Section 163(j) packs a mighty punch for being just one section of the tax code. Daria Palaschak, CPA, MST, partner in the tax department of Sisterson & Co. LLP in Pittsburgh, discusses the significant changes to the limitation on the deduction of business interest expense brought on by the Tax Cuts and Jobs Act of 2017. Also, don't miss PICPA courses related to 163(j).
By: Jim DeLuccia, PICPA Communications Manager
Section 163(j), Limitation on the Deduction for Business Interest Expense, has been around for many years but changed significantly after passage of the Tax Cuts And Jobs Act of 2017. Daria Palaschak, CPA, MST, partner in the tax department of Sisterson in Pittsburgh joins me to discuss the changes and what they mean for tax practitioners.
Dee, thanks so much for joining me on the phone today.
Hi, Jim. Thanks for having me. You were asking what are a few of the significant changes in 163(j). You're right, there are a lot of changes and the newly enacted 163(j) actually replaced a predecessor code section with the same name. The old 163(j) has been around for a long time, but it was only applied in some pretty narrow situations. Without getting into all of the specific rules, the old 163(j) targeted certain earnings-stripping transactions that were conducted by taxpayers with foreign affiliates. And at the same time, it discouraged taxpayers from assuming too much debt. It didn't apply to all taxpayers, only applied to ones with foreign affiliations and not at all to those with only domestic affiliations. I have to say that in my career, which is over 30 years, I have never needed to apply the old section 163(j) because the lion's share of the clients at the firms I've worked for and the clients I've worked on are all mainly domestic.
Now new 163(j) isn't focused on their earning stripping or debt ratios. But rather it's focused on limiting the business interest deduction. And mainly it's based on the relation to taxable income. The new 163(j) also isn't focused only on taxpayers with foreign affiliates, but instead it can affect pretty much any taxpayers, including those who are only domestic. Under the new 163(j) businesses can generally deduct business interest expense up to the sum of their business interest income plus 30% of their adjusted taxable income, which is now referred to as ATI, plus their floor plan financing interest expense. That is, in a nutshell, what some of the changes are.
Great, thanks Dee. You got right into it there with the brief overview for our listeners. I should also mention to our listeners here that though I introduced you as Daria, you are known as Dee to us and I'm sure to your clients and to I guess anyone else you interact with, right?
Yes. That's sort of a nickname that I received when I was younger.
Got it. Are there excepted trades or businesses and if so, what types of businesses qualify here?
So Jim, of course, you know with tax there's always an exception to everything. The excepted trade or businesses, and there are four of these, are one, the trade or business of providing services as an employee. Two, certain real property, trades or businesses that can elect to be accepted. Three, certain farming businesses that can elect to be accepted. And four, certain regulated utility trades or businesses. I honestly haven't seen number one, three, or four. But real properties, trade or businesses that can elect to be excepted might be something that some practitioners will have to deal with. In the case of the real property trade or business or the farming business, they can only be accepted if they make an irrevocable election to be considered an accepted trade or business. And, of course, that election comes with some consequences and some of those consequences include having to depreciate assets over a longer life and not being able to take bonus depreciation.
What about determining interest for purposes of section 163(j)? What do CPAs need to know there?
Well, Jim, you think this would be an easy answer, but of course 163(j) and the proposed regulations define it. Interest is any amount that is paid, received or accrued as compensation for the use or forbearance of money under the terms of an instrument or contractual arrangement or that is treated as interest under the internal revenue code or the regs. Interest also includes amounts that are closely related to interest, such as substitute interest payments, debt issuance costs, loan commitment fees and other amounts that affect the economic cost of funds or yield a borrowing or an interest generating asset. It's kind of technical. Then under an anti-abuse feature, certain amounts that are predominantly associated with the time value of money could also be treated as interest expense. Section 1.163(j)-1B20 of the regs provide additional information. I guess if you have a situation where you think something isn't clear cut but maybe could be interest, that would be good to consult the regs because there could be a lot of things in this area that you're not aware of, but really are interest.
You mentioned adjusted taxable income, or ATI, earlier in our conversation here. How is that calculated?
Well, Jim, this one is really not that difficult to calculate. Under the new 163(j) the ATI means it's taxable income, but without regard to any income gain deduction or loss that's not allocable to a trade or business. If they're doing some activities that don't rise to the level of a trade or business, you would have to subtract that income or add back those types of deductions. Also, it's calculated without regard to business interest expense because the reason for that is we're trying to calculate business interest expense so you don't consider that in your taxable income in this calculation.
Also without regard to net operating losses and also without regard to the new section 199A pass through deduction as well as not considering any depreciation, amortization or depletion deductions. Those are not required to be deducted through the years, through tax years beginning before Jan. 1, 2022, but for tax years after 12/31/21, these particular amounts, depreciation, amortization and depletion would need to be subtracted in calculating ATI, and as a result they would lower the ATI and also lower deductible interest. This section becomes less generous as after you hit 12/31/21.
How does section 163(j) apply to partnerships and S corporations? And better still, what if you have one entity that's engaged in excepted and non-excepted business activities? What happens there?
Those are some good questions. I think we need to break that down. Let's break those down. Starting with the first question, how it applies to partnerships. In the case of partnerships, the 163(j) limitation is applied at the partnership level. The amount of deductible interest expense in a taxable year can't exceed the partnership's business interest income, 30% of the partnership's ATI and the partnership's floor planning interest expense. Then business interest expense that is allowed after that calculation, it's taken into account in determining the non-separately stated taxable income of the partnership, which is then allocated out to each of the partners. Then any business interest expense of the partnership that is disallowed as a result of that calculation, it's also allocated to the partners in the same manner as the non-separately stated taxable income. But it's reported separately, and it's called excess business interest expense. And they would receive that amount out on their partnership K1 in footnotes sections, but it's not deductible in the partnership income per se.
Partner would carry forward his or her share of this excess business interest expense if they cannot deduct it in the current year. In a succeeding year, a partner may treat the excess business interest expense in that current year as long as it's got sufficient taxable income to deduct that. And so every year they have to determine if the partnership can take it at its level. If not pass it through the partner, then the partner carries it forward or uses it when he or she can. That's a little bit complicated but the main takeaway from that is that the partnership itself doesn't carry forward the unallowed interest expense, the partner does.
Then moving onto the S Corps, an S Corp applies the limitation at its level same as the partnership, but any business interest expense of the S Corp that is disallowed is not allocated out to the shareholders and instead is carried over at the S corporation level to succeeding taxable years. That's the big difference.
In both cases, partnership and S Corp, if there's excess taxable income, like if they have enough taxable income that allows all of their interest expense to be deducted, the amount of taxable income in excess, it gets passed out to the partners and then they can use it at their level, which is kind of interesting.
And then the final question is what happens if the entity is engaged in an excepted and a non-excepted trade or business? In that case the portion that's allocable to an excepted trade or business isn't subject to the 163(j) limitation. The amounts of income gain, deduction loss, including interest expense, allocated to an excepted trade or business is excluded, each of those items. You kind of need to allocate all tax items between excepted and non-excepted in order to determine whether you have a 163(j) limitation for the non-excepted trades or business.
There's specific rules in the regs. It's 1.163(j)-10 that gives you special rules for allocating these items. And one thing that is noted in that section is if you have assets that you use in the excepted trades or businesses and your basis, you have to allocate the assets themselves to each of the businesses to determine which portion of interest expense to allocate to each of these. There's many parts involved here, like looking at the assets themselves, looking at each of the items. I would say that's probably one of the more complicated areas. And I would think that not that many businesses would run into this. I think that would be more of the exception that you'd have just generally one trade or business that has interest expense and you'd just apply the limitation to that whole business. If you think you have a combination, look to that reg section.
You obviously had a lot to break down there, Dee. I appreciate that. And actually you kind of set up the next question that I had in my mind here about particular types of businesses and if there are any particular types of businesses that have been especially affected by the latest changes to the section 163(j).
Well, and this one Jim, I think I'm going to answer it sort of almost in the opposite way. For tax years beginning after 2017, code section 163(j) will apply to all taxpayers who have business interest expense other than those that are known as exempt small businesses. Exempt small businesses are those that meet a gross receipts test under code section 448(c). A business that meets the gross receipts test is one that is not a tax shelter, and that's a special rule defined in code section 448(a)(3), and also it has to meet both of these, and also has annual gross receipts of $25 million or less in the previous three years. So if it meets both of those, then it's an exempt small business and then it won't be affected by 163(j).
But keep in mind, the higher the interest expense that any business has and the lower the adjusted taxable income to ATI, the more likelihood there will be a limitation for that business. I envision that any highly leveraged businesses are going to be more likely affected by this code section than not, particularly if they're highly leveraged and they're not turning a real good profit.
Well, again, Dee, you've talked about so much information here just regarding this one section of the tax code. I'm wondering: where can CPAs turn for more information on this issue?
Well, that's a great question, Jim. This code section can be pretty overwhelming and intimidating, but fortunately there are some resources out there and I think as time goes on, more and more. What I would recommend is first there is our Internal Revenue Service Notice 2018-28 which was the initial guidance that they put out. I would probably start with that. Now, after that was issued practitioners and other people had raised a lot of questions and sent questions to the IRS, which I think in some cases they addressed in the proposed regs, but that's always a good starting point. And then the IRS website itself has a pretty good Q&A section on this topic under the tax reform section of the website. And then there's also the instructions to Form 8990, which is the form that is used by, whether it's an entity or the individual, to compute this business interest limitation. I would highly recommend anybody reading those instructions if you're going to be dealing with this.
Also, you can consult all the major tax research services such as CCH, RIA, and BNA. And in my opinion, BNA has done a real nice job. They have tax reform roadmaps and things like that and they even have some podcasts and things on their website on this topic as well as others. Then in addition and in scouring the web a little bit, it looks like most of the big four firms have put out some sort of white paper on this 163(j), which is helpful because some address certain issues and some address others. You can look at several and see if your issue's listed. I've also noticed that like there's a lot of articles that can be found online and many have been authored by either tax professionals or law firms. And then finally you can always read the 439 pages of the proposed regs.
That could be good beach reading. Right?
Well, thanks again, Dee, for providing this thorough insight to our listeners on this topic. Hope you enjoyed being on the program today.
Yeah, I really did enjoy it and it gave me the opportunity to reread a lot of these rules and everything because I think we do need to keep these things top of mind. They could easily be overlooked if you're not thinking about them.