IRS Issues Final Regs on Business Interest Expense Deduction Limitation

(Parker Tax Publishing August 2020)

The IRS published final regulations that provide guidance to taxpayers on how to calculate the limitation on the deduction for business interest expense under Code Sec. 163(j), what constitutes interest for purposes of the limitation, which taxpayers and trades or businesses are subject to the limitation, and how the limitation applies in consolidated group, partnership, international, and other contexts. In addition, the IRS (1) issued proposed regulations to address certain issues not covered by the final regulations, (2) issued a notice containing a proposed revenue procedure that provides a safe harbor allowing qualified residential living facilities to be treated as real property trades or businesses, and (3) posted FAQs on its website regarding the aggregation rules that apply for purposes of the Code Sec. 163(j) small business exception. T.D. 9905; REG-107911-18; Notice 2020-59.

Background

Effective for tax years beginning after December 31, 2017, the Tax Cuts and Jobs Act of 2017 (TCJA) enacted a limitation in Code Sec. 163(j) on the amount of business interest that some taxpayers may deduct. Code Sec. 163(j)(1) generally provides that, for tax years beginning after 2017, a taxpayer's deduction for business interest in any tax year cannot exceed the sum of:

(1) the business interest income of the taxpayer for such tax year;

(2) 30 percent (50 percent for years beginning in 2019 or 2020) of the adjusted taxable income (ATI) of such taxpayer for such tax year; plus

(3) the floor plan financing interest of such taxpayer for such tax year.

Code Sec. 163(j)(2) provides that the amount of any business interest not allowed as a deduction for any tax year as a result of the Code Sec. 163(j) limitation is carried forward and treated as business interest paid or accrued in the next tax year. Under Code Sec. 163(j)(3), there is a small business exemption under which the business interest expense limitation does not apply to a taxpayer, other than a tax shelter, with average annual gross receipts of $25 million or less, as adjusted for inflation ($26 million for tax years beginning in 2020). For taxpayers other than corporations or partnerships, the gross receipts test is determined as if the taxpayer were a corporation or partnership.

In addition, the limitation does not apply to certain trades or businesses listed in Code Sec. 163(j)(7). Those trades or businesses include:

(1) the trade or business of performing services as an employee;

(2) any electing real property trade or business;

(3) any electing farming business; or

(4) the trade or business of the furnishing or sale of (i) electrical energy, water, or sewage disposal services, (ii) gas or steam through a local distribution system, or (iii) transportation of gas or steam by pipeline, if the rates for such furnishing or sale meet certain conditions.

The Coronavirus Aid, Relief, and Economic Security (CARES) Act amended Code Sec. 163(j) to provide special rules relating to the 30 percent ATI limitation for tax years beginning in 2019 or 2020. Under Code Sec. 163(j)(10), the amount of business interest that is deductible under Code Sec. 163(j)(1) for tax years beginning in 2019 or 2020 is computed using 50 percent, rather than 30 percent, of the taxpayer's ATI for the tax year. A taxpayer may elect not to apply the 50 percent ATI limitation to any tax year beginning in 2019 or 2020, and instead apply the 30 percent ATI limitation.

The IRS published proposed regulations (REG-106089-18) in December of 2018 relating to Code Sec. 163(j) and withdrew proposed regulations relating to the disallowance of an interest deduction under the pre-TCJA Section 163(j) rules. In September of 2019, the IRS issued proposed regulations under Code Sec. 382(h) (REG-125710-18) that included a rule to clarify that Code Sec. 382 disallowed business interest carryforwards are not treated as recognized built-in losses (RBILs). In April of 2020, the IRS released Rev. Proc. 2020-22 to provide the time and manner of making or revoking elections under Code Sec. 163(j)(7)(B) to be an electing real property trade or business, or under Code Sec. 163(j)(7)(C) to be an electing farming business, for tax years beginning in 2018, 2019, or 2020. Rev. Proc. 2020-22 also provides the time and manner of making or revoking elections provided by the CARES Act under Code Sec. 163(j)(10) for tax years beginning in 2019 or 2020.

In late July, the IRS issued final regulations (T.D. 9905), proposed regulations (REG-107911-18), and a proposed revenue procedure in Notice 2020-59 to provide additional guidance on the business interest expense deduction limitation under Code Sec. 163(j). The IRS also posted FAQs on its website regarding the aggregation rules under Code Sec. 448(c)(2) that apply for purposes of the Code Sec. 163(j) small business exception.

Taxable Income and Tentative Taxable Income

The proposed regulations define ATI as the "taxable income" of the taxpayer for the tax year, with certain specified adjustments. Thus, in calculating ATI, the proposed regulations begin with taxable income as the amount to which adjustments are made when calculating ATI. Prop. Reg. Sec. 1.163(j)-1(b)(37)(i) generally provides that the term "taxable income" has the meaning provided in Code Sec. 63, but for purposes of Code Sec. 163(j), is computed without regard to the application of Code Sec. 163(j) and the Code Sec. 163(j) regulations. However, in some instances in the Code Sec. 163(j) regulations, the term "taxable income" is used to indicate the amount calculated under Code Sec. 63 for purposes other than calculating ATI.

To prevent confusion that could arise from using the term "taxable income" in different contexts (in determining ATI, and for purposes other than determining ATI), Reg. Sec. 1.163(j)-1(b)(43) of the final regulations uses a new term, "tentative taxable income," to refer to the amount to which adjustments are made in calculating ATI. Tentative taxable income is generally determined in the same manner as taxable income under Code Sec. 63, but is computed without regard to the application of the Code Sec. 163(j) limitation, and without regard to any disallowed business interest expense carryforwards. According to the IRS, this definitional change avoids confusion with Code Sec. 63 taxable income and ensures that disallowed business interest expense carryforwards are taken into account only once in testing business interest expense against the limitation. Therefore, the term "tentative taxable income" is used in the final regulations to describe the starting point for the calculation of ATI.

Adjustments to ATI for Depreciation, Amortization, and Depletion

Code Sec. 163(j)(8)(A)(v) defines ATI as the taxable income of the taxpayer computed without regard to certain items, including any deduction allowable for depreciation, amortization, or depletion for tax years beginning before January 1, 2022. However, the 2018 proposed regulations had provided that depreciation, amortization, or depletion expense capitalized into inventory under Code Sec. 263A was not a depreciation, amortization, or depletion deduction, that may be added back to taxable income in computing ATI. Practitioners were unhappy with this rule and requested that the add back of deductions for depreciation, amortization, and depletion include any amount that is required to be capitalized into inventory under Code Sec. 263A. First, practitioners stated that the provision in the proposed regulations did not reflect congressional intent, which was to determine ATI using earnings before interest, tax, depreciation, and amortization through tax year 2021 and using earnings before interest and tax thereafter. Practitioners also contrasted the language in Code Sec. 163(j)(8)(A)(iv), which allows an add back of "the amount of any deduction allowed under section 199A," with Code Sec. 163(j)(8)(A)(v), which allows an add back of "any deduction allowable for depreciation, amortization, or depletion."

The IRS agreed and, under the final regulations, the amount of any depreciation, amortization, or depletion that is capitalized into inventory under Code Sec. 263A during tax years beginning before January 1, 2022, is added back to tentative taxable income as a deduction for depreciation, amortization, or depletion when calculating ATI for that tax year, regardless of the period in which the capitalized amount is recovered through COGS.

Calculation of Taxable Income

Prop. Reg. Sec. 1.163(j)-1(b)(1)(i)(A) provides that business interest expense is added to taxable income to determine ATI. Practitioners noted that this provision could be construed as distorting ATI if a taxpayer has a disallowed business interest expense carryforward from a prior tax year. In the preamble to the final regulations, the IRS stated that it did not intend to create a net positive adjustment to ATI for disallowed business interest expense carryforwards. Thus, the final regulations clarify that tentative taxable income is computed without regard to the Code Sec. 163(j) limitation, and that disallowed business interest expense carryforwards are not added to tentative taxable income in computing ATI under Reg. Sec. 1.163(j)-1(b)(1).

Section 163(j) and Discharge of Indebtedness Income

One issue not addressed in the final regulations is the interaction between Code Sec. 163(j) and the rules addressing income from the discharge of indebtedness under Code Sec. 108. In response to the proposed regulations, practitioners commented that it is unclear whether cancellation of indebtedness income under Code Sec. 61(a)(11) arises when the taxpayer only receives a benefit in the form of a disallowed business interest expense carryforward, or whether any exclusions, such as Code Sec. 108(e)(2) or Code Sec. 111, or any tax benefit principles, should apply. In the preamble to the final regulations, the IRS stated that, in light of the complex and novel issues raised in the comments, the interaction between Code Sec. 163(j) and Code Sec. 108 requires further consideration and may be the subject of future guidance.

Proposed Regulations

In the proposed regulations (REG-107911-18), the IRS provides additional guidance on various business interest expense deduction limitation issues not addressed in the final regulations, including more complex issues related to the amendments made by the CARES Act. For example, the proposed regulations provide rules that discuss the characterization of interest expense associated with debt proceeds of partnerships and S corporations, including where debt is used to fund distributions and debt proceeds of partners or shareholders allocated to the acquisition of an interest in a passthrough entity.

Notice 2020-59

The proposed revenue procedure in Notice 2020-59 provides a safe harbor allowing taxpayers engaged in a trade or business that manages or operates qualified residential living facilities to treat such a trade or business as a real property trade or business solely for purposes of qualifying as an electing real property trade or business under Code Sec. 163(j)(7)(B).

IRS FAQs Regarding Aggregation Rules for Gross Receipts Test

The FAQs posted on the IRS website provide guidance regarding the aggregation rules under Code Sec. 448(c)(2) that apply to the Code Sec. 163(j) small business exemption. The FAQs provide a general overview of the aggregation rules that apply for purposes of the gross receipts test, and that apply to determine whether a taxpayer is a small business that is exempt from the business interest expense deduction limitation.

For a discussion of the business interest expense deduction limitation, see Parker Tax ¶92,323.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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