What Is the Limitation on Business Interest Expense Deductions?

November 28, 2023
What Is the Limitation on Business Interest Expense Deductions?

A taxpayer may deduct interest paid or accrued within a tax year on a valid debt, but IRC §163(j) limits the business interest expense amount allowed as a deduction. The Tax Cuts and Jobs Act of 2017 (TCJA) significantly expanded the limitation on the deductible amount of business interest expense and expanded the situations in which the limitation applies. Understanding the IRC §163(j) interest expense deduction limitation and its exceptions is an important part of a corporate tax planning strategy that complies with changing tax laws while optimizing your tax position.

What is the current IRC §163(j) deduction limitation?

The TCJA significantly expanded IRC §163(j) by limiting the IRC §163 deduction for net business interest expense to 30% of any taxpayer’s adjusted taxable income (ATI), with an exemption for small businesses and an option for real estate and farming businesses to elect out of the limitation.

Before the TCJA, business interest expense was generally deductible in the year the interest was paid or accrued, subject to certain limitations. Pre-2018 IRC §163(j) was a narrow provision limiting the deductibility of tax-exempt interest that a corporation paid on debt owed to or guaranteed by a related person.

How is the business interest deduction calculated?

Since the passage of the TCJA, IRC §163(j) provides that the amount of deductible business interest expense in a tax year is limited to the sum of the following:

  • The taxpayer’s business interest income for the year
  • 30% of the taxpayer’s ATI for the year
  • The taxpayer’s floor plan financing interest expense for the year

Three things to know about the business interest expense limitation

Bloomberg Tax’s Alex Bayrak breaks down the business interest expense limitation under IRC §163(j), from the definition of “interest” to the CARES Act’s impact on the provision, and more.

What qualifies as a business interest expense?

According to IRC §163(j), “business interest” is defined as “any interest paid or accrued on indebtedness properly allocable to a trade or business.”

“Business interest income” is defined as the amount of interest includible in the gross income of the taxpayer for the taxable year that is properly allocable to a nonexcepted trade or business.

“Business interest expense” is defined as interest expense that is properly allocable to a nonexcepted trade or business or that is floor plan financing interest expense. Both terms exclude investment income.

The current iteration of IRC §163(j) is considerably more encompassing than its predecessor; it applies regardless of whether:

  • The debt is between related parties
  • The debt is incurred by a sole proprietor, a corporation, a pass-through entity, or an entity subject to tax under IRC §511
  • The taxpayer is thinly capitalized

For purposes of the IRC §163(j) limitation on the deductibility of business interest expense, the definition of “interest” is broader than the definition of “interest” for federal income tax purposes more generally. “Interest” includes amounts paid or accrued as compensation for the use or forbearance of money, but also includes amounts associated with arrangements that create debt in substance but not in form.

The regulations characterize myriad items as “interest,” including:

  • Substitute interest payments, but only if the payment relates to a sale-repurchase agreement or a securities lending transaction that isn’t entered into by the payor in the ordinary course of the payor’s business
  • Acquisition discount
  • Deductible repurchase premium
  • Deductible bond premium
  • §163(j) interest dividends
  • Ordinary income or loss on contingent payment debt instruments and inflation-indexed debt instruments
  • §1258 gain
  • Amounts treated as interest under other provisions of the tax law
  • A portion of the payments on over-the-counter interest rate swaps (subject to an exception)

The regulations don’t expressly characterize debt issuance costs, loan commitment fees, guaranteed payments for the use of capital, or hedging income and expense as interest. However, the anti-avoidance rule contained in the regulations’ definition of interest clarifies circumstances under which hedging transactions and guaranteed payments for the use of capital are treated as interest for purposes of IRC §163(j).

§163(j) small business exception

Under the small business exemption, the IRC §163(j) business interest limitation does not apply to a taxpayer (other than a tax shelter) that satisfies the IRC §448(c) gross receipts test for any tax year. Generally, the gross receipts test is satisfied if the taxpayer’s average annual gross receipts for the three prior tax years are less than or equal to $25,000,000 (adjusted annually for inflation after 2018).

Navigate corporate tax planning with confidence

Bloomberg Tax has the corporate tax planning resources you need to stay on top of changing corporate tax laws, limits, and exceptions with expert analysis, comprehensive coverage, news, and tax research tools.

Want to learn more? Understand how the business interest expense limitation under IRC §163(j) affects deductions with our Business Interest Expense Limitation Final and Proposed Regulations Roadmap. This IRC §163(j) roadmap is your easy-to-scan resource for mastering the new limitations and exceptions in this key area of tax reform.

Bloomberg Tax subscribers have access to even more detailed insights into the limitations on business interest expense deductions. Don’t have access? Request a demo.

Join our Tax Regulatory Alerts for breaking news

By clicking submit, I agree to the privacy policy.