Joseph Most, J.D.
11.5.21 | Client Alert
Initially included as part of the Tax Cuts and Jobs Act of 2017 (“TCJA”), the current iteration of IRC section 163(j) (“163(j)”) limits the ability of certain businesses to deduct interest expense. Built into the TCJA is a provision that kicks in starting in 2022, which will place an additional restriction on the deductibility of interest expense.
163(j) Primer and Refresher
In general, 163(j) limits the ability of a business to deduct current year Business Interest Expense to the extent of 30% of its Adjusted Taxable Income (“ATI,” which closely mimics EBITA, in this case an earnings before interest, depreciation and amortization concept) plus its Business Interest Income. If there is a limitation in any given year, the limited business interest expense carries forward until the business generates Excess Taxable Income in a future year. All businesses are subject to 163(j) unless they are small businesses (aka an exempt trade or business) or an excepted business (i.e., a real estate trade or business that is allowed to make an election not to be subject to 163(j)).
A small business for 163(j) is a business whose average annual gross receipts for the prior three years is below $25 million, indexed for inflation ($26 million after the indexing in 2020 and 2021). There are complex rules which require certain related businesses to aggregate their gross receipts when making the small business determination. Additionally, if a pass-through entity passes out more than 35% of its loss to limited entrepreneurs (inactive owners), it is subject to 163(j) even though it doesn’t cross the gross receipts threshold.
The TCJA provided a major relief provision for real estate trades or businesses, which were afforded the ability to opt out of being subject to 163(j). However, the cost of making this election is that all real estate assets (including qualified improvement property) must be depreciated under the Alternative Depreciation System (“ADS”) and are not eligible for bonus depreciation.
CARES Act Changes
The Coronavirus Aid, Relief, and Economic Security Act (“CARES” Act) made certain taxpayer-friendly amendments to 163(j) in March 2020 designed to aid businesses adversely impacted by the pandemic. The CARES Act allowed businesses, for 2019 and 2020 only, to use 50%, instead of 30%, of ATI in their 163(j) limitation calculation (for partnerships, this only applied in 2020). The CARES Act also allows businesses to substitute 2019 ATI into their 2020 calculations and automatically freed up 50% of a partnership’s 2019 Excess Business Interest Expense during 2020 only.
No More Depreciation Addback Starting in 2022
Dating back to the TCJA, section 163(j) provides that for tax years starting January 1, 2022, and later, depreciation, amortization, and depletion may no longer be added back to a company’s ATI calculation. Prior to 2022, ATI was similar to an EBITDA concept (except for taxes), causing ATI to equal a company’s operating income before debt service. Now, businesses subject to 163(j) will also have to reduce their ATI by depreciation, amortization, and depletion. Many companies who have not faced a 163(j) limitation since the law went into effect in 2018 may start to see all or part of their business interest expense become non-deductible starting next year.
Businesses that expect to be impacted by the 2022 depreciation change may want to consider accelerating depreciation into 2021. With a little under two months remaining in 2021, if a business plans to place depreciable property into service in early 2022, it should consider whether it is feasible to put the property into service late in 2021. This option is particularly important for property that is eligible for 100% bonus depreciation. Such eligibility would mean that the entire property could be depreciated without affecting any 163(j) computations. Additionally, companies who may, under other circumstances, elect out of the allowance for bonus depreciation may want to consider taking the accelerated depreciation during 2021.
To further complicate matters, proposed legislation may dramatically alter the mechanics of calculating deductible interest expense. As always, Berdon will continue to monitor any potential legislation with tax provisions.
Berdon LLP New York Accountants