The newly-enacted Tax Cuts and Jobs Act (TCJA) introduced rules that potentially limit the deductibility of business interest expense. Previously, these amounts were fully deductible (except for some limitations on payments of interest by corporations to foreign related parties). The new rules are far reaching, and all taxpayers who incur business debt will need to be cognizant of their mechanics and effect on P&L. The statutory language, codified in §163(j), lays out the general rules and their application, but there remain unanswered questions that the Treasury Department will need to address in subsequent guidance. This Alert will provide a detailed explanation of the new law, including its ambiguities. As the government issues regulations or additional guidance, we will provide updates.
As enacted by the TCJA, net interest expense is now limited to 30% of a taxpayer’s Adjusted Taxable Income. The rule applies to taxpayers with average gross receipts over $25 million and becomes effective in the 2018 tax year. This permanent rule (no sunset provision) appears to include an aggregation of gross receipts among taxpayers under common control. Thus, entities below the $25 million threshold may still be subject to this limitation based on other entity ownership of its owners.
Net interest expense for limitation purposes is defined as interest expense less business interest income. Business interest income is a narrow category, and excludes, for example, bank account interest earned on the deposit of working capital. This limitation does not include investment interest expense (incurred to buy stocks, bonds, etc.), or interest expense on debt financed distributions from partnerships, which needs to be traced at the taxpayer level (though the limitation might be applied there, depending on how the taxpayer uses the distributed funds). The limitation also does not apply to capitalized interest (typically incurred during a construction period).
Adjusted Taxable Income is net income, adding back any net operating loss (NOL), and (for years through 2021) depreciation, amortization, and depletion. As a result of this depreciation, amortization, and depletion addback being removed, taxpayers will be able to deduct more interest expense in the earlier years than post-2021.
Here is a basic example:
EBITDA of $1,500,000
$500k interest expense
Net income = $500k
Before 2022, the Adjusted Taxable Income is $1,500,000, for an allowable interest deduction of $450k and a carryover of disallowed interest expense of $50k. Starting in 2022, Adjusted Taxable Income is 1,000,000 (net income of $500k with addback for $500k of interest expense), for an allowable deduction of $300k, with a $200k carryover.
For taxable entities which require income tax accruals this rule causes a circular calculation since Adjusted Taxable Income takes into account any deduction for state taxes, yet accrual of state taxes is dependent on overall taxable income.
In general, any interest expense not allowed in a given year is carried forward indefinitely and treated as paid in the subsequent year, subject to the same limitation computation. However, for partnership and tiered entities the carryover provisions are more complex, and are explained in detail below.
Opt Out Rules
Real property trades or businesses (as already defined in Internal Revenue Code under the real estate professional rules) are able to elect out of the interest expense limitation. The Conference Committee Report clarifies that hotels and lodging facilities are real property businesses for this purpose. In exchange for being able to opt out, these entities must use the Alternative Depreciation System (ADS) for their real property assets. ADS "lives" are slightly longer than under the General Depreciation System (GDS) (40 vs. 39 for commercial, 30 vs. 27.5 for residential, 20 vs. 15 for improvements). Additionally, under ADS, a taxpayer must forego bonus depreciation on the ADS assets, which under the TCJA has been increased to 100% through 2022 and is allowed on Qualified Improvement Property. Tangible personal property is not required to be depreciated using ADS, so a taxpayer can still utilize the 100% bonus allowance on those assets.
The law does not address whether old assets will need to be changed to the ADS system with a §481(a) adjustment to income (under which the IRS allows taxpayers to spread out the excess depreciation recapture over four years), or whether electing taxpayers can use a “cut-off” method and depreciate the net tax basis over the remaining ADS life. For real estate owners who have taken extensive amounts of bonus depreciation in the past on tenant improvements, a requirement to bring all their assets onto ADS with a §481(a) adjustment could mean a sizeable depreciation recapture.
Taxpayers who qualify to opt out should calculate if their interest deductions would be limited under the general rule, and if so, should model how their taxable income would be affected by opting out of the interest limitation rules in exchange for depreciation deductions that are not as generous as they would otherwise be entitled to. Property owners who are moderately-to- highly leveraged will likely choose to opt out, even if they are required to recapture through a §481(a) adjustment some of the depreciation previously taken. It may mean that they will have higher income in the initial few years, but less income over time, especially after a potential §481(a) adjustment burns off.
On the other hand, taxpayers with less debt may decide they are willing to accept a limitation on the deductibility of their interest expense and therefore claim more accelerated depreciation, especially because the new law made GDS depreciation more accelerated than it previously was in a few different ways. The depreciable life for Qualified Building Improvement assets was decreased from 39 years to 15 years, and these assets qualify for the new 100% bonus depreciation rate. So for taxpayers with large amounts of Qualified Building Improvements (which encompasses Tenant Improvements), it may be worthwhile to accept the limit on interest expense in exchange for being able to immediately write off these assets as they are placed in service.
The decision of whether a qualifying taxpayer should opt out of the default interest limitation rules is highly fact-dependent, and each taxpayer will need to determine what is most beneficial for them.
Application to Partnerships
The limitation on current interest expense is applied at the operating entity level, and any allowable deduction is included in the non-separately stated income or loss on each partner’s Form K-1. However, any disallowed interest will flow up to the partners and will be carried forward at the partner level. Partnerships subject to the §163(j) rules will need to report to their partners whether they have either excess business interest (interest expense that is not able to be deducted by the partnership) or excess business income (the capacity to deduct additional interest expense if it were incurred). A partnership with excess income following a year or years of limitation will then pass that out to its partners, thus ‘liberating’ the interest expense carryover to that extent. This will represent a significant increase in the quantity of information being reported to partners.
In year 1, a partnership has income of $100, and its only expense is interest of $40. The partnership is allowed a deduction of $30 to be included in the non-separately stated distributive share of the partners. The remaining $10 is reported to the partners as excess business interest, which they can potentially deduct in subsequent years against excess business income.
In year 2, the partnership still has income of $100, but now incurs interest expense of only $20. The full $20 is deductible by the partnership, and the partnership could deduct up to 10 more of interest if it were incurred. The partnership reports this excess capacity to its partners, which allows them to deduct $10 more of interest expense -- in this case, the amount carried over from the preceding year.
When a taxpayer is allocated excess business income from a partnership, it first goes towards freeing up any previously disallowed excess interest expense from that partnership. If there is no excess interest expense from prior years, then it appears that the excess business income can be used to support a deduction of interest incurred at the partner level (for example, interest on a debt incurred to acquire that partnership interest, or interest on a separate wholly-owned activity of the partner), but not any excess interest expense from other partnerships owned by the partner.
This partnership “silo“ treatment may cause differing results for property owned through a partnership versus outright or in a tenancy-in-common. Accordingly, it may be advantageous for taxpayers to restructure certain business operations to optimize their ability to utilize interest expense while limiting any negative effects of longer depreciation and foregoing bonus depreciation on certain assets.
Application to Tiered Entities
The application of these rules to tiered entities is one area where the Treasury will need to issue further guidance in the form of regulations, as there are a number of significant ambiguities.
First, when there are multiple partnerships in a tiered structure, it is unclear whether excess business interest or income gets reported all the way up the chain to the ultimate taxpayer, or if it gets ‘trapped’ one level above the partnership that incurs the debt.
Second, if there is debt on the books of multiple tiered entities, and the operating entity is a real property trade or business that elects out of the limitation rules, it is unclear whether that election out can be imputed to the upper tiers, allowing the upper tier entities to fully deduct their interest expense. If the upper tier entities were not able to either separately elect out or take advantage of the bottom tier’s election out, then it would appear that the upper tier could not deduct any interest expense, as it would have no Adjusted Taxable Income of its own, and no excess business income allocated from lower tiers.
The New Playing Field
These new rules represent a significant change from prior law, and will place a compliance burden on taxpayers, who will need to calculate any limitation and carryforward, and whether opting out of the rules makes sense for eligible taxpayers. In addition, pass through entities will need to report a number of additional items to their owners each year they have business interest expense.
New §163(j) is certain to impact new business formation and their financing sources. The rules have not been well publicized and the business community may be surprised by their reach, affecting extant indebtedness and virtually all businesses. Existing businesses will need to review their capital structures for possible modification as well. Moreover, guidance from the Treasury is needed on a number of issues so taxpayers can have certainty on how these rules work in all contexts.
Berdon LLP New York Accountants