each partner may be carried forward by the respective partner indefinitely until the partnership has allocated sufficient excess taxable income. Partners may not include other sources of income in an attempt to deduct excess business interest from a partnership. The interest expense must only be applied directly against its respective partnership income. Despite being unable to deduct excess business interest expense in a given year, a partner’s basis in a respective partnership will be reduced by the excess interest amount in the year that it is distributed. Comparatively, the application of this carried forward deduction in a future tax year does not reduce the partner’s basis at the time of deduction. Should a partner dispose of their respective partnership interest prior to deducting all excess business interest expense, the unused amount is immediately added back to their partnership basis.
While the business interest deduction limitation applies to nearly all taxpayers, there are several classifications that may exempt a taxpayer from the limitation. Individuals are exempt from the limitation if they are involved in the trade or business of being an employee, certain regulated utilities, and taxpayers operating a real property or farming businesses. This provision was included based on the understanding that real estate and farming businesses will ordinarily require a greater amount of leverage for the purpose of asset acquisition than other business types. This exemption is not automatically granted to these taxpayers and they must elect to be exempt from the business interest limitation; although once the election is made, the choice cannot be revoked.
Businesses electing exemption from the business interest limitation are required to use the alternative depreciation system (ADS) for depreciating any non-residential, residential rental, and qualified improvement property. ADS must be applied to all newly acquired property with a recovery period of at least 10 years. Under ADS, property must be depreciated using longer useful lives over a straight-line basis. This method results in a longer period to write-off property acquired than under the general depreciation system due in part to the fact that bonus depreciation may not be applied.
Additionally, taxpayers are automatically exempt from the business interest deduction limitation if they qualify as a small business. A taxpayer qualifies as a small business if their average annual gross receipts for the three prior tax years are less than $25 million. The calculation of a business’s receipts must include all receipts from related parties. The $25 million small business designation will be adjusted annually for inflation beginning in tax year 2019.
For more information regarding the business interest deduction limitation, as well as additional tax planning strategies, contact Aronson’s Construction Industry Services Group at 301.231.6200.