In Notice 2018-28 issued in April 2018, the U.S. Department of the Treasury (Treasury) and the IRS announced their intention to issue proposed regulations to help taxpayers comply with the changes made to the rules regarding the limitation on the deduction for business interest expense under Section 163(j) of the Internal Revenue Code (IRC) as a result of the Tax Cuts and Jobs Act (TCJA). On November 26, 2018, the IRS and Treasury issued the first set of those proposed regulations, which provide general guidelines, definitions and rules for calculating the limitation in a consolidated group, partnership and international context.
In this alert, we’ll examine some of the significant aspects of the recently proposed regulations under IRC §163(j), which taxpayers and their related parties may elect to apply for taxable years beginning after December 31, 2017. Read this BKD Thoughtware® article to learn more about how this provision changed under the TCJA, and check out this one-page summary for additional examples of how the limitation under this new regime applies.
An Overview of the Limitation
For tax years beginning after December 31, 2017, the deduction for business interest expense is generally limited to the sum of:
- Business interest income1
- Thirty percent of adjusted taxable income (ATI)2
- Floor plan financing interest
Any disallowed interest is considered paid in the following tax year and may be carried forward indefinitely.
The limitation under IRC §163(j) applies to all taxpayers except certain small businesses that meet the $25 million gross receipts test under IRC §448(c)3, those in the trade or business of providing services as an employee, regulated public utilities and real property or farm businesses that elect out of the limitation as provided under IRC §163(j)(7). For owners of pass-through entities, the limitation applies at the entity level, and the deduction is included in ordinary income. Pass-through owners determine their limitation without regard to pass-through income, gain, loss or deduction, except in cases where the pass-through is determined to have excess taxable income.4
Taxpayers will use Form 8990, Limitation on Business Interest Expense Under Section 163(j) to calculate and report the limitation, which was released in draft form.
BKD Insights & Highlights of the Proposed Regulations
Definition of ATI
ATI, for purposes of determining the limitation under IRC §163(j), includes add-backs for depreciation, amortization and depletion through December 31, 2021. While these adjustments result in an ATI that’s more aligned with a taxpayer’s cash flow, the IRS and Treasury assert that no further adjustments to ATI to approximate cash flow are appropriate. As a result, the proposed regulations don’t adopt a cash flow approach to ATI that would require adjustments for the increase in accounts payable balance (and the decrease in accounts receivable balance) between the end of the preceding year and the end of the current year as part of the calculation of an accrual basis taxpayer’s ATI.
The proposed regulations also address concerns by the IRS and Treasury of a double benefit associated with the sale or disposition of property, prior to January 1, 2022, where the related depreciation or amortization expense has been added back to taxable income in the computation of ATI. In addition, the guidance provides a somewhat unexpected clarification that a deduction for depreciation, amortization or depletion for purposes of the calculation under IRC §163(j) doesn’t include such amounts that are capitalized to inventory under IRC §263A and included in cost of goods sold.
Under this recently released guidance, the Global Intangible Low-Taxed Income (GILTI) and foreign-derived intangible income (FDII) deduction under IRC §250(a) would be included when computing taxable income for purposes of ATI without regard to the taxable income limitation included in that subsection. However, additional adjustments may be necessary to the extent some or all of the deduction is attributable to an inclusion under IRC §951A. The IRS and Treasury are currently developing a separate set of proposed regulations to provide additional guidance.
Definition of Interest
Interest is defined under the proposed regulations to include amounts associated with conventional debt instruments, as well as transactions that are indebtedness in substance, although not in form. The definition also includes amounts treated as interest under other provisions of the IRC or Treasury regulations, such as original issue discount, accrued market discount and amounts with respect to an integrated transaction under Treas. Reg. §1.1275-6.
The proposed regulations take a broader view of the definition of interest by also including certain amounts that aren’t necessarily considered “interest” but are “closely related to interest” such as the income, deduction, gain or loss from a transaction used to hedge an interest-bearing asset or liability, a substitute interest payment made on a debt instrument under the terms of a securities lending or sale-repurchase transaction and certain commitment fees.
This broad definition of interest seeks to address all transactions that are commonly understood to produce interest income and expense, including those that may otherwise have been entered into to avoid the application of IRC §163(j).
The proposed regulations further clarify the definition of interest as it relates to partnership investment interest allocated to a C corporation partner. While investment interest is excluded from the definition of business interest income for purposes of IRC §163(j), an exception is made under Prop. Reg. §1.163(j)-4(b) to recharacterize investment interest allocated to a C corp partner as interest expense properly allocable to a trade or business of the C corp and, thus, subject to the business interest limitation under IRC §163(j).
Definition of Floor Plan Financing Interest Expense
Following the changes made to the statute discussed above, the proposed regulations provide that certain business interest expense paid or accrued on indebtedness used to acquire an inventory of motor vehicles is deductible without regard to the IRC §163(j) limitation. In a response to requests made in BKD’s Comments on Notice 2018-28, the proposed regulations clarify that the definition of “motor vehicle” for purposes of floor plan financing indebtedness is based on the equipment held for sale or lease, not on the kind of business the purchaser or lessee is engaged in. With this clarification, the IRS and Treasury did not include BKD’s recommended rule that debt incurred to purchase construction machinery or equipment for sale or lease to farmers be considered floor plan financing indebtedness for purposes of §163(j).
Definition of Trade or Business & Electing Real Property Trade or Business
Similar to the recently released proposed regulations under IRC §199A, the proposed regulations define a trade or business for purposes of IRC §163(j) as a trade or business within the meaning of IRC §162.
The proposed regulations provide that taxpayers can make an election to treat a certain trade or business as an excepted trade or business if it’s a real property trade or business under IRC §469(c)(7)(C), or a certain trade or business conducted by a real estate investment trust. Also included in the proposed regulations are amendments to §1.469-9(b) to provide the definition of “real property trade or business” for purposes of IRC §469(c)(7)(C). Specifically, the proposed regulations provide that taxpayers engaged in trades or businesses that aren’t directly or substantially involved in the creation, acquisition or management of rental real estate, or that provide personal services that are merely ancillary to a real property trade or business, will generally not be treated as engaged in real property trades or businesses for this purpose. In addition, the guidance clarifies that machinery, equipment and other assets or items that aren’t generally viewed as items of real property won’t be treated as real property for this purpose.
The IRS also released Rev. Proc. 2018-59, which provides a safe harbor for certain infrastructure trades or business for purposes of qualifying as an electing real property trade or business under IRC §163(j)(7)(B).
Proposed Reg. §1.163(j)-5(b)(3) provides disallowed business interest expense carryforwards are deducted after current-year business interest expense and in the order of the taxable years in which they arose, beginning with the earliest year. These disallowed interest expense carryforwards also are subject to the separate return limitation year rules, as defined in Treas. Reg. §1.1502-1.
The proposed regulations also address the methods by which the business interest limitation and associated carryforwards should be allocated among consolidated group members. In situations where the aggregate amount of business interest expense, including carryforwards, of all members exceeds the consolidated group’s IRC §163(j) limitation for the year, the following rules apply:
- Each member with current-year business interest expense and either current-year business interest income or floor plan financing interest expense deducts its current-year business interest expense up to the amount of its business interest income and floor plan financing interest expense for the year.
- Each member with remaining current-year business interest expense, after applying the previous rule, deducts its current-year business interest expense pro rata, based on the relative amounts of remaining current-year business interest expense of all members.
Any member with remaining business interest expense after applying the above rules carries the disallowed expense forward to the succeeding taxable year. Members leaving the consolidated group will include their allocated carryforwards in their first separate return year.
ATI of Partnerships & Partners
The proposed regulations address the issue of partner-level adjustments made pursuant to IRC §743(b). Proposed Reg. §1.163(j)-6(f) states these adjustments aren’t taken into account when the partnership determines its IRC §163(j) limitation; however, these basis adjustments will be considered, if applicable, when determining ATI at the partner level under Prop. Reg. §1.163(j)-6(e). Conversely, adjustments made to the basis of partnership property under IRC §734(b) will be taken into account when determining partnership-level ATI.
The proposed regulations also include rules for determining the portion of the proceeds from the sale of a partnership interest that should be included in a selling partner’s ATI as well as an 11-step computation for allocating deductible business interest expense, excess taxable income, excess business interest income and excess business interest expense among partners.
Elections for Excepted Trades or Businesses
Certain real property and farming trades or businesses may elect out of the business interest expense limitation by following the guidance provided in Prop. Reg. §1.163(j)-9. An election statement must be attached to the taxpayer’s timely filed original federal tax return, including extensions, and is applicable for all subsequent years. A separate election statement must be made for each electing trade or business and should include basic information about the taxpayer and the trade or business.
Where a taxpayer transfers all the assets of an electing trade or business to a related party, any previously-made election remains intact and transfers with the trade or business to the related party. The proposed regulations also include an anti-abuse rule to prevent the unauthorized termination of a prior election. An anti-abuse rule also exists to prevent businesses that lease at least 80 percent of their real property to another trade or business under common control from using the real property trade or business exemption election.
Taxpayers with excepted and nonexcepted trades or businesses must allocate interest expense and interest income based on the relative amounts of the taxpayer’s adjusted basis in the assets used in each trade or business. Proposed Reg. §1.163(j)-10(c)(1) contains a general de minimis rule that allows a taxpayer having at least 90 percent of its basis in assets allocable to either excepted or nonexcepted trades or businesses to designate all of its properly allocable interest expense and income to excepted or nonexcepted trades or businesses, as applicable.
While the proposed regulations provide some clarity and guidance, several key areas of uncertainty remain pending future guidance—specifically, guidance on self-charged lending transactions. The IRS and Treasury have requested comments regarding the proposed regulations, which must be received within 60 days of being published in the Federal Register. A public hearing is scheduled for February 25, 2019.
The recently released proposed regulations also cover rules for calculating the limitation in international contexts and provide several detailed examples for taxpayers and their advisors to follow. Visit BKD’s Tax Reform Resource Center for insights into other TCJA provisions and contact Julia or your trusted BKD advisor for help determining how the new business interest limitation affects you and your business.
1Business interest income is interest includible in gross income and properly allocable to a trade or business
2ATI is taxable income computed without regard to any item of income, gain, deduction or loss not properly allocable to a trade or business, any business interest income or expense, net operating loss, IRC §199A deduction and, for tax years beginning before January 1, 2022, any deduction for depreciation, amortization or depletion
3Other than a tax shelter as defined in IRC §448(a)(3)
4Excess taxable income occurs when a pass-through entity’s business interest incurred is less than the calculated limitation. The proportion of ATI attributable to this “excess” is allowed to be included in the pass-through owner’s calculation of ATI