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IRS Intends to Issue Proposed Regulations Regarding the Limit for the Deduction of Business Interest

Internal Revenue Service|Tax|Tax Reform

By Joseph Heisler

On April 2, 2018, the Internal Revenue Service ("IRS') issued Notice 2018-28 announcing its intent to issue proposed regulations addressing the amendments to Section 163(j) regarding the deductibility of business interest expense.  For purposes of Section 163(j), business interest expense is interest that is paid or accrued on indebtedness that is properly allocable to a trade or business (including rental activities).

Originally, Section 163(j) placed limits on the deductibility on certain disqualified interest paid or accrued by a corporation in a taxable year if the payer's debt-to-equity ratio exceeded 1.5  to 1.0 and the payer’s net interest expense exceeded 50% of its adjusted taxable income.  The so-called “interest stripping” rules generally applied to corporations paying interest to related parties exempt from U.S. taxation.

The Tax Cuts and Jobs Act amended Section 163(j) to replace the old rules with a new and different set of limitations on the deduction of business interest for tax years after December 31, 2017.  The limitation now applies to all taxpayers, except for certain small businesses and farm businesses. 

Specifically, Section 163(j)(1) limits the amount of business interest expense that may be deducted in a tax year to the sum of (1) the taxpayer's business interest income, (2) 30% of the taxpayer's adjusted taxable income, and (3) the taxpayer's floor plan financing interest (indebtedness used to finance inventory acquisition of motor vehicles held for sale or lease). 

The notice indicates that the IRS intends to issue proposed regulations in five specified areas and also provides that until those regulations are released, the notice serves as interim guidance that taxpayers can rely upon.  The five areas include:

  1. Treatment of interest disallowed and carried over under prior Section 163(j)(1)(A)
  2. Defines corporate business interest expense and business interest income to be all interest expense and income (no classification as investment interest expense allowed for example)
  3. Application to Consolidated Groups
  4. Impact on Earnings and Profits Calculations of “C” Corporations
  5. Business Interest Incomeand Floor Plan Interest of Partnerships and “S” Corporations

Of particular interest to many taxpayers is the impact the rules have on partnerships, “S” corporations, and their owners.  The new rules require that the annual limitation on the deduction for business interest expense be applied at the partnership level and that any deduction for business interest be taken into account in determining the non-separately stated taxable income or loss of the partnership.  In certain circumstances, the limitation may also be applied at the individual partner's level.  The notice indicates that the proposed regulations will provide that, for purposes of calculating a partner’s annual deduction for business interest, a partner, with exceptions, generally will not include the partner’s share of the partnership’s business interest income for the taxable year.  Additionally, it’s intended that the proposed regulations will provide that a partner cannot include his or her share of the partnership’s floor plan financing interest in determining the partner’s annual business interest expense deduction limitation.  The intent of the regulations is to prevent the double counting of business interest income and floor plan financing interest.  The IRS intends to create similar rules for “S” corporations and their shareholders.

What goes unstated in the notice is that there are still a number of other issues and questions surrounding the deductibility of interest.  For example, the notice is silent as to how interest of a partnership with a corporate partner will be treated, how interest of a partnership in the business of trading securities or other investment assets will be treated, and how the interaction of the interest rules with the application of global intangible low-taxed income provisions might apply. However, if and when that guidance is ultimately provided or not, the Schneider Downs’ tax professionals will be there to guide you.

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