Effective 2018, there will be a limitation on the deduction of business interest. Under this limitation, the deduction allowed for business interest for any tax year cannot exceed the sum of:
- the taxpayer’s “business interest income” for the tax year;
- 30% of the taxpayer’s adjusted taxable income for the tax year [i]; plus
- the taxpayer’s floor plan financing interest for the tax year [ii].
“Business interest” is considered any interest paid or accrued on indebtedness properly allocable to a trade or business. Further, any amount treated as “interest” under the Internal Revenue Code is interest for purposes of the business interest limitation. “Business interest” does not include investment interest within the meaning of Code Section 163(d).
“Business interest income” means the amount of interest that can be included in the taxpayer’s gross income for the tax year that’s properly allocable to a trade or business. The term does not include investment interest within the meaning of Code Sec. 163(d).
Because the business interest limitation ties the amount of deductible business interest to the taxpayer’s adjusted taxable income, it can hurt a business that has had an unsuccessful year. The reduction in the taxpayer’s adjusted taxable income in the off-year will reduce the amount of interest that the taxpayer can deduct in that year. This effect is partly, but not fully, mitigated by the carryforward of disallowed interest. More specifically, any business interest that is not deductible because of the business interest limitation is treated as business interest paid or accrued in the following tax year and may be carried forward indefinitely (subject to the restrictions applicable to partnerships [iii]).
The business interest limitation applies at the taxpayer level (i.e. at the corporate level for C corporations, and at the partner/shareholder level for partnerships and S corporations, respectively). For an affiliated group of corporations that file a consolidated return, it applies at the consolidated tax return filing level.
Example
For 2018, Corporation X has the following items:
- $100,000 of adjusted taxable income;
- $2,000 of business interest income;
- $12,000 of business interest expense; and
- No floor plan financing interest.
X can deduct all $12,000 of its business interest expense, because that amount is less than its $2,000 of business interest income plus 30% of its adjusted taxable income (30% × $100,000 = $30,000).
Variation
For 2019, the same Corporation X has the following items:
- ($20,000) of adjusted taxable income;
- $2,000 of business interest income;
- $12,000 of business interest expense; and
- No floor plan financing interest.
Since X’s adjusted taxable income is negative, it is deemed to be zero for purposes of the business interest limitation. Thus, X can only deduct $2,000 of its business interest but can carry forward the $10,000 of disallowed interest indefinitely.
Small Business Exception
The business interest limitation will not apply to a taxpayer for any taxable year if the taxpayer’s average annual gross receipts for the three preceding tax years does not exceed $25 million dollars (this is the gross receipts test of Code Section 448(c)).
For a taxpayer that is not a corporation or a partnership (i.e., a sole proprietorship), the gross receipts test is applied as if the taxpayer were a corporation or partnership.
The small business exception does not apply to tax shelters that are prohibited from using the cash method of accounting under Code Sec. 448(a)(3).
Other Business Interest Exceptions
For purposes of the business interest limitation, the term “trade or business” does not include the trade or business of performing services as an employee, any electing real property trade or business, any electing farming business, and certain trades or businesses of regulated utilities.
contact your Withum professional to discuss your individual facts and the mechanics of this limitation as applied to your specific situation.
- [i] 30% of the taxpayer’s adjusted taxable income for the year cannot be less than zero.
- [ii] Floor plan financing interest is fully deductible under the new law. “Floor plan financing interest” means the interest paid or accrued on floor plan financing indebtedness. “Floor plan financing indebtedness” means indebtedness (i) used to finance the acquisition of motor vehicles held for sale or lease, and (ii) secured by the inventory so acquired.
- [iii] “Carryforward of disallowed interest” does not apply to partnerships, and business interest that is not deductible because of the business interest limitation is instead treated as excess business interest that is allocated to each partner in the same manner as the partnership’s non-separately stated taxable income or loss; see Code Section 163(j)(4)(B)(i)(II).
Author:CJ Stroh, Esq | [email protected]
