The IRS has issued final regulations regarding the limitation for the business interest expense deduction under Code Sec. 163(j), including recent legislative amendments made for the 2019 and 2020 tax years. Also, a safe harbor has been proposed allowing taxpayers managing or operating residential living facilities to qualify as a real property trade or business for purposes of the limitation. In addition, new proposed regulations are provided for a number of different areas.
Section 163(j) Limitation
A taxpayer’s deduction of business interest expenses paid or incurred for the tax year is generally limited to the sum of:
- the taxpayer’s business interest income for the tax year for which the taxpayer is claiming the deduction (not including investment income);
- 30 percent of the taxpayer’s adjusted taxable income (ATI), but not less than zero; and
- the taxpayer’s floor plan financing interest.
The percentage limit is generally increased to 50 percent of ATI for 2019 and 2020. For a partnership, however, the 50 percent limit applies for 2020 only, and a special allocation of excess business interest expense (EBIE) to a partner may apply for the 2019 tax year. A taxpayer may elect not to use the 50 percent ATI limit, and any taxpayer other than a partnership may elect for 2020 to use its ATI from the 2019 tax year to calculate its limitation.
The 163(j) limitation does not apply to certain small businesses whose gross receipts are less than a threshold amount ($26 million for 2020). It also does not apply to electing real property trades or businesses, electing farming businesses, and certain regulated public utilities.
The final regulations generally adopt proposed rules that were issued in December 2018, with some modifications. Taxpayer may continue to rely on some of the rules in the proposed regulations. One significant change is that the final regulations provide any that any depreciation, amortization, or depletion that is capitalized into inventory under Code Sec. 263A before 2022 will be added back to tentative taxable income in calculating ATI.
This is change from the proposed rules which effectively resulted in taxpayers with inventory to effectively use earnings before interest and tax (EBIT) instead of earnings before interest, tax, depreciation, and amortization (EBITDA) before 2022 in calculating ATI. Also, the final rules eliminate the “lesser of” standard with respect to sales and disposition of stock, and require taxpayers to back out depreciation deductions that were allowed or allowable during the EBITDA period.
The IRS had adopted the broad definition of business interest in the proposed rules, including the definition of substitute interest and the embedded loan rule with some modifications. However, the final regs exclude commitment fees, debt issuance costs, guaranteed payments (except used as capital), and hedging rules. The IRS has also modified the anti-avoidance rule for time value of money.
Qualified Residential Living Facilities
The IRS has proposed a safe harbor for a trade or business that manages or operates a qualified residential living facility to be treated as a real property trade or business solely for purposes of qualifying as an electing real property trade or business. A facility is qualified if it:
- consists of multiple rental dwelling units within one or more structures that generally serve as primary residences on a permanent or semi-permanent basis to individual customers or patients;
- provides supplemental assistive, nursing, or other routine medical services; and
- has an average period of customer or patient use of the individual rental dwelling units that is 90 days or more.
The safe harbor is proposed to apply to tax years beginning after December 31, 2017.
In addition to the final regulations, the IRS has issued new proposed regulations that provide rules regarding:
- different computational methods a taxpayer can choose in determining certain adjustments to tentative taxable income;
- the treatment of EBIE allocated to a partner in 2019, and the election to use ATI from 2019 for the 2020 tax year under Code Sec. 163(j)(10);
- interest expense associated with debt proceeds of partnerships and S corporations (passthrough entities);
- application of the limitation for a partnership’s self-charged lending transactions, partnerships engaged in trades or businesses that are not passive activities, publicly traded partnerships, certain section 734(b) adjustments, and tiered partnership structures;
- application to U.S. shareholders of controlled foreign corporations (CFCs) and to foreign persons with effectively connected income in the United States; and
- application to corporate look-through provisions.
Finally, the IRS has also released FAQs that provide a general overview of the aggregation rules that apply for purposes of the gross receipts test, and that apply to determine whether a taxpayer is a small business that is exempt from the business interest expense deduction limitation.