How Tax Reform Could Limit Your Business Interest Deduction

On December 22, 2017, Public Law No. 115-97, commonly referred to as the Tax Cuts and Jobs Act (The Act), was enacted, and resulted in considerable changes to the federal tax code. The Act contains a variety of changes including a new limitation on business interest deductions.

Under prior law, business interest expense was generally deductible, subject to limitations in very specific situations. Under new Internal Revenue Code (IRC) section 163(j), the limitation on the deduction of business interest expense was significantly broadened, potentially limiting the interest deductions for many businesses. Starting in 2018, the business interest deduction will now be limited to the sum of: (1) business interest income, (2) 30 percent of adjusted taxable income (ATI), and (3) floor plan financing interest, each described in more detail as follows:

  • Business Interest Income: The amount of interest income allocable to a trade or business, i.e. interest expense is deductible to the extent of interest income
  • Adjusted Taxable Income: Interest expense properly allocable to a trade or business is limited to 30 percent of ATI
    • In taxable years 2018 through 2021: ATI is taxable income before interest, taxes, depreciation and amortization (an EBITDA based calculation)
    • In taxable years after 2021: depreciation and amortization are not added back to determine ATI (EBIT based calculation, instead of EBITDA)
  • Floor Plan Financing: Interest incurred to acquire inventory of motor vehicles held for sale or lease

For partnerships, S corporations and other pass-through entities, the limitation generally applies at the entity level and rules limit the netting of income and interest expense between related partnerships, S corporations and other pass-throughs.

There is no provision for grandfathering the deductibility of interest on existing debt. Interest on all debt is potentially subject the interest deduction limitation.

Disallowed interest deductions are carried forward indefinitely and can be deducted in future taxable years to the extent of excess capacity under the interest limit in future years.

The interest limitation does not apply to taxpayers with average gross receipts that do not exceed $25 million for the prior three-taxable-year period. The $25 million threshold applies in the aggregate to certain related taxpayers.

Real estate trades or businesses can elect to not apply the interest deduction limitation, which also requires the use of slower depreciation of property.

This is a complex new area of tax law. Above is a highlevel summary of these new provisions and does not fully articulate all of the complexity and nuance of these new rules — this requires the management of multiple professionals, which can be a costly and time-consuming process. To fully understand the newly enacted limitations, contact your tax advisor or the authors of this article.