Thea Kruger, J.D., LL.M. and Nastassia Koyfman, J.D., LL.M.
4.2.20 | Client Alert – COVID-19
The CARES Act (Coronavirus Aid, Relief, and Economic Security Act) contains many favorable tax changes aiming at helping both businesses and individuals. One particularly favorable tax change affecting the business community is a relaxation of the limits on the deductibility of business interest expense for the 2019 and 2020 tax years.
The existing law, enacted in the 2017 Tax Cuts & Jobs Act (TCJA), limits the amount of deductible business interest expense for tax years beginning after December 31, 2017 to the sum of business interest income, 30% of the taxpayer’s adjusted taxable income (ATI) and floor plan financing interest. The limitation does not apply to small business taxpayers (taxpayers whose average annual gross receipts for the preceding 3 years are $26mil or below, unless the taxpayer is a tax shelter, as defined in those rules). ATI is defined as the taxpayer’s taxable income, with certain adjustments: interest expense is added back, as is depreciation & amortization (only through January 1, 2022) and nonbusiness income or loss is subtracted or added back as appropriate. Real estate businesses are able to elect out of this rule, the consequence of which is to accept longer depreciation schedules for depreciable real estate assets.
Interest expense disallowed in one year is carried over and may be deductible in a future year, if the business generates sufficient ATI. (See: New Business Interest Expense Deduction Limitation is a Game Changer from 1.25.18)
Due to the TCJA, many businesses with moderate to high amounts of leverage found themselves unable to deduct all or a portion of their interest expense, which previously had been fully deductible without limitation.
General Rule Under the CARES Act
The CARES Act retroactively increases the limitation of deductible business interest expense from 30% to 50% of ATI for tax years 2019 and 2020, unless the taxpayer elects to not have the rule apply. In addition, for 2020, a taxpayer may elect to calculate the 2020 50% limitation using 2019 ATI. This election may produce a higher business interest deduction, as many businesses will have reduced income in 2020 due to the coronavirus pandemic (COVID-19).
In addition, the CARES Act is favorable to taxpayers with a short 2019 tax year (i.e. the 2019 tax year was shorter than 12 months). If a taxpayer elects to use 2019 ATI in 2020 for purposes of the limitation, the taxpayer can gross up the 2019 ATI based on the number of months in the 2019 short tax year.
Example: In 2019, a taxpayer had a 3-month tax year and ATI of $300. For 2020, the taxpayer could use $1,200 as deemed 2019 ATI ($300 2019 short-year ATI)/3 in 2019 for the short year) *12 (the gross up)). Hence, business interest expense up to $600 can be deducted for the 2020 taxable year.
Application to Partnerships and Partners
A partnership is not eligible for the limitation increase from 30% to 50% of ATI for 2019, but is in 2020. As such, a partnership must apply the existing 30% limitation for the 2019 taxable year. Any disallowed business interest expense is passed out to the partners and is suspended at the partner level under TCJA rules. However, favorable tax treatment is available in 2020. If a partnership had disallowed business interest expense in 2019 (i.e., allocated ‘excess business interest expense’ to its partners), 50% of the suspended excess business interest expense from tax year 2019 “frees up” and is fully deductible at the partner level on the partner’s 2020 tax return.
This treatment is automatic, unless a partner elects on a 2020 tax return for this provision not to apply. The remaining 50% of 2019 suspended business interest expense remains suspended until the partnership generates excess taxable income or excess interest income and passes it to a partner. A partnership electing to use its 2019 ATI to compute its 2020 interest expense limitation can potentially enjoy a higher ATI and a higher business interest expense deduction, benefitting the partners in addition to the special allowance of a deduction for 50% of any 2019 disallowance.
Example: In 2019, Partnership A has ATI of $100, and incurs interest expense of $40. Partnership A may deduct 30%, or $30 of interest against its other 2019 income. The remaining $10 of interest expense is suspended at the partner level. In 2020, the partner may deduct $5 of that $10 without further testing or limitation.
If Partnership A’s ATI in 2020 is $0 (or even a loss), it may elect to use $100 as 2020 ATI, and deduct up to $50 of interest expense in 2020 in addition to the $5 from the 2019 limitation.
Real Property Trades or Businesses
Many taxpayers engaged in real property trades or businesses made an election in 2018 to ‘opt out’ of the 163(j) limitations. These taxpayers were able to deduct 100% of their business interest expense, but at the cost of using longer depreciable lives for their real estate assets. This opt out election is a one-time, irrevocable election, and, absent regulatory dispensation, these taxpayers are bound by it as the CARES Act does not provide an option to revoke this election. Therefore, these taxpayers are still able to deduct all their interest expense and are unaffected by the CARES Act’s changes to section 163(j). For additional insight, see CARES Act Designates Qualified Improvement Property (QIP), which discusses the legislative correction to the TCJA made in the CARES Act to the treatment of qualified improvement property which interacts with this opt out election.
For more information on this topic or any other matter related to the COVID-19 pandemic, please contact your Berdon advisor and visit Berdon’s COVID-19 Information Center.
Berdon LLP, New York Accountants