IRS Issues Final Regs on Sec. 163(j) Interest Expense Deduction Limitation

(Parker Tax Publishing January 2021)

The IRS issued final regulations providing guidance regarding the limitation on the business interest expense deduction under Code Sec. 163(j) to reflect amendments made by the Tax Cuts and Jobs Act and the Coronavirus Aid, Relief, and Economic Security Act. Specifically, the regulations address the application of the limitation in contexts involving passthrough entities, regulated investment companies (RICs), and controlled foreign corporations and also provide guidance regarding the definitions of "real property development," "real property redevelopment," and "syndicate." T.D. 9943.

Background

Code Sec. 163(j) generally limits the amount of business interest expense (BIE) that can be deducted in the tax year. Code Sec. 163(j) was amended by the Tax Cuts and Jobs Act (TCJA) and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). The TCJA amendments are effective for tax years beginning after December 31, 2017. The CARES Act provided special rules for applying Code Sec. 163(j) to tax years beginning in 2019 or 2020.

Under Code Sec. 163(j)(1), the amount allowed as a deduction for BIE is limited to the sum of:

(1) the taxpayer's business interest income (BII) for the tax year;

(2) 30 percent of the taxpayer's adjusted taxable income (ATI) for the tax year (30 percent ATI limitation); and

(3) the taxpayer's floor plan financing interest expense for the tax year (in sum, the Code Sec. 163(j) limitation).

Under Code Sec. 163(j)(2), the amount of any BIE that is not allowed as a deduction in a tax year due to the Code Sec. 163(j) limitation is treated as business interest paid in the succeeding tax year.

The Code Sec. 163(j) limitation applies to all taxpayers, except for certain small businesses that meet the gross receipts test in Code Sec. 448(c) and certain trades or businesses listed in Code Sec. 163(j)(7) (excepted trades or businesses). Under Code Sec. 163(j)(7), the excepted trades or businesses are (1) the trade or business of providing services as an employee, (2) electing real property businesses, (3) electing farming businesses, and (4) certain regulated utility businesses.

Code Sec. 163(j)(4) provides special rules for applying Code Sec. 163(j) in the case of passthrough entities. Code Sec. 163(j)(4)(A) requires that the Code Sec. 163(j) limitation be applied at the partnership level, and that a partner's ATI be increased by the partner's share of excess taxable income, as defined in Code Sec. 163(j)(4)(C), but not by the partner's distributive share of income, gain, deduction, or loss. Code Sec. 163(j)(4)(B) provides that the amount of partnership BIE exceeding the Code Sec. 163(j)(1) limitation is carried forward at the partner level as excess business interest expense (EBIE). Code Sec. 163(j)(4)(B)(ii) provides that EBIE allocated to a partner and carried forward is available to be deducted in a subsequent year only to the extent that the partnership allocates excess taxable income to the partner. Code Sec. 163(j)(4)(B)(iii) provides rules for the adjusted basis in a partnership of a partner that is allocated EBIE and Code Sec. 163(j)(4)(D) provides that rules similar to the rules of Code Sec. 163(j)(4)(A) and (C) apply to S corporations and S corporation shareholders.

Code Sec. 163(j)(10), as amended by the CARES Act, provides special rules relating to the 30 percent ATI limitation for tax years beginning in 2019 or 2020. Under Code Sec. 163(j)(10)(A)(i), the deductible amount of BIE 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 (50 percent ATI limitation). 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. This election must be made separately for each tax year. Once the taxpayer makes the election, the election may not be revoked without the IRS's consent.

Code Sec. 163(j)(10)(A)(ii)(I) and Code Sec. 163(j)(10)(A)(iii) provide that, in the case of a partnership, the 50 percent ATI limitation does not apply to partnerships for tax years beginning in 2019, and the election to not apply the 50 percent ATI limitation may be made only for tax years beginning in 2020, and may be made only by the partnership. Under Code Sec. 163(j)(10)(A)(ii)(II), however, a partner treats 50 percent of its allocable share of a partnership's EBIE for 2019 as BIE in the partner's first tax year beginning in 2020 that is not subject to the Code Sec. 163(j) limitation (50 percent EBIE rule). The remaining 50 percent of the partner's allocable share of the partnership's EBIE remains subject to the Code Sec. 163(j) limitation applicable to EBIE carried forward at the partner level. A partner may elect out of the 50 percent EBIE rule.

Code Sec. 163(j)(10)(B)(i) allows a taxpayer to elect to substitute its ATI for the last tax year beginning in 2019 (2019 ATI) for the taxpayer's ATI for a tax year beginning in 2020 (2020 ATI) in determining the taxpayer's Code Sec. 163(j) limitation for the tax year beginning in 2020. Code Sec. 163(j)(11) provides cross-references to provisions requiring that electing farming businesses and electing real property businesses excepted from the Code Sec. 163(j) limitation use the alternative depreciation system (ADS), rather than the general depreciation system, for certain types of property. The required use of ADS results in the inability of these electing trades or businesses to use the additional first-year depreciation deduction under Code Sec. 168(k) for those types of property.

In September of 2020, the IRS published final regulations under Code Sec. 163(j) in T.D. 9905. Concurrently, the IRS published proposed regulations under Code Sec. 163(j) in REG-107911-18 (proposed regulations) to provide additional guidance under Code Sec. 163(j) and to reflect amendments made by the CARES Act. The proposed regulations provided proposed rules:

(1) for allocating interest expense associated with debt proceeds of a partnership or S corporation to supplement the rules in Reg. Sec. 1.163-8T regarding the allocation of interest expense for purposes of Code Sec. 163(d) and (h) and Code Sec. 469 (Prop. Reg. Secs. 1.163-14 and 1.163-15);

(2) amending the definition of ATI and permitting certain RICs to pay Code Sec. 163(j) interest dividends (Prop. Reg. Sec. 1.163(j)-1);

(3) amending the rules for applying Code Sec. 163(j)(4) to partnerships and S corporations (Prop. Reg. Sec. 1.163(j)-6);

(4) re-proposing the proposed rules for applying the Code Sec. 163(j) limitation to foreign corporations and United States shareholders (Prop. Reg. Sec. 1.163(j)-7) and to foreign persons with effectively connected income (Prop. Reg. Sec. 1.163(j)-8);

(5) amending the definition of real property trade or business (Prop. Reg. Sec. 1.469-9);

(6) amending the rules for determining tax shelter status and providing guidance on the election to use 2019 ATI to determine 2020 Code Sec. 163(j) limitation (Prop. Reg. Secs. 1.163(j)-2 and 1.1256(e)-2); and

(7) amending the corporate look-through rules as applicable to tiered structures (Prop. Reg. Sec. 1.163(j)-10).

On April 27, 2020, the IRS published Rev. Proc. 2020-22 to provide the time and manner of making a late election, or withdrawing an election, 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. These elections are: (1) to elect out of applying the 50 percent ATI limitation; (2) to elect to use the taxpayer's 2019 ATI to calculate the taxpayer's Code Sec. 163(j) limitation for any tax year beginning in 2020; and (3) for a partner to elect out of the 50 percent EBIE rule.

Final Regulations

Last week, the IRS finalized the proposed regulations with the issuance of T.D. 9943. The final regulations retain the same basic structure as the proposed regulations with revisions made in response to practitioners' comments.

The proposed regulations provided special rules for partners and partnerships for tax years beginning in 2019 or 2020 under Code Sec. 163(j)(10) as enacted by the CARES Act. Prop. Reg. Sec. 1.163(j)-6(g)(4) provided that 50 percent of any EBIE allocated to a partner for any tax year beginning in 2019 is treated as BIE paid or accrued by the partner in the partner's first tax year beginning in 2020. The amount treated as BIE paid or accrued by the partner in the partner's 2020 tax year was not subject to a Code Sec. 163(j) limitation at the partner level. The proposed regulations further provided that if a partner disposed of its interest in the partnership in the partnership's 2019 or 2020 tax year, the amount treated as BIE paid or accrued by the partner under Prop. Reg. Sec. 1.163(j)-6(g)(4) would be deductible by the partner and thus would not result in a basis increase. The proposed regulations stated that a taxpayer could elect to not have Prop. Reg. Sec. 1.163(j)-6(g)(4) apply.

One practitioner requested that the final regulations clarify that an election out of the 50 percent EBIE rule is made by a partner with respect to each partnership in which the partner holds an interest. The practitioner stated that partners may have different reasons to elect out of the 50 percent EBIE rule and that, by allowing partners to make the election out with respect to each partnership, partners will have greater flexibility in managing their tax consequences. The IRS agreed with this comment, and the final regulations clarify that partners may elect out of the 50 percent EBIE rule on a partnership by partnership basis.

Another practitioner requested confirmation with respect to an aspect of the example in Prop. Reg. Sec. 1.163(j)-6(o)(36). In the example, the partner is allocated EBIE in 2018 and 2019 and sells its partnership interest in 2019. The practitioner requested confirmation that the partner would not deduct 50 percent of the EBIE since the sale of the partnership interest occurred in 2019, resulting in a gain/loss recognition event during the 2019 tax year, and there would be no basis in the partnership for the partner to deduct 50 percent of the 2019 EBIE. In response, the IRS clarified in the final regulations that, under Reg. Sec. 1.163(j)-6(g)(4), business interest expense can be deducted by the disposing partner only to the extent such deduction would not have been limited under Code Sec. 704(d) immediately before the disposition.

Effective Date

The final regulations apply to tax years beginning on or after the date the final regulations are published in the Federal Register. Some provisions regarding the choice to apply the final regulations to tax years beginning before the applicability date were changed from the proposed regulations. Practitioners noted that these provisions in the proposed regulations were complicated. Specifically, in the proposed regulations, retroactive application of certain provisions required application of all of the Code Sec. 163(j) regulations contained in T.D. 9905, some or all of the provisions in these final regulations, and other specified provisions. Additionally, most provisions had to be applied to subsequent tax years once applied for a tax year. To simplify the applicability date provisions and provide certainty to taxpayers, the final regulations generally require taxpayers choosing to apply the final regulations to a tax year beginning before the applicability date to apply the Code Sec. 163(j) regulations contained in T.D. 9905 as modified by the final regulations in T.D. 9943, along with other specified provisions, and require subsequent year application. Generally, taxpayers and their related parties may choose to apply the final regulations in T.D. 9943 to a tax year beginning after December 31, 2017, and before the date the final regulations are published in the Federal Register, provided that they consistently apply the Code Sec. 163(j) regulations contained in T.D. 9905 as modified by the final regulations in T.D. 9943.

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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