Deductability of Business Interest Expensesby
The relatively new rules for business interest expenses may require filing Form 8990. The form’s Part II deals with partnerships and its Part III deals with S corporations.
Seasoned tax professionals still have to adjust to the basic idea that current period business interest expenses may have limited deductibility. The concept arose with the Tax Cuts and Jobs Act of 2017 and then was amended in the CARES Act as to taxable years beginning after December 31, 2018.
Generally speaking, business interest expenses in excess of business interest income may run into limitations as it exceeds 30 percent of the taxpayer’s adjusted taxable income (ATI). As amended by the CARES Act, the 30 percent is 50 percent for 2019 and 2020. Clients can elect to use their 2019 ATI in computing the 2020 limit. Taxpayers are permitted to apply the more restrictive 30 percent-of-adjusted-taxable-income limit.
Under the CARES Act, for partnerships, the increase to 50 percent of ATI applies only to taxable years beginning in 2020. For corporations, including S corporations, the increase to 50 percent of ATI applies to taxable years beginning in 2019 or 2020.
Old Debt Isn’t Excepted From These Rules
There is smaller taxpayer relief from this limitation which asks if average gross receipts in the prior three years have averaged more than $25 million. As adjusted for inflation, the $25 million is $26 million in 2019 and 2020.
Proliferating entities may be disregarded when the purpose is avoiding these rules (Regs. 1.163(j)-2(j)). The anti-avoidance rules reach the use of lower-tier partnerships to avoid the rules.
This exemption doesn’t apply to “tax shelters,” generally defined as other than a C corporation if more than 35 percent of the losses are allocable to limited partners or limited entrepreneurs, those not active in management.
Relief is also provided to farmers and real estate businesses via an election which brings into play lesser depreciation deductions. There is another exception for floor plan financing which focuses on cars, boats, farm machinery. Generally, interest expense that encounters such limitation is treated as business interest expense in the following year.
Increased limitation for interest deductions is on its way for some taxpayers. For tax years beginning after 2017 and before 2022, the basic limitation focus – “adjusted taxable income” – is computed without regard to deductions for depreciation, depletion, amortization, or business interest expense. For taxable years beginning after 2021, adjusted taxable income is reduced by depreciation and amortization but not business interest expense.
A partnership or S corporation may be below the level of limitation and have “excess taxable income” that can flow through to help the partner or shareholder. The partner or shareholder can use “excess taxable income” in computing their own adjusted taxable income for the year.
For S corporations, if there is disallowed business interest expense, such amount carries over to the following year of the S corporation to be treated as additional interest in such year. Since not a current deduction, the disallowed interest expense of the S corporation doesn’t reduce the shareholder’s basis in the S stock (See instructions to 2020’s Form 1120-S, K-1, instructions AA and AB).
Partnership business interest expense that is less than or equal to the limitation is computed at the entity level and flows through as a deduction to the partners. It isn’t tested a second time at the partner level.
For partnerships, any disallowed interest expense (“excess business interest”) passes through to the partners and does not carry to the next year. Such excess business interest is treated as business interest of the partner in the next succeeding year in which the partner is allocated excess taxable income from such partnership.
The partner can consider such excess business interest to the extent of excess taxable income from that partnership. Excess business interest passes through to the partner and reduces the partner’s basis in the partnership interest (See instructions to 2020’s Form 1065, K-1, instructions Codes K, AE, and AF).
Excess taxable income and excess business interest income or expenses are generally allocated to each partner in the same manner as non-separately stated income. This is generally enacted via an 11-step calculation on Form 8990 unless all Section 163(j) items are allocated proportionately.
Among the complexities that can arise are allocations of interest expense when there are multiple businesses in the same entity, only some of which are subject to the Section 163(j) limitations, and partnerships making debt-financed distributions.
In general, the work added by these rules may be disproportionate to the actual tax impact. One of the practical considerations is that tax professionals may need to apprise clients of added fees due to the complexities. Moreover, the business interest expense deduction has become more complicated.
Mike Pusey, CPA served as National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in...