The Coronavirus Aid, Relief, and Economic Security (CARES) Act provides roughly $2 trillion of much-needed financial relief, including tax relief, to individuals and businesses. This relief is in response to the coronavirus (COVID-19) pandemic. One CARES Act provision temporarily relaxes the Tax Cuts and Jobs Act (TCJA) limitation on deductions for business interest expense. Here’s the story.
|What is ATI?
Adjusted taxable income (ATI) refers to taxable income calculated by making adjustments to factor out the following:
Deductions for depreciation, amortization and depletion are added back when calculating adjusted taxable income for tax years beginning before 2022. For tax years beginning in 2022 and beyond, these deductions won’t be added back, which may greatly increase the taxpayer’s adjusted taxable income amount and result in a lower interest expense limitation amount.
TCJA Limitation on Business Interest Expense Deductions
Before the TCJA, some corporations were subject to the so-called “earnings stripping” rules. Those rules attempted to limit deductions by U.S. corporations for interest paid to related foreign entities that weren’t subject to U.S. income tax. Other taxpayers could generally fully deduct business interest expense (subject to other tax-law restrictions, such as the passive loss rules and the at-risk rules).
The TCJA shifted the business interest deduction playing field. For tax years beginning in 2018 and beyond, a taxpayer’s deduction for business interest expense for the year is limited to the sum of:
- Business interest income,
- 30% of adjusted taxable income (ATI), and
- Floor plan financing interest expense paid by certain vehicle dealers.
Business interest expense is defined as interest on debt that’s properly allocable to a trade or business. However, the term trade or business doesn’t include the following excepted activities:
- Performing services as an employee,
- Electing real property businesses,
- Electing farming businesses, and
- Selling electrical energy, water, sewage disposal services, gas or steam through a local distribution system, or transportation of gas or steam by pipeline, if the rates are established by a specified governing body.
Interest expense that’s disallowed under the limitation rules is carried forward to future tax years indefinitely and treated as business interest expense incurred in the carry-forward year.
Small Business Exception
Many businesses are exempt from the interest expense limitation rules under what we’ll call the small business exception. Under this exception, a taxpayer (other than a tax shelter) is exempt from the limitation if the taxpayer’s average annual gross receipts are $25 million or less for the three-tax-year period ending with the preceding tax year.
Businesses that have fluctuating annual gross receipts may qualify for the small business exception for some years but not for others — depending on the average annual receipts amount for the preceding three-tax-year period. For example, if your business has three good years, it may be subject to the interest expense limitation rules for the following year. But if your business has a bad year, it may qualify for the small business exception for the following year. If average annual receipts are typically over the $25 million threshold, but not by much, judicious planning may allow you to qualify for the small business exception for at least some years. Your tax advisor can help with that.
Special Rules for Partnerships and S Corporations
The interest expense deduction limitation rules get more complicated for businesses operating as partnerships, limited liability companies (LLCs) treated as partnerships for tax purposes and S corporations.
Basically, the limitation is calculated at both the entity level and at the owner level. Special rules prevent double counting of income when calculating an owner’s adjusted taxable income (ATI) for purposes of applying the limitation rules at the owner level.
IRS proposed regs set forth the special rules for applying the business interest expense limitation to partnerships and S corporations and their owners. The rules are complex and present significant compliance challenges. That’s what tax professionals are for.
Favorable CARES Act Changes
The CARES Act generally allows businesses, unless they elect otherwise, to increase the interest expense deduction limitation to 50% of ATI for tax years beginning in 2019 and 2020. (See “Electing Out of the Limitation,” below.) Businesses can also elect to use 2019 ATI to calculate the 2020 ATI limitation.
For partnerships (including LLCs treated as partnerships for tax purposes), the 30% of ATI limitation remains in place for tax years beginning in 2019 but is 50% for 2020. Disallowed partnership business interest expense from a partnership’s 2019 tax year is allocated to partners and carried over to their 2020 tax years. Unless a partner elects otherwise, 50% of carried-over partnership business interest expense from 2019 is deductible in the partner’s 2020 tax year without regard to the business interest expense limitation rules. The remaining 50% is subject to the normal limitation rules, calculated at the partner level, for carried-over partnership business interest expense. Like other businesses, partnerships can elect to use 2019 ATI to calculate the 2020 ATI limitation.
Help Is Available
As you can see, the business interest expense limitation rules are complicated. The temporarily relaxed limitations on business interest deductions included in the CARES Act can allow affected businesses to reduce their federal tax liabilities for 2019 and 2020. However, for partnerships and partners, the business interest expense limitation rules are only relaxed for 2020. Your tax advisor can help your business take advantage of the relaxed rules for business interest expense deductions and benefit from other tax relief measures made available by the CARES Act.
|Electing Out of the Business Interest Expense Limitation
Eligible real property and farming businesses can elect out of the business interest expense limitation. However, electing to be exempt has a tax cost.
Real Property Businesses
Real property businesses can elect out of the business interest expense limitation rules if they use the slower Alternative Depreciation System (ADS) method to depreciate their nonresidential real property, residential rental property and qualified improvement property. Using the ADS method results in lower annual depreciation deductions because its depreciation periods are longer than the depreciation periods under the regular MACRS (Modified Accelerated Cost Recovery System) method. Real property businesses include developing, redeveloping, constructing, reconstructing, acquiring, converting, renting, operating, managing, leasing and brokering real property.
Affected real estate businesses should evaluate the tax benefit of gaining bigger interest expense deductions by electing out of the interest expense limitation rules vs. the tax detriment of lower depreciation deductions under the ADS method. If the election out is made, first-year bonus depreciation that would otherwise be allowed for eligible real property is not allowed under the ADS method.
Eligible farming businesses can also elect out of the business interest expense limitation rules. Farming businesses include nurseries; sod farms; raising or harvesting of tree crops, other crops, or ornamental trees; and certain agricultural and horticultural cooperatives. These businesses can elect out of the rules if they use the ADS method to depreciate assets used in the farming business that have MACRS depreciation periods of 10 years or more.
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