The Tax Cuts and Jobs Act (TCJA) offers numerous benefits for the business community, but included in the TCJA are a few adjustments that could reduce tax benefits for some businesses. Under previous law, there was a limitation on the amount of interest expense certain corporations could deduct when that interest was paid to taxpayers who were, in simple terms, not subject to U.S. income tax. These rules were known as the “earnings-stripping” rules. The TCJA repealed the old rules and replaced them with a broader but simpler limitation on the amount of interest businesses can deduct.
The new limitation included in the TCJA applies to more entity types than previously. Not only are corporations subject to the limitation, but business activities of all forms are now too, i.e., partnerships, S corporations and sole proprietorships. Under the new rules, the net deduction for business interest can’t exceed the sum of (1) total business interest income for the year, (2) 30 percent of adjusted taxable income of the taxpayer (not less than zero) and (3) floor plan financing interest for the year. In general, the interest limitation is determined each tax year on a company-by-company basis; however, upcoming IRS guidance is expected to allow the limitation to be applied on a consolidated group basis for taxpayers that file consolidated returns. The excess interest for any year is carried forward indefinitely and is treated as paid or accrued in the succeeding taxable year. If you were previously subject to the limitations, transition rules are unclear and should be clarified as future regulations and guidance are released. Interest expense related to investments isn’t subject to the new limitation, and such expense continues to be subject to the existing limitations on investment interest expense.
For tax years beginning after December 31, 2017, and before January 1, 2022, adjusted taxable income is defined as taxable income without regard to income, gain, deduction or loss not properly allocable to a trade or business; any business interest expense or business interest income; any net operating loss; any §199A deduction and any depreciation, amortization or depletion. For tax years beginning after December 31, 2021, the limitation is modified—the deduction for depreciation, amortization and depletion is included in the computation. This change further limits the interest deduction.
Small Business Exception
The good news is there’s an exemption for some smaller businesses. Those with average annual gross receipts of less than $25 million for the preceding three tax-year periods aren’t subject to the limitation. While the limitation is determined on a company-by-company basis, this exception is determined annually on an aggregate company basis. There’s no rule preventing a business that’s exempt in one year from being subject to the limitations in future years. The limitations aren’t dependent on the nature or tax status of the lender or the guarantor, as was previously the case.
This exception, however, may not apply to all businesses that otherwise meet the average gross receipts threshold. Any company that falls within the definition as a tax shelter isn’t eligible for the small business exception. The definition of a tax shelter for this purpose is broader than some may expect. A company with interests that have been offered for sale, and are therefore required to be registered with a federal or state authority regulating such sale, may be considered a tax shelter for this purpose. In addition, business investment entities of which more than 35 percent of losses are allocable to limited partners who aren’t active in the business also may be considered a tax shelter and are therefore not eligible for the small business exception.
Electing Real Property Trade or Business
One significant item in the new law is the opportunity for real property trades and businesses, as well as farming businesses, to elect out of these limitations. The election is an irrevocable election and requires electing businesses to use the Alternative Depreciation System (ADS) to depreciate all real property (residential, nonresidential and qualified improvement property). While at first glance this may seem to have a substantial cost, this election wouldn’t prevent a qualifying business from taking advantage of favorable bonus depreciation rules for tangible personal property, i.e., vehicles and equipment, nor would it prevent the qualifying business from using the Section 179 expensing election for qualified real property—which, as a result of the TCJA, now includes qualified improvement property, roofs, HVAC and security and fire alarm systems for nonresidential properties (to the extent placed in service after the date such property was first placed in service). It’s important to remember the §179 deduction only is available to those real property trades or businesses that meet the other requirements of the expensing provision. However, the election would prohibit the bonus depreciation deductions for qualified improvement property, which is another substantial change in the TCJA. Under the new rules, the ADS lives for nonresidential property and residential rental property are 40 years and 30 years, respectively. This is compared to 39 years and 27.5 years under MACRS.
For purposes of this election, a real property trade or business is defined to include more than just lessors of residential rental or nonresidential property. Internal Revenue Code §469(c)(7)(C) provides that eligible businesses include all of the following:
- Real property development or redevelopment
- Construction or reconstruction
- Rental and operation
- Management or leasing
As we look at different planning ideas, it’s important to remember that while reviewing the potential effect, the change in methodology in 2022 should be considered. Any analysis should be two-pronged and consider a long-term effect of the limitations and the possible solutions. The first idea to consider is whether the timing of depreciation could provide a long-term benefit, especially considering the increased limitation in 2022 and thereafter. Could a cost segregation study accelerate depreciation in years before 2022, or even before 2018, in an effort to reduce the effect of the interest limitation?
Another possible strategy would be to consider the benefit of restructuring the debt/recapitalization of brother-sister businesses. If one entity is facing the limitation due to low profitability or higher interest, while another commonly owned business has a sufficient limitation that could be used, is there an opportunity to recapitalize entities to avoid the interest limitation?
Finally, if a business that isn’t qualified to make the real property election has substantial real estate, is there an opportunity to separate the real property into a separate entity? While the operating business would still be subject to the rules of the limitation, the real property company could elect otherwise. This is a complicated idea that should be considered in light of other existing tax laws and regulations, but for purposes of this discussion, the separation of the real property business would serve to reduce or eliminate disallowed interest. These are just a couple ideas that may provide a path to reducing the effect of the new business interest limitations in the absence of the ability or benefit of making the real property business election.
The decision to make the real property business election shouldn’t be based on a limited analysis of just one year or one strategy. A long-term analysis that considers the interest limitation, as well as the effect of slower and limited depreciation rules, should be evaluated. Other strategies may be available. Also, any analysis performed in the first few years of the new law should be revisited when the computation method changes in 2022.
The effect of this provision and the available elections will vary based on the facts and circumstances for each taxpayer. If your business is subject to the limitations and qualifies for the real property election, that may provide for an easy resolution. However, while the election may seem to be a favorable way to avoid the interest limitations, the real cost of the election may outweigh the interest limitation itself. Planning considerations related to this new limitation also should consider the effect on other new provisions in the TCJA, such as the §199A deduction for noncorporate taxpayers. Be sure to visit BKD’s Tax Reform Resource Center for more information on the new law, including a one-page summary of the new interest limitation rules. Contact Michael or your trusted BKD advisor to determine the effect and any planning opportunities specific to your situation.