Before tax reform, there were not many limitations on a business's ability to deduct interest expense on their tax return. However, beginning in 2018, tax reform will significantly alter the ability to deduct business interest expense for a great many taxpayers.
Generally, under a revamped Section 163(j), business interest expense that can be deducted will be limited to 30% of the taxpayer's adjusted taxable income. Let's address a few questions related to this limitation:
- What is adjusted taxable income? For the years 2018-2021, adjusted taxable income is taxable income with certain addbacks such as interest, depreciation and amortization. The calculation of adjusted taxable income will be the same for years after 2021, with the exception that there will be no add back for depreciation or amortization. As a result, after 2021 it is expected that adjusted taxable income will be lower than previous years resulting in a potentially smaller interest expense deduction.
- Is everyone subject to this limitation? All taxpayers, no matter how organized, that have business interest expense will be subject to this calculation. However, a few taxpayers are not subject to the interest limitations calculation, including small businesses, electing real property trade or businesses, businesses that have floor plan financing, and electing farming businesses.
- What is a small business? Generally, a small business is a taxpayer that has average gross receipts over the prior three years of less than $25 million. While that seems straight forward, related party rules come into play that require an aggregation of all related entities to determine the $25 million threshold.
- What is an electing real property trade or business? A real property trade or business is any business in the development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage of real property which makes an irrevocable election to be exempt from Section 163(j).
- Are there consequences of not being subject to the interest limitations? There are no consequences to small businesses, but for real estate, farming, or businesses with floor plan financing, there is an impact on the available methods of tax depreciation, including possibly the ability to take bonus depreciation.
- What happens if you are subject to the interest limitations? Depends on the type of entity, but generally the amount of interest in excess of the limitation will be disallowed as a deduction in the current year and will be carried forward to the subsequent year(s) when it will be subject to the same limitation calculations.
There are many additional nuances to these interest limitation rules. However, as with many tax reform items, proper and timely planning can ensure the maximum interest deduction by minimizing the possible impact of these interest limitation provisions.
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