3 Updates you Need to Know About Business Interest Expense Deduction Limitations
August 7, 2020
On July 28, 2020, the Treasury and IRS published several pieces of regulation and guidance that will have a significant impact on many taxpayers. If you are affected by the business interest expense deduction limitations under IRC Section 163(j), or if you own a business that manages or operates a residential living facility, read on to learn about the new changes and understand their impact on your bottom line.
1. New Final Regulations Bring Clarity and Changes to Business Interest Expense Deduction Limitations
The new final regulations, effective January 1, 2020, for calendar year taxpayers, provide long-awaited clarity on the business interest expense deduction limitation under IRC Section 163(j), which was created by the Tax Cuts and Jobs Act in 2017. Recently, the CARES Act further modified Section 163(j) to provide new relief to taxpayers for the 2019 and 2020 tax years.
While the new final regulations provide some much-needed guidance and clarification around many of the uncertain provisions of the limitation, they also introduce some significant changes:
- Previous guidance required the inclusion of items such as commitment fees and debt issuance costs to be included in interest expense. These items are now explicitly excluded from interest expense.
- The 163(j) rules do not apply to partnerships or S Corporations that have less than $26M of gross receipts for the previous three years ($25M for 2018). The final regulations clarify that if the entity qualifies for the exemption, the partners/members/shareholders do not have to separately analyze whether any limitations should be imposed at their level on their share of this interest.
- An election to treat rental real estate activities as an electing real property trade or business (ERPTOB) is available even if the business doesn’t meet the trade or business standards under Section 162. This provision expands the beneficial ERPTOB to a larger number of taxpayers, and thus would allow them to elect out of the interest expense limitation rules.
- The portion of depreciation, amortization, or depletion that was capitalized into inventory for tax purposes under IRC Section 263A was previously excluded from favorable adjustments to the interest expense limitation. This exclusion created a disadvantage for capital-intensive companies such as manufacturers and distributors, as they generally rely on debt financing to fund major capital improvements to their operations. The final regulations clarify that these capitalized items can now favorably adjust the limitation, potentially allowing more interest expense to be deductible.
2. A New Notice Proposes Safe Harbor for Taxpayers Operating a Residential Living Facility
In addition to the final regulations for Section 163(j), the IRS also published Notice 2020-59, which provides crucial clarity for taxpayers who manage or operate residential living facilities. Previously, it was unclear whether a residential living facility could qualify as an RPTOB, and thus elect out of the rules that limit the deductibility of interest expense. This Notice proposes a safe harbor for the trade or business to be treated as an RPTOB when the residential living facility meets certain qualifications.
To qualify, the residential living facility must:
- Consist 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;
- Provide supplemental assistive, nursing, or other routine medical services; and
- Have an average period of customer or patient use of the individual rental dwelling unit that is 90 days or more.
These qualifications should allow many residential living facilities to qualify as a RPTOB, although they should closely review their operations and consider adjusting various aspects if needed to meet the safe harbor rule.
The safe harbor is proposed to apply to tax years beginning after December 31, 2017.
3) New Proposed Regulations Provide Further Guidance on Section 163(j) and the CARES Act
The IRS also announced new proposed regulations for Section 163(j) in a continued effort to provide comprehensive guidance on business interest expense deduction limitations. Some of the proposed regulations include guidance on:
- Allocating interest expenses related to debt-financed distributions;
- Tiered Partnerships and how to apply Section 163(j);Defining real property development and real property redevelopment to include Timberlands; and,
- The recent changes to Section 163(j) stemming from the CARES Act, including the treatment of excess business interest expenses allocated to a partner and the election to use ATI from the 2019 tax year to determine Section 163(j) limitations.
The most significant change lies in the proposed regulation’s guidance around the application of 163(j) to foreign companies and persons.
The proposed regulations:
- Make clear that 163(j) does apply to controlled foreign corporations (CFCs);
- Allows CFCs to elect to apply 163(j) on a group basis to reduce the administrative and compliance burden of applying the limitation on an entity by entity basis;
- Provides a safe harbor election that exempts certain standalone CFCs from 163(j); and,
- Modified existing guidance to clarify that only items related to effectively connected U.S. income should be factored into computing the various components of deductible interest.
These proposed regulations primarily aim to provide guidance on more complex issues not addressed in the final regulations, especially as it pertains to the changes created with the CARES Act. The most significant change being limiting interest expense to 50% of ATI instead of the current 30% limitation. The IRS will continue to seek public comment on these new proposed regulations before releasing the final regulations in the future. Aprio will continue to monitor these for any changes or updates.
The Tax Cuts and Jobs Act created the limitation on the deduction for business interest expenses to offset other tax cuts, but the CARES Act temporarily eased some of the restrictions as an alternative form of relief for taxpayers. The new guidance issued provides clarity as well as new opportunities for some taxpayers.
If you have been affected by Section 163(j) limitations for prior tax years, or if you operate a residential living facility, now is the time to revisit and analyze new opportunities for 2019 and 2020 to maximize your tax-deductible business interest expense. Consult with Ori Epstein, Lena Klaskala or Jake Patton to assess your tax liability and determine what deduction options are available to you.
About the Author
Ori's practice focuses on the technology sector, including software, biosciences and healthcare IT companies at all stages of their life cycles. In his 12 years at Aprio, he has assisted with numerous complicated issues and transactions, including navigating the medical device excise tax, tax-free spinoffs and reorganizations, and international tax planning.