In the United States, the tax treatment of business interest expense is governed by Section 163(j) of the Internal Revenue Code. This provision places limits on the amount of interest businesses can deduct on their tax returns based on their income and other factors. Unfortunately, the calculation for determining the limit has changed starting with the tax year 2022 and stands to impact many large businesses negatively.
TCJA limitations on business interest expense
The Tax Cuts and Jobs Act (TCJA) widened the scope of the business interest expense deductibility limitation provisions of section 163(j). It also established a cap on the amount of business interest expense that companies can deduct from their taxable income.
Under the TCJA, companies are limited to deducting business interest expense equal to the sum of:
- Business interest income,
- 30% of adjusted taxable income (ATI), and
- Floor plan financing interest (for certain businesses).
The CARES Act increased the percentage of ATI from 30% to 50%, but only for tax years 2019 and 2020. Thereafter, it reverted to 30% for the 2021 tax year and forward.
The change to the ATI calculation
The equation for ATI is central to calculating the business interest deduction. For tax years beginning before 2022, the ATI was computed without regard to the following:
- Any item of income, gain, loss, or deduction that is not allocable to a trade or business;
- Any business interest or business interest income;
- The amount of any net operating loss deduction under Sec. 172;
- The amount of any deduction allowed under Sec. 199A; and
- Any deduction for depreciation, amortization, or depletion attributable to a trade or business.
However, starting with the 2022 tax year, the ATI calculation does not include #5 (“Any deduction for depreciation, amortization, or depletion attributable to a trade or business”). This means that ATI is calculated net of depreciation, amortization, and depletion. Thus, companies with depreciation, amortization, or depletion will calculate a lower ATI for 2022 than in 2021 (with all other inputs being equal). And since the calculation for the limitation for business interest deductibility is based on 30% of ATI, a lower ATI will result in a lower limit for the business interest deduction.
Depreciation can significantly affect ATI, especially for companies taking advantage of accelerated depreciation such as Section 168k bonus depreciation. For example, a company with high debt that realizes $1 million of bonus depreciation may significantly reduce its ability to deduct business interest expense.
For entities limited under section163(j), there is some good news. The amount of business interest expense disallowed as a deduction in the current year under section 163(j) is carried forward to the next taxable year.
Types of companies affected by the limitations
The TCJA limitations on business interest expense apply to a wide range of companies, including C corporations, partnerships, and S corporations. The limitations also apply to certain multinational companies and consolidated groups of companies.
The limitation doesn’t apply to small businesses not considered a “tax shelter” and have less than $29 million in average annual gross receipts for the preceding three years in 2023. While tax shelters typically bring to mind entities formed for tax avoidance, the IRS definition of a tax shelter is much broader. According to the IRS, tax shelters include partnerships and other pass-through entities if more than 35% of their losses are allocated to owners who don’t actively participate in management (limited partners).
Other types of trades and businesses are exempt from the limitation, such as a trade or business providing services as an employee. However, the details are beyond the scope of this article.
This article is intended to provide a brief overview of changes to the business interest expense deduction and is not a substitute for speaking with one of our expert advisors. If you’d like to learn more about the business interest expense deduction limitation for your company, please contact our office.