Monday, September 7, 2020
The rules surrounding the limitation on deducting business interest have changed significantly for tax years beginning after 2017. They were modified again earlier this year as part of one of the relief packages designed to deal with the 2020 self-inflicted recession related to the virus that originated in China and ultimately spread to the United States. Guidance was then provided about the ability of some taxpayers to elect out of the limitation and making late elections. Final and proposed regulations have also been issued as well as Frequently Asked Questions (FAQs) for determining a taxpayer’s gross receipts for purposes of the small business exception to the limitation.
The rules on deducting business interest – it’s the topic of today’s post.
The deduction limitation. The Tax Cuts and Jobs Act (TCJA) specified that, for tax years beginning after 2017, deductible business interest expense is limited to business interest income for the tax year plus 30 percent of the taxpayer’s adjusted taxable income (ATI) for the tax year that is not less than zero. I.R.C. §163(j). Not relevant to farmer and ranchers, “floor plan financing interest,” is fully deductible. That’s a “biggie” for automobile dealers.
Definitions. Business interest is defined as the amount of interest paid or accrued on indebtedness that is included in the taxpayer’s gross income for the tax year that is properly allocable to a trade or business. It does not include investment income within the meaning of I.R.C. §163(d). Defining a trade or business for purposes of the determining business interest is based on the passive loss rules of I.R.C. §469. I.R.C. §163(j) excludes I.R.C. §163(d) interest, which excludes trade or business interest as defined by the passive loss rules. I.R.C. §163(j)(5).
ATI is defined as the taxpayer’s taxable income computed without regard to any item of income, gain, deduction or loss that is not properly allocable to a trade or business; any business interest expense or business interest income; any NOL deduction and any I.R.C. §199A deduction, and (for tax years beginning before 2022) any deduction allowable for depreciation, amortization, or depletion.
Carryover. Any disallowed amount is treated as business interest paid or accrued in the succeeding tax year. I.R.C. §163(j)(2); Notice 2018-28. A taxpayer is to use Form 8990 to calculate and report the deduction and the amount of disallowed business interest expense to carry forward to the next tax year.
“Small business” exception. A “small business,” defined as a business entitled to use cash accounting (i.e., average gross receipts do not exceed $25 million (inflation-adjusted) for the three tax-year period ending with the tax year that precedes the tax year at issue) are not subject to the limitation. I.R.C. §163(j)(3). Thus, if average gross receipts are $25 million or less, there is no change in the rules concerning the deductibility of interest – business interest remains fully deductible. The threshold for being able to utilize cash accounting is, for 2020, set at average gross revenue not exceeding $26 million.
Gross receipts are defined as gross sales; investment income (regardless of whether it is earned in a business); and all amount received for services. Treas. Reg. §1.448-1T. The test applies to the taxpayer rather than the business. In addition, the receipts of all persons that are treated a single employer under I.R.C. §52(a) or (b) (businesses that are under common control) or I.R.C. §414(m) or (o) (employees of an affiliated service group) are aggregated. Id.
The threshold test applies to the taxpayer rather than the business. That has particular implications for partnerships. For a partnership, the business interest limitation applies at the partnership level. Thus, a partnership treats its business interest as a non-separately computed deduction for purposes of I.R.C. §702. Any business interest deduction that is allowed after being limited (if necessary) is combined with other non-separate deductions and income and passed through to the partners as ordinary income or loss. I.R.C. §163(j)(4)(i). Thus, each partner’s ATI is determined without regard to the partner’s distributive share of any of the partnership’s items of income, gain, deduction, or loss. Stated another way, a partner’s ATI is tied to the partner’s non-partnership income and the partner’s share of any excess taxable income of the partnership. I.R.C. §163(j)(4)(ii). Comparable rules apply to S corporations and their shareholders. I.R.C. §163(j)(4)(D).
Election out of the limitation. Two types of businesses can make an irrevocable election to avoid the limitation on interest deductibility – a “real property trade or business” and a “farming business.” For this purpose, a cash rent landlord is not engaged in a farming business. An “electing farm business” that is barred from using cash accounting because gross revenue exceeds the threshold can elect to not be subject to the limitation on the deductibility of interest. For this purpose, a “farm business” is defined as the trade or business of farming, including the trade or business of operating a nursery or sod farm, or the raising or harvesting of trees bearing fruit, nuts or other crops, or ornamental trees. An evergreen tree which is more than six years old at the time that it is severed from the roots is not treated as an ornamental tree. I.R.C. §263A(e)(4).
In return, such farm business must use the alternative depreciation system (ADS) on purchases of farm property with a recovery period of 10 years or more. The use of ADS will result in the inability to take bonus depreciation on otherwise eligible assets (in accordance with I.R.C. §263A). Also, the required switch to ADS for the taxpayer’s existing property is not a change in accounting method. It’s just a change in use. See Rev. Proc. 2019-8, 2019-3 I.R.B.
Treas. Reg. §1.168(i)-4(d) specifies that when a business switches to a longer ADS life as the result of a change in use, the depreciation deductions beginning with the year of the change are determined as though the taxpayer originally placed the property in service with the longer recovery period and/or the slower depreciation method. Then, the business uses the asset’s remaining basis and depreciates it via the straight-line method over the asset’s remaining life as if it had originally been placed in service with the ADS life. See Treas. Reg. §1.168(i)-4(d)(6), Example 3.
CARES Act Changes
The Coronavirus Aid, Relief, and Economic Security (CARES) Act enacted in late March of 2020 allows a business with gross receipts over $26 million (for 2020) to elect to increase the limitation on the deduction of interest from 30 percent of ATI to 50 percent of ATI for tax years beginning in 2019 and 2020. A business may elect to use 2019 ATI in calculating the 2020 limitation. If an election is made to compute the limitation using 2019 ATI for a tax year that is a short tax year, the ATI for the taxpayer’s last tax year beginning in 2019 which is substituted under the election will be equal to the amount which bears the same ratio to the ATI as the number of months in the short taxable year bears to 12. A taxpayer may elect out of the increase for any tax year beginning in 2019 or 2020. It is an irrevocable election unless IRS consents to a revocation.
IRS Guidance. In Rev. Proc. 2020-22, 2020-18 I.R.B., the IRS set forth the rules for making a late election or withdrawing an election for real property trades or businesses and farming businesses. The IRS, in the Rev. Proc, also provided guidance concerning the following:
- The time and manner for electing out of the 50 percent of ATI limitation for tax years beginning in 2019 and 2020;
- Using the taxpayer’s ATI for the last tax year beginning in 2019 to calculate the taxpayer’s limitation for tax year 2020; and
- Electing out of deducting 50 percent of excess business interest expense for tax years beginning in 2020 without limitation.
A farming business that previously elected not to have the interest limitation apply, can either make a late election or elect out of the election that was previously made. This provides flexibility and may allow the use of bonus depreciation on assets with a 10-year or longer life and MACRS depreciation.
The 50 percent of ATI limitation does not apply to partnerships for taxable years beginning in 2019. Rather, a partner treats 50 percent of the partner’s allocable share of the partnership’s excess business interest expense for 2019 as an interest deduction in the partner’s first taxable year beginning in 2020 without limitation. The remaining 50 percent of excess business interest from 2019 is subject to the ATI limitation as it is carried forward at the partner level. Effective for tax years beginning after 2018, a partner may elect out of the 50% limitation.
Regulations. In late July of 2020, the IRS issued final and proposed regulations that detail how to calculate the interest expense limitation, what constitutes “interest” for purposes of the limitation, the taxpayers that are subject to the limitation, and how the limitation applies to partnerships (among other types of taxpayers). T.D. 9505. In large part, the final regulations mirror the 2018 proposed regulations. However, while the proposed regulations provided a broad definition of “business interest,” the final regulations are narrower. The regulations are generally applicable to tax years beginning on or after November 13, 2020.
The proposed regulations issued along with the final regulations address the allocation of interest expense for passthrough entities, and propose a modification to the definition of a real property trade or business under I.R.C. §163(j)(7)(B).
FAQs. The IRS has also posted FAQs on it website concerning the aggregation rules that apply for purposes of the gross receipts threshold. https://www.irs.gov/newsroom/faqs-regarding-the-aggregation-rules-under-section-448c2-that-apply-to-the-section-163j-small-business-exemption#footnote-1
The typical farm and ranch business will have little business interest income unless sales are financed. However, livestock feedlots follow a highly leveraged business model with characteristically high levels of business interest income and expense. The substantial majority of farming/ranching businesses will be able to elect out of the limitation and fully deduct business interest. But the election out comes at a price. Once again, sage tax and legal counsel is a must.