This information is based on the statutes and guidance available as of the date of publication and is subject to change. 

Congress has felt that the corporate interest limitation rules have been outdated for some time. While the rest of the world has moved to a BEPS (“Base Erosion and Profit Shifting” under OECD guidelines) model for determining the limitation of interest expense, the U.S. has imposed a related party debt limitation based on adjusted income and debt to equity ratios.  Tax reform attempted to “refresh” the U.S. rules with a new limitation on deductions for interest expense under §163(j) effective for tax years beginning on or after January 1, 2018.

What Type of Interest is Subject to the New Limitation?

All business interest is subject to limitation under the new rules. Under prior §163(j), only interest paid to or guaranteed by a related party was subject to the limitation rules. The new limitation is applied against all business interest expense.

Since all interest expense of corporations is deemed to be “business interest”, these rules will apply to all interest expense of a corporation. It is possible for partnerships, however, to have investment interest expense, which would not be subject to these rules.

When Does the Limitation Apply?

The limitation applies to all taxpayers.  The only exception to this is for “certain small businesses” (including partnerships and sole proprietors)  generally defined as a taxpayer with average gross receipts of less than $25 million (adjusted for inflation after 2018) for the preceding three tax years. In calculating average gross receipts, affiliated group rules apply to a member of an affiliated group with more than 50% common ownership. Foreign corporations can be included in the definition of affiliated group for this purpose, which could reduce the number of businesses that can claim this exception.

How is the Limitation Calculated?

The limitation is computed under the following formula:

Business interest income for the year

+      30% of “adjusted taxable income” for the year (not less than $0)

+      “floor plan financing interest” for the year  ← interest expense of car inventory for auto retailers

=      Deductible Interest Expense

“Adjusted Taxable Income” is calculated as follows:

For tax years 2018 – 2021:

Taxable income before NOL Deduction

+/-  Any item not allocable to a trade or business

+/-  Business Interest Expense or Business Interest Income

+-   §199A Deduction (new qualified business income deduction; n/a for corporations)

+/-  Depreciation, Amortization and Depletion

+/-  Any other adjustments as prescribed by the Secretary

For tax years 2022 and after, the calculation is the same as above, but there is no adjustment for depreciation, amortization and depletion.

Note that the limitation is generally computed at the entity level except for consolidated returns which computes the limitation at the consolidated level.

Carryforward Amounts

Any interest that is limited under §163(j) is not deducted and is carried forward to be treated as paid or accrued in the subsequent tax year (an exception to this is for partnerships, described below). If a taxpayer calculates an excess limitation (i.e., the 30% of adjusted taxable income in excess of the interest expense), this amount is not carried forward as prior §163(j) allowed.

Please note that it appears that any current excess limitation amounts will not be carried forward into 2018.

Partnerships

In the partnership context, §163(j) is calculated at the partnership level. The excess interest expense is not carried over by the partnership; rather, it is allocated to each partner in the same manner as taxable income. Additionally, excess limitation of interest is also allocated to each partner in the same manner as taxable income. 

Example Calculation

Below is an example calculation for a corporate or individual partner in a partnership, XYZ.  

ABC calculates the following interest limitation:

Taxable Income                   $140

+ Interest Expense                 60

Adjusted Taxable Income     $200

Limitation (x 30%)              $  60

All interest expense is deductible.

ABC income allocated to XYZ = $70

ABC income allocated to M = $70

 

On XYZ’s Form 1120, XYZ cannot use the $70 of flow-through income to calculate XYZ’s adjusted taxable income to compute its interest limitation:

Taxable Income                   $(25)

+ Interest Expense                 25

Adjusted Taxable Income      $  0

Limitation (x 30%)               $  0 

All of XYZ’s interest expense is limited. $25 is carried forward by XYZ.

 

Now assume that ABC incurs $40 of interest expense instead of $60 in the previous example:

ABC calculates the following interest limitation:

Taxable Income                        $160

+ Interest Expense                       40

Adjusted Taxable Income           $200

Limitation (x 30%)                    $  60 

All interest expense is deductible.

ABC income allocated to XYZ = $80

ABC income allocated to M = $80

 

Excess taxable income allocated to XYZ =

Excess adjusted taxable income           $ 20 ($60 Limitation less $40 Interest Expense)

Divided by Limitation                           $ 60

Result                                             33.33%

Adjusted Taxable Income                     $200

Excess Taxable Income                     $66.67

ABC excess taxable income allocated to XYZ:   $33.33

ABC excess taxable income allocated to M:       $33.33 

 

XYZ’s interest limitation:

Taxable Income / (Loss)                        $(25)

+ Interest Expense                                   25

Adjusted Taxable Income                       $   0

+ Excess Taxable Income from ABC        $ 33

Adjusted Taxable Income                       $ 33

Limitation (x 30%)                                $ 10

XYZ can deduct $10 of the $25 interest expense.

XYZ carries forward the remaining $15 indefinitely.

Other Considerations Under Interest Limitation Rules

With respect to related party debt, interest must still be paid before the above limitation rules are applied.

385 debt / equity classification rules continue to apply.

New §267A rules disallow certain payments to related hybrid entities or pursuant to a hybrid transaction.

Excess interest expense will carryover in a tax-free reorganization.

Any §382 change in ownership will limit future utilization of excess interest.