The impact that Internal Revenue Code (IRC) Section 163(j) will have on debt-leveraged private equity-owned businesses is startling.
It is not unusual for tax practitioners to find themselves caught between multiple tax years when working with their clients. As practitioners, we’re busy determining extension payments or filing returns for the 2021 tax year; but, we also got our first real look at what tax year 2022 may bring as we worked through first quarter estimated tax payment requirements.
To step back a bit, the Tax Cuts and Jobs Act enacted IRC Section 163(j), which placed limitations on the deductibility of business interest expense for certain taxpayers, including those with average revenues in excess of $25 million (indexed for inflation to $27 million for 2022). For tax years 2018-2021, interest expense was generally deductible up to 30% of adjusted taxable income (ATI), which was effectively a tax EBITDA (Earnings Before Interest, Depreciation and Amortization). Given the large amortization deductions from which many private equity-owned companies benefit (resulting from acquisition goodwill), the IRC Section 163(j) limitations were, in many cases, not terribly impactful. Additionally, the CARES Act made the limitation less restrictive in tax years 2019 and 2020 for certain entities.
The IRC Section 163(j) limitation increases significantly beginning with the 2022 tax year. Tax practitioners knew this day was looming, and now we are seeing the impact. Effective for tax year 2022, ATI will be calculated based on a tax EBIT (Earnings Before Interest and Taxes), which means that taxpayers will no longer gain the benefits of depreciation and amortization in determining business interest expense deductibility. As a result, and as we saw in calculating first quarter 2022 estimated taxable income, the limitation is a substantial shift from the four previous tax years for most taxpayers. Capital-intensive and/or highly leveraged companies should expect to see a considerable amount of their business interest expense limited, if not limited entirely.
All is not lost, however. While portfolio companies may experience increased taxable income in 2022 because of reduced interest expense, the disallowed interest expense, referred to as excess business interest (EBI), carries forward indefinitely. And the EBI, at least in the partnership context, will generally be realized as a basis increase upon a partner’s disposition of their interest (if not able to be used prior to disposition).
Private equity-owned companies will likely feel the sting of this change more than most other privately held businesses, but any business, aside from the carved-out exceptions, can be caught by the provision. Please reach out to Evan Ogrodnik or your Schneider Downs tax advisor for more information.
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