One overlooked item of the Tax Cuts and Jobs Act (TCJA) P.L. 115-97 is business interest expense limitation. This limitation may affect more businesses than originally anticipated. The good news is proper planning and accurate reporting will go a long way to safeguarding a current year deduction.
Under the newly created code Section 163(j), business interest deduction is limited to the sum of business interest income and 30% of adjusted taxable income. Adjusted taxable income is taxable income before any business interest expense or business interest income, net operating loss deduction and Section 199A deduction. For years beginning before January 1, 2022, any deduction for depreciation, amortization or depletion are also added back.
The TCJA included an exemption for small business’ who were not a tax shelter prohibited from using the cash method of accounting, where gross receipts for the last three years does not exceed $25 million. Don’t get too excited, because commonly controlled business receipts must be aggregated for these purposes. This includes businesses invested in partnerships and S-corporations. In this case, the business must include its share of pass-through business receipts when computing the $25 million threshold.
Businesses that incur “floor plan financing interest” are excluded from the business interest expense limit. An example of this is dealerships selling motor vehicles who use floor plan financing interest to finance motor vehicles held in inventory.
The exemption from limitation on business interest under Section 163(j) does not apply to tax shelters prohibited from using the cash method of accounting under Section 448(a)(3) and tax shelter is defined under Section 448(d)(3) and 461(i)(3).
What is the Definition of a Tax Shelter?
The term tax shelter means:
1. Any enterprise, other than a C-Corporation, if at any time interest in such enterprise have been offered for sale in any offering required to be register with any Federal or State Agency has the authority to regulate the offering of securities for sale,
2. Any syndication (with the meaning of section 1256(e)(3)(B), and
3. Any tax shelter (as defined in section 66629d)(2)(C)(ii).
Most investors don’t think they are involved in a tax shelter but as we look at the definition of a syndicate, things begin to change.
What is the Definition of a Syndicate?
The term “syndicate” means any partnership or other entity (other than a C-corporation) allocating more than 35% of the losses of such entity during the taxable year to limited partners or entrepreneurs.
Partnerships and limited liability companies are formed all the time and many owners are personally liable for the partnership debts. These owners are considered general partners. Limited partners are the ones whose liability is limited to the amount of money or other property the partner contributed or is required to contribute to the partnership. Limited entrepreneur is someone who has an interest in an enterprise other than as a limited partner and does not actively participate in the management of such enterprise. So if 35% or more losses are allocated to limited partners or limited entrepreneurs, business interest may be limited.
Example 1:
Smith & Jones each own 50% of an S-corporation. Smith works full time for the company and receives a salary. If the company has operating revenue of $100 and operating expenses other than interest of $120 and interest of $15, the company would have a loss before interest expense of $20. The new Section 163(j) limit will apply since Jones owns 50% of the S-corporation of Jones & Smith. As such, there is no interest deduction of $15 in the current year and the current year loss is only $20.
Syndicate is further expanded to say that an interest in an entity shall not be treated as held by a limited partner or limited entrepreneur if the holdings are attributed to active management.
Sec. 1256(e)(3)(C) provides some further guidance by attributing a holding to one held as an active participant in management if:
1. For any period if during such period such interest is held by an individual who actively participates at all times during such period in the management of such entity,
2. For any period if during such period such interest is held by the spouse, children, grandchildren, and parents of an individual who actively participates at all times during such period in the management of such entity,
3. If such interest is held by an individual who actively participated in the management of such entity for a period of not less than 5 years,
4. If such interest is held by the estate of an individual who actively participated in the management of such entity or is held by the estate of an individual if with respect to such individual such interest was at any time described in clause 2, or
5. If the Secretary determines (by regulations or otherwise) that such interest should be treated as held by an individual who actively participates in the management of such entity, and that such entity and such interest are not used (or to be used) for tax-avoidance purposes.
Example 2:
Using the same facts as Example 1, but where Smith & Jones reports income of $140 during the year, the entity is not a tax shelter because the company has income and their gross receipts are less than $25 million they meet the small taxpayer exception. Therefore, all of the business interest is deductible.
Example 3:
Harper Smith, LLC have three owners, each who owns 33 1/3% of the LLC. Two of the owners guarantee the company debt of $100,000. If the LLC were to have a loss of $5,000 for the year, the LLC would not be considered a tax shelter because 66 2/3% of the loss is attributed to general partners. Therefore, any interest paid would be deductible.
Under Section 163(j), a real property trade or business and a farming business can elect to be treated as an electing real property trade or business, eliminating any limitation on business interest deduction. This election is irrevocable and requires longer depreciation methods and assets are depreciated over a longer period of time. We are a long way from tax simplification as long as tax laws such as Section 163(j) come into play. It will impact more businesses than most realize. Don’t let the business interest expense deduction catch you by surprise. Proper planning and reporting can help preserve a current year deduction.
