By Miranda Aavatsmark
Iceberg! Straight ahead! Although there are many theories why the unsinkable ship, the Titanic, sank, ultimately the piercing claws of the iceberg underwater was the cause of her untimely fate. When The Tax Cuts and Jobs Act of 2017 (TCJA) rolled out a new limitation on business interest expense, it appeared, at first glance, to affect mostly large businesses whose average annual gross receipts exceed $25 million. However, in dissecting this new law, the image of a looming iceberg comes to mind. As accountants and business owners begin to muddle through the process of compliance with the new tax laws, we should pay close attention to this new limitation. The same way an iceberg appears friendly and non-threatening on the surface, this new law has the potential to do some damage if we do not dive into the deep waters of the Tax Code. In particular, the rules of aggregation and attribution may cause smaller businesses to be subject to the limitation. Many family-owned businesses and their related companies, as stand-alone entities, may not exceed the $25 million threshold; however, when aggregated together, their combined gross receipts may push them over the edge. Before explaining how the rules related to attribution and aggregation work, let’s do give an overview of the old and new law for deducting business interest expense.
In the olden times, before TCJA, certain interest expense paid by corporations was already limited. Earnings stripping, as it was called, referred to interest paid to a related party who paid no U.S. income tax. Such interest was disqualified and not deductible by a corporation if their debt-to-equity ratio exceeded 1.5 to 1. Generally, all other interest expense was fully deductible. But file this in the “who cares” bucket because TCJA repealed these rules and replaced them with a general limitation on business interest expense, regardless of who receives the interest. Additionally, Proposed Regulations were issued by the Internal Revenue Service on November 26, 2018, that provides additional explanation and details regarding this deduction.
Interest paid by a business is now limited to the sum of the following:
- Business interest income
- 30% of adjusted taxable income, plus
- Floor plan financing interest (interest paid by vehicle dealers)
A few items to note regarding the limitations above:
- Business interest income is generally not investment interest, but interest earned on trade accounts, for example. However, a C-Corporation does not differentiate between investment interest and “trade or business” interest for tax purposes. Therefore, a C-Corporation would consider all interest income when calculating the limitation.
- If a business incurs a loss, then 30% of adjusted taxable income would not be less than $0.
- Vehicle dealers can generally deduct all of their floor plan financing interest but doing so would preclude them from taking 100% bonus depreciation on qualified assets.
Any interest expense not deductible in the current year can be carried forward indefinitely. Note that the Proposed Regulations referenced above explain how the disallowed interest expense carryforwards of C corporations are treated, which is beyond the scope of this article, but is briefly discussed here.
Let’s discuss some examples:
Jack’s car dealership has adjusted taxable income of $40,000, $0 business interest income, paid interest expense on a building loan of $20,000 and floor plan interest expense of $5,000. Deductible interest expense is limited to $17,000 (($40,000 x 30%) + $5,000). The interest carried over to the following year is $8,000 (($20,000+$5,000) – $17,000).
Rose owns a clothing store that incurs interest expense of $30,000, interest income on trade accounts of $2,000 and an adjusted taxable loss in the business of $40,000. Interest expense is limited to $2,000 and the remaining $28,000 is carried over to the next year.
Adjusted taxable income is defined as the taxpayer’s “taxable income” computed without regard to:
- Any items of income, gain, deduction, or loss that are not allocable to a “trade or business”
- Any business interest expense or business interest income
- The amount of any net operating loss deduction
- The amount of any pass-through deduction under Section 199A
- Any deduction allowable for amortization, depreciation or depletion for tax years beginning before January 1, 2022
To illustrate this computation consider the following facts:
Leo runs a huge hotel that is organized as a single member LLC and reported on Schedule C of his Form 1040. In 2018 he reports the following income and expenses:
Operating expenses ( 4,000,000)
Depreciation ( 150,000)
Amortization ( 50,000)
Interest Expense ( 10,000)
Schedule C Net Profit $5,790,000
Interest Income 7,000
Less NOL deduction ( 250,000)
Less 199A deduction ( 1,158,000)
Taxable income $4,389,000
Adjusted taxable income of the hotel business for purposes of the interest expense limitation is $6,000,000 ($10,000,000 Revenue – $4,000,000 operating expenses). All other income and expense items are not taken into account.
As is usually the case, there are exceptions to this limitation. The overwhelming exception I eluded to before is for small businesses, defined as a business with average annual gross receipts of $25 million or less. Before getting into more detail on that let’s take a look at other exceptions:
- Although being an employee is considered a “trade or business,” it is not considered a trade or business for purposes of the business interest expense limitation. In other words, a taxpayer cannot combine W2 income with other business income to increase their adjusted taxable income.
- A real property trade or business can make an election under Internal Revenue Code Section 163(j)(7)(B) to not be treated as a “trade or business” for purposes of the business interest expense limitation and therefore deduct all interest expense. An electing real property trade or business is described in Code Section 469(c)(7)(C) for purposes of qualifying as a real estate professional under the passive loss rules. Be cautioned if making this election because doing so would require the business to use the alternative depreciation system (ADS) for depreciating any of its non-residential real property, residential rental property and qualified improvement property.
- A farming trade or business can also make an election under Internal Revenue Code Section 163(j)(7)(C) to not be treated as a “trade or business” for purposes of the business interest expense limitation. Similar to real property trades or businesses, electing farming businesses will be required to depreciate any property used in the farming business with a recovery period of ten years or more using the ADS method.
The interest expense limitation applies to partnerships at the partnership level. This means the amount of interest expense deduction is determined by the partnership, using the partnership’s adjusted taxable income, and other modifying items. The partners cannot include their share of the partnership income to increase their adjusted taxable income and deduct additional interest unless there is “excess taxable income” from the reporting partnership. This also applies to shareholders of an S-Corporation. For example, consider the facts below:
Ti, LLC Partnership’s adjusted taxable income is $1,500 and business interest expense is $450. Since interest expense is exactly 30% of the partnership’s adjusted taxable income it is all deductible. Ti, LLC issues a K-1 to a 50% partner, JR, LLC in the amount of $525. JR LLC’s adjusted taxable income is a loss of $50 and paid $100 of business interest expense. JR, LLC is not allowed any deduction of the business interest expense of $100.
Consider the same facts above except that Ti, LLC’s adjusted taxable income is $2,000 instead. Ti, LLC has excess taxable income in the amount of $150 (($2,000 x 30%) – $450). JR, LLC’s share of the excess taxable income is $75 ($150 x 50%). JR, LLC’s adjusted taxable income is now $25 ($75 – $50), excess taxable income from Ti, LLC less the amount of loss incurred that year. JR, LLC can now deduct $8 of business interest expense ($25 x 30% – rounded for tax purposes).
The disallowed portion of interest expense is not carried over at the partnership level, instead, it is distributed out to the partners as excess business interest in the year incurred. Excess business interest allocated to each partner can only be deducted by partners in future years when the allocating partnership distributes excess taxable income, as described in example #5. Further, excess business interest expense allocated to each partner reduces their partnership basis in the year distributed, even though the expense is not deductible that year. If the partner disposes of their partnership interest before all of the excess business interest expense is used up, then the unused amount can be added back to their basis. The carryforward and basis treatment does not apply to shareholders in S-Corporations.
Let’s circle back to the small business exception to the business interest expense limitation. The law reads that businesses with average annual gross receipts over the last three years less than $25 million are not subject to the limitation. But, businesses with common control must be aggregated to make this determination. Under the rules of common control, if five or fewer individuals own 80% or more of the same businesses, then there is common control and those businesses must be aggregated. For example:
Company A Company B
Owner 1 25% 25%
Owner 2 50% 50%
Owner 3 25% 25%
Gross receipts $15,000,000 $15,000,000
Company A and Company B have common control since five or fewer individuals own 80% or more of each company. Therefore, gross receipts of each company are aggregated for a total of $30 million, subjecting each of the companies to the limitation. The reason for the aggregation rules is to prevent companies from splitting up their income among multiple companies to shield themselves from this limitation.
Consider the family attribution rules in this next example. The family attribution rules dictate that certain family members are virtually one in the same. If a shareholder owns 20% of a corporation and his/her spouse also owns 20%, with attribution this is, in effect, one shareholder owning 40% of the corporation. In order to meet the common control tests, the other 40% of ownership could be made up of four other shareholders instead of three. See below:
Company A Company B
Spouse A 20% 20%
Spouse B 20% 20%
Owner 3 10% 10%
Owner 4 10% 10%
Owner 5 10% 10%
Owner 6 10% 10%
Owner 7 10% 10%
Owner 8 10% 10%
Gross receipts $15,000,000 $15,000,000
Spouse A and Spouse B’s ownership, combined with owners 3 through 6’s ownership percentages total 80%. Without the family attribution rules, these two companies would not be aggregated as it would have taken six owners to reach 80% ownership. Therefore, Company A and B would be subject to the business interest expense limitation since their aggregated gross receipts total $30 million.
As stated, generally spouses attribute ownership to each other, although, no surprise, there are exceptions to this that would need to be considered based on circumstances. Minor children under age 21 are generally attributable to their parents. Adult children, if their ownership percentage is greater than 50%, can be attributable to their parent’s companies. Conversely, parents’ ownership can be attributable to an adult child’s business if their percentage of ownership is greater than 50%. Grandparents and grandchildren are subject to the same rules above. Adult siblings do not attribute ownership to each other.
On the surface, most small business taxpayers may not be subject to these rules. But as the examples above demonstrate, smaller businesses may need to aggregate their gross receipts to make this determination.
An iceberg colliding with a massive ship is without a doubt destructive, but maybe a little more dramatic than applying the new tax laws. Nonetheless, we still need to beware the deep waters and be on the lookout for all the potential ways businesses may need to navigate the new tax laws.
This article was originally published in The Kentucky CPA Journal.