The Tax Cuts and Jobs Act (TCJA) enacted additional limitations on the deductibility of business interest expense in new IRC Sec. 163(j). If Sec.163(j) applies, the amount of deductible business interest expense in a taxable year cannot exceed the sum of:
- the taxpayer’s business interest income for the year;
- 30% of the taxpayer’s adjusted taxable income (ATI) for the year; and
- the taxpayer’s floor plan financing interest expense for the year.
Although there are a number of exceptions to this new interest deduction limitation, the one that is looked to most often is the gross receipts exception. IRC Section 163(j) does not apply to businesses (other than tax shelters) with average annual gross receipts for the previous three years of less than $25 million. For tax year 2019 and subsequent years, the $25 million amount will be adjusted for inflation.
You Could Be Subject to the 30% Limit on Net Business Interest Expense Regardless of Gross Receipts
If you think you are not subject to the limitation because your business falls below the $25 million threshold, you may not be correct. The issue arises from the IRS’s definition of a tax shelter.
A tax shelter under IRC Sec. 461(i)(3)(B) includes any syndicate under IRC Sec. 1256(e)(3)(B), which is defined as a partnership or other entity, including an S corporation, if more than 35% of its losses are allocable to limited partners or limited entrepreneurs (persons who have an interest in the enterprise and who do not actively participate in managing the enterprise). A person who actively participates in the management of the enterprise (or whose relative actively participates in the management or who actively participated for at least five years) is not considered a limited partner/entrepreneur for this purpose.
This can cause a problem for many entities, in particular rental activities. Consider a partnership that owns a commercial rental property with a hefty mortgage that has four partners each owning 25% and a loss for 2018. One partner is active in the business and the other three are passive investors. This partnership would be subject to the interest expense limitation rules of 163(j) regardless of its gross receipts because more than 35% of the losses are allocated to limited entrepreneurs.
How MBAF Can Help
The 163(j) rules and proposed regulations are very technical and have many nuances. We can help you determine their applicability and discuss planning opportunities to minimize the impact of this limitation.
If you would like to benefit from our expertise in these areas, or if you have further questions on this Advisory, do not hesitate to contact our Tax and Accounting Specialists, or call us at 1-800-239-1474.