The IRS released proposed regulations to provide taxpayers with guidance on applying a tax reform provision related to business interest expense deductions. The 2017 tax law commonly known as the Tax Cuts and Jobs Act (TCJA) set new limits on business interest expense deductions for most businesses, including C corporations and partnerships.
Taxpayers are required to apply the limitation in tax years beginning after Dec. 31, 2017, but several provisions had been unclear, including:
- The definition of interest and business interest for purposes of the limitation
- The mechanics of calculating the interest expense limitation
- How the limitation applies to corporations and consolidated groups
- How partnerships, S corporations, and their owners apply the limitation
- How the limitation applies to foreign corporations with U.S. partners or shareholders
The proposed regulations clarify how taxpayers calculate and apply the limitation, though some questions remain unanswered. The IRS also released a draft of new Form 8990, Limitation on Business Interest Expense Under Sec. 163(j), but has not yet provided instructions to this form.
Refresher on the Business Interest Expense Limitation
The TCJA modified Internal Revenue Code (IRC) Section 163(j) and set limits on deductions for business interest expense to interest income plus 30 percent of the taxpayer’s adjusted taxable income (essentially EBITDA through 2021, thereafter EBIT). Business interest expense in excess of the new limit can be carried forward indefinitely.
The modifications to Section 163(j) apply to most types of taxpayers, except for certain trades or businesses and certain activities. Businesses exempt from the Section 163(j) business interest limitation include taxpayers with average annual gross receipts under $25 million for the prior three years, though certain aggregation rules and exceptions apply. One notable, but easily overlooked, provision is that taxpayers considered “tax shelters” cannot use the $25 million gross receipts exception to escape the new interest expense deduction limitation. The definition of “tax shelters” used for purposes of the interest expense deduction limitation is quite broad and includes, among others, any partnership if more than 35 percent of the losses of the entity during the tax year are allocable to limited partners or limited entrepreneurs.
Real trade or property businesses, including farming businesses, can elect out of the deduction but they must give up their right to bonus depreciation and Section 179 deductions and instead depreciate property using a straight-line method over a longer period than under the typical depreciation rules. Regulated utility companies are also not considered a trade or business subject to the business interest limitation. A separate notice, IRS Revenue Procedure 2018-59, was issued previously and will permit qualifying infrastructure businesses to elect to be a real property trade or business, and therefore be exempt from the Section 163(j) limitation.
In the proposed regulations, the IRS offers more precise definitions of certain key terms, including what constitutes interest under the provision, adjusted taxable income, business interest expense and applicable trade or business.
The proposed regulations’ definition of business interest is very broad and includes both items that are treated as interest under other federal income tax provisions, as well as items that are closely related to business interest and affect the economic yield or cost of funds of a transaction involving interest, including:
- Substitute interest payments
- Certain debt issuance costs
- Certain commitment fees
- Guaranteed payments for the use of capital
- Income, deductions, gains or losses from derivatives or transactions used to hedge an interest-bearing asset or liability
The regulation also includes an anti-avoidance rule requiring that amounts incurred in a transaction that would otherwise be a deductible expense or loss would be re-characterized as interest expense if they are incurred in a transaction pursuant to which the taxpayer is securing the use of funds for a period of time, and these amounts are predominantly consideration for the time value of money.
The proposed regulations offer rules that prescribe the mechanics of the calculation of the limitation. The IRS affirms that the business interest limitation kicks in only after other IRC provisions that disallow, defer, capitalize or otherwise limit business interests. It also provides specific rules for how C corporations, C corporations that are partners in a pass-through entity, Real Estate Investments Trusts (REITs), tax-exempt corporations, consolidated groups, pass-through entities and their partners, and foreign corporations apply the limitation.
The proposed regulations confirm prior administrative guidance released in April 2018, and provide that a C corporation’s interest income and expense will be deemed to be business interest subject to the interest expense limitation unless it is specifically carved out from the new provision. This also applies where a C corporation is a partner in a partnership that allocates investment interest income and expense to its corporate partner.
Corporate partners need to be mindful of the aggregation rules that apply when determining whether a taxpayer is exempt from the new interest expense limitation under the $25 million gross receipts test. The aggregation rules require that partners in a partnership take into account their share of the partnership’s gross receipts when determining their gross receipts for purposes of this test.
The proposed regulations further discuss the impact of disallowed business interest expense on the earnings and profits (E&P) of a C corporation and provide that the disallowance and carryforward of business interest expense would not affect whether or when such interest expense reduces the corporation’s E&P. This is consistent with the general principles of calculating E&P, which is meant to reflect a corporation’s economic ability to make dividend distributions to its shareholders.
A consolidated group will be considered to have a single Section 163(j) business interest limitation. All members of the consolidated group would be treated as one taxpayer when determining which business interests would be subject to the limitation. Intercompany transfers and other consolidated group transactions would be excluded. Any transfers of partnership interests within the consolidated group in which the partnership is not terminated will be treated as a disposition.
The proposed regulations clarify the application of the member stock basis investment adjustment, and how Section 250(a)(1) adjustments affect the business interest limitation.
The proposed regulations affirm that the Section 163(j) business interest limitation applies to controlled foreign corporations (CFCs) and the partnerships they own. Thus, CFCs with business interest expense will have to apply the rules of Section 163(j) when computing Subpart F income, tested income for Global Intangible Low Tax Income (GILTI) purposes, and income that is effectively connected with the conduct of a U.S. trade or business. In the proposed regulations, the IRS provides guidance on an alternative method that qualifying CFCs can use to apply the limitation. Detailed examples that illustrate the application of the business interest expense limitation to CFCs are included in the proposed regulations as well.
The business interest limitation applies both at the partner level and the partnership level. The limitation is first calculated at the partnership level. The proposed regulations then outline an 11-step process to allocate the partnership’s adjusted taxable income, deductible and excess partnership interest expense, and business interest income to its partners.
Deductible business interest expense of the partnership retains that character at the partner level, even if the partner does not materially participate in the trade of business of the partnership. Similarly, deductible and excess business interest expense retain their character as either passive or non-passive at the partner level.
One of the questions that came about from the initial TCJA language is the effect the revised Section 163(j) business interest expense limitation would have on other partner-specific adjustments to partnership adjusted taxable income. The proposed regulations clarify that Section 734(b) adjustments to partnership property are included in the calculation of the partnership’s adjusted taxable income. Partner-specific basis adjustments, such as Section 743(b) adjustments and Section 704(c)(1) amounts, instead are considered in the calculation of a partner’s adjusted taxable income.
Carryforwards of partnership business interest expense that exceed the deduction limitation at the partnership level (excess business interest (EBI)) are only permitted at the partner level. Partners take their share of the partnership’s EBI as a tax attribute, which is allocated to each partner in the same way as the partnership’s non-separately stated taxable income or loss.
Unless they qualify for the small business exemption, partners can only take deductions for their share of the partnership’s EBI in succeeding years if they have excess taxable income (ETI) or excess business interest income (EBII) from the same partnership allocated to them in that tax year. EBI from a partnership cannot be used to offset taxable income from other sources. However, ETI and EBII from a partnership can be used in the partners’ own interest expense limitation calculation to offset business interest expense from non-partnership sources.
The provisions of the proposed regulations on the business interest limitation will take effect prospectively, starting in the tax year that ends after the date the regulations are finalized in the Federal Register. Taxpayers may elect to apply these proposed regulations in tax years beginning after Dec. 31, 2017, provided that they and their related parties apply these regulations consistently.
The proposed regulations provide much needed clarity on a variety of issues that arose with the enactment of the new business interest expense limitation, but still leave some questions unanswered. The treatment of the excess business interest expense in tiered partnerships, in partnership mergers and divisions, and in lending transactions between a partner and a partnership has been reserved in the proposed regulations.
Businesses need to carefully consider the application of the small business exemption to the entities in their structure and whether the exemption is available to partnerships considered tax shelters under the proposed rules.
The complexity of the proposed mechanism to calculate the business interest expense limitation at the partner level requires partnerships to make extensive disclosures to their partners. Businesses operating as partnerships should evaluate their disclosure requirements and begin conversations with their portfolio investments to ensure that the required information will be available in time for the issuance of the funds’ Schedule K-1s.
For more information on the clarifications to business interests, please contact us.