Business Interest Expense Limitation
Last Updated August 23, 2022
A taxpayer may deduct interest paid or accrued within a tax year on a valid debt. Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), business interest expense was generally deductible in the year the interest was paid or accrued, subject to certain limitations.
The TCJA replaced the earnings stripping rules in §163(j) by limiting the deduction for net business interest expense to 30% of a taxpayer’s “adjusted taxable income,” with an exemption for small businesses.
The current iteration of §163(j) is considerably more encompassing than its predecessor; it applies:
- Regardless of whether the debt is between related parties
- Regardless of whether the debt is incurred by a sole proprietor, a corporation, a pass-through entity, or an entity subject to tax under §511
- Regardless of whether the taxpayer is thinly capitalized
What limitations did the TCJA place on deductible business interest expense?
Since the passage of the TCJA, §163(j) now stipulates that the amount of deductible business interest expense in a tax year cannot exceed the sum of:
- The taxpayer’s business interest income for the year
- 30% of the taxpayer’s adjusted taxable income for the year
- The taxpayer’s floor plan financing interest expense for the year
According to §163(j), “business interest” is defined as “any interest paid or accrued on indebtedness properly allocable to a trade or business,” and “business interest income” is defined as “the amount of interest includible in the gross income of the taxpayer for the taxable year which is properly allocable to a trade or business.” Both terms exclude investment income.
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Is the definition of “interest” for purposes of the §163(j) limitation on deductibility of business interest expense broader than the definition of “interest” for federal income tax purposes generally?
For purposes of the IRC §163(j) limitation on deductibility of business interest expense, “interest” includes amounts paid or accrued as compensation for the use or forbearance of money, but also includes amounts associated with arrangements that create indebtednesses in substance but not in form.
Included among the myriad items specified as interest under the regulations are:
- Substitute interest payments (but only if the payment relates to a sale-repurchase agreement or a securities lending transaction that is not entered into by the payor in the ordinary course of the payor’s business)
- Acquisition discount
- Deductible repurchase premium
- 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 do not 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).
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Download: Section 250 Final Regulations Roadmap
The Section 250 Final Regulations Roadmap will guide your organization and clients in 250 deductions and related definitions for taxable years beginning January 1, 2021.
Are there exemptions to the limitation under §163(j)?
Yes, under the small business exemption, the §163(j) business interest limitation does not apply to a taxpayer (other than a tax shelter) that satisfies the §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 (indexed for inflation).
How does the CARES Act impact §163(j)?
The CARES Act temporarily increased the ATI portion of the limitation from 30% to 50% of ATI for tax years 2019 and 2020 (with the ability to elect out of the increased limitation) and allowed taxpayers to elect to substitute 2019 ATI for 2020 ATI. Even with this additional relief, the limitation is likely to impact more businesses than originally thought when the provision was enacted.
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