Section 163(j) was enacted as part of the Tax Cuts and Jobs Act (TCJA) and temporarily modified by the Coronavirus Aid, Relief and Economic Security Act (CARES Act). This article provides a high-level summary of the new regulations with a focus on how they impact the financial services industry.
The Final Regulations provide rules for the CARES Act provisions that expand the section 163(j) limitation from 30% to 50% of adjusted taxable income (ATI) for taxable years beginning in 2019 and 2020. Taxpayers are automatically subject to the 50% limitation, unless they elect out of it. The CARES Act also permits a taxpayer to elect to use its 2019 ATI (in lieu of its 2020 ATI) in determining the amount of its 2020 section 163(j) limitation.
The 2018 proposed regulations would have provided that interest expense of a partnership engaged in non-passive activities under section 469, such as trading activities, is subject to section 163(j) at the partnership level, even if the interest expense also would be subject to limitation under section 163(d) as investment interest expense at the partner level for certain non-materially participating partners. The New Proposed Regulations would require a trading partnership to bifurcate its interest expense from a trading activity between partners that materially participate in the trading activity and partners that are passive investors (as determined under section 469), and would be subject to section 163(j) at the partnership level only the portion of the interest expense that is allocable to the materially-participating partners. This will cause an increased recordkeeping burden on partnerships with both active and passive partners.
The IRS released FAQs to provide an overview of the aggregation rules that apply for purposes of the gross receipts test under section 448(c) to help determine whether a taxpayer meets the small business exemption under section 163(j). Taxpayers (other than tax shelters) with average annual gross receipts of $26 million or less for the three prior tax years are wholly exempt from the section 163(j) limitation. This represents an expansion of the small business exemption from the 2018 Proposed Regulations.
The Final Regulations provide that if a partner or shareholder is allocated business interest expense from an exempt entity, such business interest expense is not also subject to the limitation at the partner level. The Final Regulations clarify that the gross receipts test under section 448(c) is applied as though the taxpayer were a partnership or a corporation, but the aggregation rules under section 448(c) are applied in accordance with the taxpayer’s actual entity status. The gross receipts test requires aggregation for partnerships if they owns 50% or more of another corporation or partnership. The aggregation rules combine the gross receipts of multiple taxpayers as if they are treated as a single employer.
The treatment of excess business interest expense (EBIE) in tiered partnerships was not addressed in the 2018 Proposed Regulations and has now been addressed in the New Proposed Regulations and is out to the industry for comments. Without prior guidance, the industry practice was to take either an “aggregate approach” or an “entity approach” to account for EBIE in tiered partnerships. The New Proposed Regulations would take an entity approach to tiered partnerships by providing that if a lower-tier partnership allocates EBIE to an upper-tier partnership, the EBIE is carried forward by the upper-tier partnership (rather than to the upper-tier partnership’s partners), and basis reduction occurs only in the upper-tier partnership’s basis in the lower-tier partnership (and not in the basis of the partners in the upper-tier partnership). With no acknowledgement or guidance on how to account for this change, comments are expected for the transition from an aggregate approach whereby EBIE is allocated to the partners of the upper-tier partnership, to an entity approach for entities that have limitations outstanding.
Many commenters noted the complexity of the eleven-step process for allocation of EBIE and excess taxable income (ETI) and urged the IRS to allow taxpayers to rely on a simpler alternative method. The IRS generally rejected these comments, and thus the Final Regulations provide that such items must be allocated in accordance with the eleven-step process. Although complex, this approach attempts to preserve the entity-level calculation required in section 163(j)(4) while also preserving the economics of the partnership, including respecting any special allocations made in accordance with section 704(b) and its regulations. For partnerships that allocate all items of income and expense on a pro rata basis (i.e., the pro rata exception), the Final Regulations provide an exception from steps 3 through 11 of the 11-step approach because these partnerships by nature “do not make the kinds of allocations the 11-step calculation is designed to address.” Instead, these partnerships must allocate all section 163(j) items in step 2 proportionately.
A narrower definition of interest means fewer items are subject to the limitation in section 163(j), so a larger business interest expense deduction may be allowed. The Final Regulations remove a number of the more problematic items from the overbroad definition of interest in the 2018 Proposed Regulations. The Final Regulations and New Proposed Regulations narrow the definition on the following topics.
Favorable modifications include a narrowed definition of interest expense and the section 263A addback; unfavorable modifications include expanded anti-avoidance rules and treatment of premiums upon deemed satisfaction/reissuance of debt as interest.