When the Tax Cuts and Jobs Act (“TCJA”) was passed in late 2017, there was a lot for manufacturers to be excited about. The return of bonus depreciation, a lowering of the corporate tax rate, and the enactment of the 20% deduction for qualified business income all have the potential to drastically lower income taxes for manufacturers across the country. But there is, as they say, no such thing as free lunch.
Because of the structural framework used to pass the tax reform, tax increases were needed to balance out some of the benefits that were bestowed upon us by Congress. Among the largest revenue raisers (i.e. tax increase) in TCJA was a limitation on the deductibility of interest expense, which is expected to raise $250 billion over the next 10 years.
For taxable years beginning on or after 1/1/2018, a taxpayer’s deduction for interest expense is limited to 30% of their adjusted taxable income (i.e. taxable income computed without regard to nonbusiness income, any interest income or expense, net operating loss deductions, the deduction for 20% of qualified business income, and for years beginning before 1/1/2022, depreciation and amortization). The limitation is also increased for any business interest income of the taxpayer and for any amount of “floor plan financing”, which is a term specific to companies engaged in the sale or leasing of vehicles.
If a taxpayer has interest expense limited under this statute, it’s not permanently disallowed; rather, it carries forward indefinitely until such time as the taxpayer has sufficient adjusted taxable income to utilize the expense.
With most tax rules, there are exceptions, and this is no different. If a taxpayer’s average annual gross receipts for the previous three taxable years do not exceed $25 million, they are not subject to the interest expense limitation. There are other exceptions to the limitation, such as those for an electing farming business or electing real property trade or business, but the $25 million gross receipts exclusion will keep this limitation from applying to many taxpayers.
Before you look to break up your company with $40 million of gross receipts into two smaller companies to take advantage of the $25 million exclusion mentioned above, the IRS has already thought of that and put rules into place to disallow it. When determining your gross receipts for purposes of the $25 million test, you must aggregate the gross receipts of companies with similar ownership. The mechanics of aggregation are beyond the scope of this article, but they do exist.
While the basics of the interest expense limitation were covered in this article, rest assured this is one of the more complicated areas of the new tax law. Please reach out to your local Blue & Co. advisor should you have any further questions.