Tax Reform Series #2: Limitations on Business Interest

This week’s alert discusses the Tax Cuts and Jobs Act’s broad limitations imposed on the deductibility of business interest expense.

Previously, only interest deductions of C-corporations were limited in situations where the income was not being taxed by the recipient and where it exceeded 50% of adjusted taxable income. The rules rarely caused a deduction limitation for most corporations. The Tax Cuts & Jobs Act (TCJA) of 2017 restricts business interest deductions of far more taxpayers.

• All business types are subject to the new rules, but there are some important exclusions.
• Any business under $25 million of average gross receipts over three years will be excluded from the rules.
• Regulated utilities are excluded.
• Real estate and farming trades or businesses may elect out of the rules if they forego bonus depreciation deductions for the year. 

How is the limitation determined?

The business interest expense may not exceed the sum of business interest income (as opposed to investment income), PLUS 30% of Adjusted Taxable Income (ATI), and the amount of floor plan financing interest expense incurred for the year. So what adjustments from taxable income are used to get to ATI?

+ Business interest expense
+ Net Operating Losses (NOLs)
– items of non-business income or + losses
+ New 20% Qualified Business Income deduction
+ Depreciation, Amortization and Depletion (through 2021 only)

The business interest limitation applies to pass-through entities (PTE) such as partnerships and S-corporation at the entity level. Each owner’s adjusted taxable income is determined without regard to his/her share of the PTE’s income. The rule is intended to prevent double-counting.

• Example, if a PTE owner has business interest, his/her limitation is generally based on his/her own income and does not include income from the PTE.

If the PTE has what is termed “excess income” that would have allowed it to deduct more interest, that excess allowance flows up to the PTE’s owners. The “excess income” allows the owner to deduct more business interest expense.

Any interest expense over the limitation for the year carries over to subsequent years without expiration. Special rules apply for interest carried over at the pass-through level so that those carryovers may not be used unless the generating PTE has “excess income” in a subsequent year.

This limitation will not affect 2017 tax returns, but taxpayers need to take steps now to make sure they are not blindsided with their 2018 tax return.

We’re here to help you better understand this business interest limitation and determine the impact to your business. Contact us to discuss this limitation or any other provisions of the TCJA of 2017.