IRS & Treasury Release Long-Awaited Business Interest Limitation Rules
On July 28, 2020, the IRS and U.S. Department of the Treasury (Treasury) released a series of new rules related to the limitation on deduction for business interest expense under Internal Revenue Code (IRC) Section 163(j). The new guidance takes the form of proposed and final regulations, a proposed revenue procedure, and a series of frequently asked questions. In this alert, we’ll cover key aspects of the new rules that modify or expand upon the proposed regulations previously issued on November 26, 2018 (2018 Proposed Regulations).
For an overview of the business interest expense limitation and to learn more about how this provision changed under the Tax Cuts and Jobs Act (TCJA), check out this BKD Thoughtware® article. In March 2020, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) made additional amendments to §163(j), including several elections taxpayers can make related to their 2018, 2019, and 2020 tax years. You can read more about those changes in this Thoughtware alert.
Definition of Adjusted Taxable Income (ATI)
Tentative Taxable Income
The final regulations retain the same basic structure as the 2018 Proposed Regulations, with certain revisions. The first significant shift from the proposed regulations is the introduction of a new term, “tentative taxable income,” which refers to the starting point in calculating ATI. This modification was made to help prevent confusion from using the term “taxable income” in different contexts that evoke different meanings. In general, tentative taxable income is the same as taxable income; however, it is computed without regard to any §163(j) limitation or disallowed business interest expense carryforwards.
Depreciation, Amortization, & Depletion Capitalized under IRC §263A
The next major definitional shift related to the determination of ATI will have a significant impact on the §163(j) limitation for manufacturers and other taxpayers subject to the Uniform Capitalization (UNICAP) rules under §263A. The final regulations allow the amount of any depreciation, amortization, or depletion that’s capitalized into inventory under §263A during taxable years beginning before January 1, 2022, to be added back to tentative taxable income when calculating ATI for that taxable year, regardless of when the capitalized amount is recovered through cost of goods sold.
This modification within the final regulations is a welcome change from the previously proposed guidance that excluded such capitalized amounts from being added back when determining ATI, regardless of when or if the expense was recovered through cost of goods sold. Also, as noted under the Applicability Dates section of this alert, taxpayers choosing to adhere to the 2018 Proposed Regulations for tax years beginning before the effective date of the final regulations also may opt to follow this new §263A rule.
Definition of Interest
In response to comments to the 2018 Proposed Regulations, the final regulations make several changes to the definition of interest, including:
- Exclusion of commitment fees
- Exclusion of debt issuance costs
- Removal of the explicit inclusion of guaranteed payments for the use of capital; however, these payments may be considered interest depending on the specific facts and circumstances of the arrangement
- Removal of the explicit inclusion of hedging transactions; however, these items may be considered interest for purposes of §163(j) in some circumstances
General Rules Regarding the §163(j) Limitation
Gross Receipts Test & Aggregation
Certain taxpayers, such as small businesses, are exempt from the §163(j) limitation. Under §163(j), a small business taxpayer is one that meets the gross receipts test in §448(c) and is not a tax shelter under §448(a)(3). The gross receipts test is met if a taxpayer has average annual gross receipts for the three prior taxable periods of $25 million or less, adjusted for inflation (note, this threshold increased to $26 million for the 2019 and 2020 tax years). In response to comments noting the complexity of the aggregation rules required under §448(c), the IRS and Treasury concurrently released a series of FAQs that explain the basic operation of the aggregation rules taxpayers must use when determining gross receipts for purposes of the small business exemption under §163(j).
In addition to the guidance provided by the new FAQs, the final regulations also clarify the term “tax shelter,” providing a definition of the term “syndicate” for purposes of §163(j) that’s consistent with the definition provided under Treasury Regulation §1.448-1T. Under the final regulations, an entity must actually allocate more than 35 percent of its current year losses to limited partners or entrepreneurs to be considered a syndicate. This is an important clarifying distinction to help certain entities from being mischaracterized as tax shelters and excluded from the small business exemption.
Elections for Excepted Trades or Businesses
The final regulations provide a rule that would allow taxpayers seeking to make “protective elections” to do so regardless of whether they’re exempt from the §163(j) limitation as a small business taxpayer. This taxpayer-favorable change would allow taxpayers seeking to make a farming or real property trade or business election to avoid determining their aggregate gross receipts first, which is a requirement under the 2018 Proposed Regulations.
The final regulations also provide that an election to treat rental real estate activities as an electing real property trade or business is available regardless of whether the taxpayer making the election is engaged in a trade or business within the meaning of §162. This allows a taxpayer engaged in rental real estate activities, but unsure whether its activities rise to the level of a §162 trade or business, to make an election to be an electing real property trade or business.
The IRS and Treasury also released a proposed revenue procedure through Notice 2020-59 that provides a safe harbor allowing taxpayers engaged in a trade or business that manages or operates qualified residential living facilities to treat such trade or business as a real property trade or business solely for purposes of qualifying as an electing real property trade or business under §163(j). The revenue procedure, which applies to taxable years beginning after December 31, 2017, includes definitions and examples to help taxpayers determine if they’re eligible for this new safe harbor.
Pass-Through Entity Considerations
Treatment of Excess Business Interest Expense in Tiered Partnerships
The proposed regulations released concurrently with the final regulations under §163(j) provide additional guidance on various business interest expense deduction limitation issues not addressed in the final regulations. One such issue relates to the application of §163(j) to tiered partnership structures, a topic the IRS and Treasury chose to remain silent on in the 2018 Proposed Regulations.
In the proposed regulations released on July 28, 2020, the IRS and Treasury take an “entity approach” and provide that if a lower-tier partnership allocates excess business interest expense to an upper-tier partnership, the upper-tier partnership reduces its basis in the lower-tier partnership; however, the partners in the upper-tier partnership do not reduce the basis in their upper-tier interest until the upper-tier partnership treats such excess business interest expense as paid or accrued.
Business Interest Expense Allocated from Exempt Entities
The final regulations make an important clarification that departs from guidance provided in the 2018 Proposed Regulations related to the treatment of untested business interest expense allocated to owners of small business pass-throughs. The final regulations provide that business interest expense of an exempt partnership or S corporation, i.e., a partnership or S corp that’s under the $26 million average gross receipts threshold, doesn’t retain its character as business interest expense and, as a result, isn’t subject to the §163(j) limitation at the partner or S corp shareholder level.
Self-Charged Lending Transactions
Another key area in which the IRS and Treasury chose to remain silent in the 2018 Proposed Regulations relates to the treatment of business interest income and business interest expense with respect to lending transactions between a partnership and its partner(s). In the recently issued guidance, the IRS and Treasury propose adding a rule that would recognize such self-charged lending transactions and provide that if a partner loans money to a partnership, receives interest income attributable to the self-charged lending transaction, and is later allocated excess business interest expense from the borrowing partnership, then the lending partner is deemed to receive an allocation of excess business interest income from the borrowing partnership in such taxable year.
This rule alleviates the mismatch between the character of the interest income and of the interest expense at the partner level from the same lending transaction.
Other Issues Related to Pass-Through Entities
In response to comments that the 11-step computation for allocating deductible business interest expense, excess taxable income, excess business interest income, and excess business interest expense among partners was too complex, the IRS and Treasury reiterate that they provided a worksheet and multiple examples to aid in the completion of the computation. The final regulations also provide an exception from the majority of the 11 steps for partnerships that allocate all items of income and expense on a pro rata basis. Instead, these entities would only complete steps 1 and 2, resulting in a pro rata allocation of all §163(j) items.
Regarding basis adjustments upon disposition of a partnership interest, commenters to the proposed regulations recommended that a partial disposition of a partnership interest should trigger a proportionate excess business interest expense basis addback and corresponding decrease in such partner’s excess business interest expense carryover. The final regulations adopt this recommendation, departing from the rule provided in the 2018 Proposed Regulations.
Taxpayers may apply these final regulations to taxable years beginning after December 31, 2017, so long as the rules are applied consistently among the taxpayers and their related parties. Alternatively, taxpayers may rely on the 2018 Proposed Regulations for those taxable years. The final regulations generally apply to taxable years beginning on or after the date that is 60 days after the date upon which the regulations are published in the Federal Register.
Taxpayers who choose to rely on the 2018 Proposed Regulations may choose to also apply the beneficial rule under Treasury Regulation §1.163(j)-1(b)(1)(iii), which allows taxpayers to include the entire capitalized amount of depreciation under §263A as an addback to tentative taxable income when calculating ATI.
While this Thoughtware alert includes the most significant issues contained within the guidance issued by the IRS and Treasury on July 28, 2020, there may be additional issues not discussed here that would affect your specific tax situation. Accordingly, we recommend that you reach out to your BKD Trusted Advisor™ or submit the Contact Us form below for help applying this guidance.