The IRS released final regulations on the Tax Cuts and Jobs Act (TCJA) Section 163(j) business interest limitation as well as new proposed regulations addressing complex issues for partnerships and controlled foreign corporations (CFCs).
Certain small business taxpayers with average aggregated gross receipts of $26 million or less for 2019 and 2020 (adjusted annually for inflation) may be exempt from the Sec. 163(j) limitation on business interest expense deductions. The IRS released FAQs regarding the aggregation rules which we discuss in this blog here.
Background
Under the Tax Cuts and Jobs Act (TCJA), the deduction for business interest expense is limited, with several exceptions, to 30% of the adjusted taxable income (ATI) of the business for tax years beginning on or after January 1, 2018. The CARES Act temporary increases this threshold to 50% of ATI for tax years 2019-2020 (more on this information in our previous blog here). The IRS issued proposed regulations in November 2018 addressing the TCJA changes to business interest and have now issued final regulations which primarily adopt the proposed regulations with a few key exceptions. At the same time, the IRS also issued new proposed regulations to provide supplemental guidance on various issues primarily for partnerships and controlled foreign corporations (CFCs).
Key Differences in the Final Regulations
- Certain items removed from the definition of business interest: The final regulations narrowed the definition of business interest to exclude commitment fees, debt issuance costs, partnership guaranteed payments for use of capital, and hedging transactions. While this is a favorable change for taxpayers, the IRS also expanded anti-avoidance rules.
- Addback allowed for depreciation, amortization, and depletion capitalized under IRC 263A: Depreciation, amortization, and depletion that is capitalized to inventory under IRC Section 263A is allowed as an addback to “tentative taxable income” (a new term introduced in the final regulations) when calculating ATI. This is another favorable change from the proposed regulations which did not allow an addback for the portion capitalized into inventory until it was recovered through cost of goods sold.
- Adjustments for dispositions: For dispositions of depreciable property, a subtraction is required for depreciation deductions taken after 12/31/17 and before 1/1/22 (the EBITDA period) instead of subtracting the lessor of the gain or depreciation taken during the EBITDA period as prescribed under the previously proposed regulations. However, the new proposed regulations issued alongside the final regulations continue to allow the “lessor of” approach if used consistently. The final regulations also contain changes to the rules for adjusting ATI upon disposition of stock of a consolidated group member or interest in a partnership.
Ordering Rules Addressed
- The final regulations confirm that the Section 163(j) limitation applies after other provisions affecting the deductibility of interest such as capitalized interest and deferral of accrued interest to related taxpayers or foreign persons under IRC Section 267.
- Amounts that are not characterized as interest expense under another provision are also not subject to the Section 163(j) limitation.
- Section 163(j) generally applies before the limitation on excess business loss of noncorporate taxpayers under IRC Section 461(l), the at-risk basis limitation under Section 465, and the passive activity loss limitation under Section 469. These three sections are first factored into the calculation of tentative taxable income to determine the 163(j) limitation. After the 163(j) limitation is determined, Sections 461(l), 465, and 469 are applied. If any business interest expense allowable after application of 163(j) is disallowed as a result of a 465 or 469 limitation (section 461(l) was not mentioned), that interest is not subject to the 163(j) limitation in subsequent tax years.
- For now, the final regulations allow “any reasonable approach” as long as consistently used to address the circular calculation caused by the interaction of the Section 163(j) limitation with other provisions that limit deductions based on taxable income (such as FDII and GILTI deductions under Section 250(a)(2), the charitable contribution 10% limitation, and NOL deduction.)
- Use of 2019 ATI for a 2020 short year under the CARES Act: The CARES Act allows 2019 ATI to be used in calculating the interest limitation for 2020. If 2020 is a short year, the final regulations allow ATI for the last tax year beginning in 2019 to be prorated based on the number of months in the short year during 2020.
- Order of utilization for business interest expense carryforwards: Current year business interest expense is deducted before any carryovers of disallowed interest. Carryforwards are then used in order, starting with the oldest year. For corporations, Section 382 and SRLY limitations apply. The regulations also address specific situations affecting utilization of carryforwards for consolidated group members.
Provisions Impacting Pass-Through Entities
- Simplification of the 11-step allocation for partnerships with pro rata allocations: The proposed regulations previously provided an 11-step calculation to allocate excess taxable income, excess business interest expense, and excess business interest income for partnerships. While the final regulations adopt this 11-step allocation, it also allows a more simplified approach for partnerships which allocate all items proportionately (similar to an S Corporation.) Using this “pro rata exception”, the partnership would allocate all items proportionately at step 2 and skip the remaining steps. The final regulations also confirm that allocations under the 11-step approach meet the requirements of Section 704(b).
- Business interest expense allocated by exempt small-business partnerships/S Corporations not subject to 163(j) at the partner/shareholder level: Business interest expense allocated by exempt small-business partnerships and S Corporations (average gross receipts of $26 million or less) is not subject to the 163(j) limitation at the partner/shareholder level. This is a favorable change from the proposed regulations which required the 163(j) limitation to be applied at both the entity and partner/shareholder levels.
- Basis adjustments for partial disposition of a partnership interest: Excess business interest expense (EBIE) reduces a partner’s adjusted basis. Upon disposition of a partnership interest, unused EBIE carryforward generally increases the partner’s adjusted basis. A partial increase in basis is now allowed under the final regulations for partial dispositions (and the EBIE carryforward is reduced by the same proportion). This is a favorable change from the proposed regulations which only allowed the basis increase for complete dispositions.
- C corporation interest income/expense all deemed trade or business: All interest expense, interest income, and other items of income/deduction of a C corporation are allocated to a trade or business. Thus, investment interest expense and investment interest income allocated from a partnership to a C corporation partner are treated as business interest expense/income of the corporation. This does not impact the characterization at the partnership level. The investment interest expense is not treated as excess business interest expense (and the investment interest income is not treated as excess taxable income) from the partnership. Rather, they are included as the corporation’s own business interest expense/income subject to limitation at the corporate level.
- Elections for excepted trades or businesses: The final regulations address elections available to excepted trades or businesses, including allowing a protective election for an “electing real property trade or business” when it is unclear whether the activity rises to the level of a trade or business (such as real property rented under a triple net lease.)
- Foreign corporations subject to 163(j): The final regulations confirm that the Section 163(j) limitation applies to CFCs and other foreign corporations whose income is relevant for U.S. tax purposes. However, the new proposed regulations issued simultaneously with the final regulations contain many provisions impacting CFCs which simplifies the application. This is discussed in more detail below.
The final regulations generally apply to the first tax year beginning 60 days after the final regulations are published in the Federal Register which would mean tax year 2021 for calendar year taxpayers. The final regulations may be applied prior to this date if applied entirely and consistently.
New Proposed Regulations Impacting Partnerships and CFCs
Along with the final regulations, new proposed regulations were also issued which address complex issues for partnerships and controlled foreign corporations (CFCs). Click here for our comprehensive blog detailing these new proposed regulations.
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