Limitation on deduction for interest

Your Guide to State, Local, Federal, Estate + International Taxation

deduction, interest, tax, reformIf new tax laws excite you then you’re in luck. With the passing of the Tax Cut and Jobs Act, there are many changes to the code for us to explore. Several of these changes will undoubtedly decrease taxes for businesses and their owners. But the new limits on the deduction of business interest isn’t one of them. Fortunately, this cumbersome new rule may not apply to you if you meet one of several exceptions, which will be discussed later.

For tax years beginning after December 31, 2017, every business, regardless of its form, is generally subject to a disallowance of a deduction for net interest expense in excess of 30% of the business’s adjusted taxable income (see definition to follow). Net interest expense is defined as the excess of interest paid or accrued over interest income for the year. This disallowance is determined at the tax filer level.

Adjusted Taxable Income (ATI) is computed without regard to:

  1. Any item of income, gain, deduction or loss not properly allocable to a trade or business
  2. Business interest income and expense
  3. NOL deductions
  4. 199A Pass-through deductions (the new 20% deduction)
  5. Depreciation, amortization or depletion before 2022 (meaning ATI will decrease after 2021, effectively lowering the maximum amount of deductible business interest expense)

The amount not allowed as a deduction for any taxable year is treated as business interest paid or accrued in the succeeding taxable year. Unused business interest may be carried forward indefinitely. Special rules apply to certain pass-through entities and their owners, which is beyond the scope of this article.

Several exemptions apply to the new rule:

  1. An exemption from these rules applies for taxpayers (other than tax shelters) with average annual gross receipts for the three-tax year period ending with the prior tax year that do not exceed $25 million. This is tested on an affiliated group basis.
  2. The business-interest-limit provision does not apply to certain regulated public utilities and electric cooperatives.
  3. Real property trades or businesses can elect out of the provision if they use ADS to depreciate applicable real property used in a trade or business. Farming businesses can also elect out if they use ADS to depreciate any property used in the farming business with a recovery period of ten years or more. Electing out is irrevocable.
  4. An exception from the limitation on the business interest deduction is also provided for floor plan financing (i.e., financing for the acquisition of motor vehicles, boats or farm machinery for sale or lease and secured by such inventory).

As mentioned earlier, some items of the new law are beyond the scope of this article. Please contact your tax advisor for an in-depth analysis on how the changes may affect you.

Scott W. Clouse, CPA