U.S. Tax Deductibility of Business Interest Expense
Section 163(j) of the Internal Revenue Code (IRC) states that business interest expense includes any interest paid or accrued on indebtedness that is "properly allocable" to a trade or business. In accordance with the Internal Revenue Code, the potential capitalization or general limitation of interest paid or incurred in a trade or business can impact its deductibility.
- Interest Incurred in a Trade or Business
(1)
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General Limitations on Business Interest
In a given taxable year, the deduction for business interest expense for an entity is subject to the sum of business interest income, 30% of adjusted taxable income (ATI) (50% for the years 2019-2020), and floor plan financing interest.
In tax years 2018 to 2021, the deduction for interest expense, after subtracting interest income, is allowable up to a maximum of 30% of taxable earnings before interest, taxes, depreciation, and amortization.
Beginning in 2022, the limitation on deductibility of interest is determined solely by the earnings before interest.
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(2)
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Adjusted Taxable Income (ATI)
The limitation is partially contingent upon the adjusted taxable income (ATI) of the taxpayer, making it imperative to comprehend this concept. For tax years after January 1, 2022, ATI computations will not be adjusted for depreciation, amortization, or depletion.
According to the Internal Revenue Code (IRC), ATI encompasses taxable income that has been modified through various adjustments, such as the exclusion of income, expense, gain, or loss not properly allocable to a trade or business (or allocable to an excepted trade or business).
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(3)
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Floor Plan Financing Interest Expense
Floor plan financing interest refers to the interest paid or accrued on debt incurred to finance the purchase or lease of motor vehicles, which is secured by those motor vehicles. The term "motor vehicles" encompasses various types of vehicles, including cars, boats, and farm equipment. The section effectively allows for the deduction of floor plan financing interest without being subject to the Adjusted Taxable Income (ATI) limitation. However, there is a trade-off, as any property acquired by a trade or business using floor plan financing is generally not eligible for bonus depreciation.
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(4)
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Carryforward of Disallowed Business Interest
In a given taxable year, any business interest expense that is disallowed as a deduction for a specific taxable year can be considered as business interest expense paid or accrued. This provision primarily pertains to C corporations, while partnerships and S corporations are subject to distinct regulations regarding carryforwards.
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- Small Business Exceptions to Limitation on Business Interest
The TCJA and CARES Act replaced the former section 163(j) with a new limitation on the "business interest" of all taxpayers (with certain exceptions). Statutorily, the small business exception is applicable to businesses, excluding certain tax shelters, that meet the gross income test outlined in section 448(c).
(1)
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Business Meeting the Gross Income Test
For taxpayers who are not corporations or partnerships, section 163(j)(3) stipulates that the determination of the gross receipts test for section 163(j) purposes should be made as if the taxpayer were a corporation or partnership.
In accordance with certain aggregation rules, taxpayers are obligated to consolidate the gross income figures of affiliated entities. To satisfy the gross income test, the average annual gross receipts for the three preceding taxable years (prior to the current year) must not exceed $25 million (including any adjustments for inflation as outlined in section 448(c)(4).
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(2)
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Exception for Certain Trade and Business
Section 163(j)(7) contains certain exceptions to the general limitations for select trades or businesses. The definition of "trade or business" would exclude the following:
(a) The trade or business of performing services as an employee
(b) Real property trade or business
(c) Farming business
(d) Certain trades or businesses involving utilities
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- Application of Limitations on Business Interest
(1)
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Application to C Corporation
The application of Section 163(j) to C corporations is relatively uncomplicated in comparison to its application to partnerships and S corporations.
It is important to note that all profit and loss (P&L) items, including interest income and expense, are deemed to be appropriately assignable to a trade or business. However, it is possible for these items to be assigned to certain trades or businesses that are exempted from this general rule.
In accordance with section 163(j)(2), interest that is not permitted is carried forward. The Proposed Regulations designate this carried forward interest as a "disallowed business interest expense carryforward."
In the majority of cases, the Corporate Earnings & Profits (E&P) of C corporations are diminished in the fiscal year in which the business expense is accrued, irrespective of whether the interest is subject to limitations imposed by section 163(j).
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(2)
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Application to Partnership
Section 163(j) is applicable at the entity level, specifically for partnerships. These entities may possess either disqualified interest, which refers to interest that is limited by 163(j) and referred to as "excess business interest," or excess limitation, which pertains to additional adjusted taxable income (ATI) capacity for interest deductions and is generally known as "excess taxable income." Both excess business interest and excess taxable income are allocated to the owners of the entity. Therefore, the limitation to partnership is applicable to:
(a) The election to replace the partnership’s 2020 Adjusted Taxable Income (ATI) with the 2019 ATI through an election process.
(b) The allocation of Excess Business Interest Expenses (EBIE) to a partner during the tax year that starts in 2019.
(c) Adjustments to the partnership’s basis when a partner disposes of their interest.
(d) The treatment of EBIE in partnerships with multiple tiers.
(e) Self-charged lending transactions
(f) Trading partnerships and publicly traded partnerships
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See also：
U.S. Excess Business Loss Limitation Introduction -- Based on TCJA and CARES
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