The Side Dish

Finance to Table Education for Operating Your Restaurant

Section 163(j): trap for the unwary!

Section 163(j), tax reform, restaurantAlthough the Qualified Business Income deduction (QBI or “pass through deduction”) receives all the favorable buzz with the new tax law, we want to make sure that you are aware of another provision established by tax reform – Section 163(j) – which is alarming to your tax-geeky CPA.

First off, does this sound familiar?

  • You have multiple stores with each store set up as its own “flow-through” entity and each has similar, but not necessarily the same, ownership.
  • Some of the stores are profitable (perhaps the older ones), some are not (perhaps the newer ones).
  • You have borrowed money to finance opening new stores, perhaps even from one of your investors.
  • When added all together, the gross revenue of all the stores exceeds $25 million (average over preceding three years).

Don’t think I’m painting a picture that is all that unusual.

Read more: other ways tax reform can impact you

Now for the rule

New Section 163(j) applies to businesses with gross revenues in excess of $25 million and limits the amount of interest expense you can deduct to 30% of your “adjusted taxable income.” Adjusted taxable income is your taxable income, plus interest expense, plus depreciation/amortization. (Starting in 2022, you cannot add back depreciation and amortization, which makes the limitation easier to affect you). Let’s say in 2019 your taxable income was $100,000 and you deducted interest expense of $50,000 and depreciation of $100,000 to get to that number. Your adjusted taxable income would be $250,000, and the most interest expense you could deduct in the current year would be $75,000, so you are in the clear and can deduct the full amount of interest expense of $50,000.

What if your interest expense was $150,000 with everything else being the same? Then your adjusted taxable income would be $400,000 and the most interest expense you could deduct would be $120,000 (30% of adjustable taxable income) even though your interest expense was $150,000. You would have to carry forward the disallowed portion of $30,000 to a future year (even though you incurred it!!) and do the limitation calculations again in the subsequent year.

Now for the trap

The IRS says when you do business in multiple entities that are not disregarded for tax purposes, you must aggregate the ones with common ownership (complex determination) to determine whether you meet the greater than $25 million gross revenue rule. You would think you can use the profitable stores’ income to offset the interest expense of the less profitable stores BUT that is not the case. You can only use the interest expense of profitable stores against the income from the profitable stores. You cannot use the income from the profitable stores to “absorb” the interest expense of the stores subject to the limitation. Huh?!? You put gross revenues of the stores together to see if you are burdened by the rule, but you keep the stores apart when applying the rule. Seems extraordinarily unfair to this author.

Learn more about the major issues impacting restaurant owners today

See the chart which illustrates these inequities. If A owned 100% of all the entities, or if all stores were combined in the same entity, there would be no limitation. Due to the disparate ownership, however, the newer stores in Entity 4 have limitation applied which cannot be absorbed by the mature, profitable stores. A, therefore, will end up paying more tax to the extent of his share of the $280 of limitation in the example.

Example

Assumptions

  1. (000)
  2. A owns 75% of 4 LLCS owning entities 1-4 (each having two stores)
  3. B, C, D and E, respectively, own the remaining 25% of LLCs owning entities 1-4
  4. Year is 2019; entities 1 and 2 have been open a number of years while entity 3 stores opened in 2018 and entity 4 stores opened in 2019
Store/Entity1234Totals
Gross revenue$10,000$9,000$6,000$2,800$27,800
Net income (loss) before 163(j)c$1,200$1,000$ -$(2,000)$200
Depreciation4003001,0002,0003,700
Interest expensea3002603004001,260
Adjustable taxable income (ATI)$1,900$1,560$1,300$400$5,160
Limitation (up to 30% of ATI)b$570$468$390$120$1,548
Interest expense less than (in excess of) limitation (a-b)d$270$208$90$(280)$288
Net income after 163(j) add back of ONLY interest expense in excess of limitation (c minus d)$1,200$1,000$ -$(1,720)$480

The solution? Obviously, combine the profitable stores and less profitable stores into the same entity. Sounds easy, but in real life, you need to involve attorneys and get multiple owners to agree on valuations, etc. Not necessarily accomplished with the stroke of a pen. Another solution? Use equity rather than debt to finance growth which is exactly what the new law intends to accomplish.

There are many levels of complexities that must be dealt with to report this information through multiple flow-through entities. Also, with anything tax-related there are tons of exceptions, complicated rules, etc. so be sure to talk to your Henry+Horne tax advisor.

Bradley Dimond, CPA