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Tax Planning for Business Interest Deductions

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The deduction limitations and special rules are now so numerous, one might even wonder whether we continue to have an income tax. If it is any comfort, even though deduction limitations proliferate, we do find Treasury telling us that we still have an income tax. The limitations on deducting business interest do come up in that discussion of whether we continue to have an income tax.

Jul 18th 2022
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One of the relatively recent deduction limitation rules we find of interest to tax planners is Section 163(j)’s rules now limiting business interest deductions. 

Our topic is not crediting foreign taxes, but one of the concepts there deals with whether the foreign tax is an income tax.  (See T.D. 9959, regulations issued December 28, 2021.)  Here we find such comments as the following:

“Cost recovery requirement replaces net income requirement.  A foreign tax that is based on gross receipts is creditable only if the foreign country provides cost recovery (i.e., deductions) for costs and expenses, including capital expenditures, interest (excluding limitations similar to Code Sec. 163(j)), rents, royalties, wages or payments for services, and research and experimentation. The character of a deduction is determined under foreign law. Foreign tax law satisfies this requirement even when deductions are disallowed for all or a portion of an expense, provided that the disallowance is consistent with principles underlying disallowances required by the Code.”  (“Planning Around Major Changes to the Foreign Tax Credit,” Brandstetter and Grossberg, thomasreuters.com, 5/19/22.)

The foreign country can limit, for example, business interest deductions in a manner similar to the U.S. limitations that we’re about to discuss.

“Observation:  For example, the foreign tax may limit interest deductions so as not to exceed 10% of a reasonable measure of taxable income, based on principles similar to those underlying Code Sec. 163(j).” (Ibid.)

Limitations on business deductions seem to just proliferate in recent times. For example, we find employee business deductions basically nondeductible in 2022 and recent years.  (“Here’s who qualifies for the employee business deduction,” IRS Tax Tip 2020-155, November 16, 2020.)

“The unreimbursed employee expense deductions have been suspended for tax years beginning after 2017, and before 2026, per section 67(g).” (IRS instructions to 2021’s Form 2106.)

While still permitting amortization of research and development that otherwise qualifies as a business expense, we find post-2021 limitations limiting the current deductibility of R&D (Sec. 174(a)).

The Section 163(j) Interest Limitation

The rule usually reaches all types of businesses and taxpayers, limiting the ability of a business to deduct interest only to the extent of 30 percent of adjusted taxable income, roughly earnings before interest, depreciation and amortization. In 2022 (tax years beginning after December 31, 2021), depreciation, amortization and depletion are no longer added back, such that the limitation becomes even more significant. 

The initial rule here was modeled after other countries but the tighter new rule “is set to go beyond other countries beginning in 2022..” (“The Interest Limitation Pile On,” Cody Kallen, Tax Foundation, 12/10/21, taxfoundation.org).

Note generally the thirty-percent rule might seem a surprisingly small figure; i.e., a surprisingly severe limitation given the importance of business interest generally.  In March of 2020, the 30 percent rules were modified to a 50 percent for many taxpayers in 2019 and 2020 by the CARES Act. The provision arose December 22, 2017, as part of the Tax Cuts and Jobs Act. 

When the limitation applies, the expense can carry forward until the business generates Excess Taxable Income in a later year.

The IRS “Basic questions and comments” on our topic can serve as an introduction (See generally “Basic questions and answers about the limitation on the deduction for business interest expense,” IRS.gov, up to Q17 as we write in mid-2022.  See also Form 8990, “Limitation on Business Interest Expense Under Section 163(j),” and its instructions.  The form has sections focused on partnerships and S corporations).

The big exception to the business interest expense limitation relates to small businesses, defined as those having average annual gross receipts for the prior three years of an indexed $25 million.  The indexed amount for 2020 and 2021 was $26 million, with the threshold rising to $27 million in 2022. Measuring the threshold can involve complexities under the related party rules.

Real estate trades and businesses may qualify for an exception from these rules.  When they elect out of these rules, the realty trade or business runs into real estate assets having to be depreciated under ADS, the Alternative Depreciation System. Plus, they forego bonus depreciation and special opt-out elections can also benefit farmers (Sec. 163(j)(7)).

There are detailed rules galore, including adjustments for business interest income, floor plan financing interest expense, special rules for flow-through entities, and rules governing consolidated reporting corporate groups. Treasury was reasonably speedy in guidance, including 575 pages of final regulations, proposed regulations, Notice 2020-59, and its frequently asked questions.  (See KPMG discussion of the section 163(j): “Background and applicability dates for the 163(j) Package,” KPMG Regulations, guidance under section 163(j)).

The complexities include applying section 163(j) in the context of other provisions that also have taxable income limitations:

“Allow any reasonable method, including simultaneous equations, for purposes of determining deductions that are limited by taxable income (e.g., deductions under sections 163(j), 250, and 172). Taxpayers need guidance regarding the coordination of deductions limited by taxable income.”  (Letter to IRS re Notice 2021-28, “RE: Recommendations for the 2021-2022 Guidance Priority List,” Letter by Christopher W. Hess, CPA, Chair, AICPA Tax Executive Committee,  American Institute of Certified Public Accountants, 5/14/21).

In the above, we note section 250 relates to foreign-derived intangible income and global intangible low-taxed income, and section 172 is the net operating loss deduction.

Legislative Perspective – Will There Be Changes?

A change being considered by President Biden is whether to apply Section 163(j) at the partner or shareholder level, rather than the entity level. Also being considered is a five-year carryover of interest disallowed under section 163(j) (“House and Senate Advance President Biden’s Far-Reaching 2021 Tax Changes,”  BakerHostetler Alert,  bakerlaw.com, 9/15/21).

The article later includes a discussion of “Senate Finance Partnership Tax Rule Changes,”:

“Amend the Section 163(j) business interest expense limitation rules to provide that a stricter entity-level approach applies to partnerships and S corporations. Current law, in contrast, requires a hybrid approach. Amended Section 163(j) would apply to taxable years beginning after Dec. 31, 2021.” (Ibid.)

For larger multinationals, there are in President Biden’s “Green Book” proposals further limitations such that the company’s interest deduction could be the lesser of that under section 163(j) or a new provision that could limit the interest deduction to a proportionate share of the entire group’s interest deduction (“Biden Administration’s Green Book Proposes Significant Changes to Tax Regime,” Heller, Hollender, Rizzo, Schockett, Sensenbenner, Spinowitz, and Wood; Skadden Arps et al, 6/15/21, skadden.com).

On the Republican side, we note President Trump signed the legislation originating section 163(j) and its amendment with the CARES Act. So, major relief from the impact of section 163(j) seems unlikely at this juncture, as we write in mid-2022.

According, we need to generally plan for the potential impact of Section 163(j) within the firm’s client base.  As a practical matter, the focus of most CPA/EA practitioners will be on applying the rules to groups with average gross receipts exceeding $27 million, and studying the rules that go into measuring the group.  

Strategies of closely-held ownership may be particularly important when section 163(j) introduces a (relatively) new limitation on the very important business interest deduction.