On July 28, the Treasury Department and the Internal Revenue Service (IRS) released highly anticipated final (TD 9905) and newly proposed (REG-107911-18) regulations for computing business interest expense under Internal Revenue Code (IRC) Section 163(j).
Under the Tax Cuts and Jobs Act (TCJA), Section 163(j) was amended to limit deductions of business interest expense to the total of a taxpayer’s 1) business interest income, 2) 30 percent of adjusted taxable income (ATI), and 3) floor plan financing. The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) generally increased the ATI threshold from 30 to 50 percent for the 2019 and 2020 taxable years to accommodate for economic hardship; however, partnerships do not get this increase until 2020 and have special rules for 2019. Disallowed business interest expense is carried forward to the subsequent year.
Read on for some of the highlights from the final and newly proposed regulations.
Definition of interest narrowed
The final regulations have narrowed the definition of interest for purposes of the business interest expense limitation rules to exclude commitment fees and debt issuance costs. Additionally, the final regulations generally do not include in the definition of interest guaranteed payments for the use of capital under Section 707(c), and certain hedging transactions. The regulations also finalized rules related to: swaps with significant non-periodic payments; bond issuance premiums; income, gain deduction, or loss related to certain financial instruments; and substitute interest payments. The anti-avoidance rule was also updated to provide clarity on whether hedging transactions and guaranteed payments for the use of capital in certain circumstances should be treated as interest for purposes of Section 163(j).
Technical correction to ATI and floor plan financing interest
The final regulations made a technical correction to include a subtraction of floor plan financing interest expense in computing ATI because the 2018 proposed regulations provided taxpayers with an unintended increase to ATI.
Certain adjustments to tentative taxable income in computing ATI under Section 163(j)(8)(B)
The 2018 proposed regulations included adjustments to taxable income in computing ATI to address certain sales or other dispositions of depreciable property, stock of a consolidated group member, or interests in a partnership.
Without these adjustments, there would be a double benefit in a taxpayer’s calculation of ATI. For example, “if a taxpayer were to sell its depreciable property after making the foregoing adjustment to ATI, the taxpayer would realize additional gain (or less loss) on the disposition as a result of its [ reduced basis due to] depreciation deductions, and the taxpayer’s ATI would be increased yet again,” the preamble to the regulations says.
The 2018 proposed regulations stated that the adjustment was the lesser of the amount of depreciation taken or the gain realized on the sale of depreciable property, stock of a member of a consolidated group, or other interest in a partnership. The final regulations eliminate the “lesser of” standard, and therefore all previous depreciation is added back regardless of gain. This rule was added to help simplify ATI calculations. However, realizing this may create an unfair result in the situation where gain is less than previous depreciation, the newly proposed regulations do allow taxpayers to use the “lesser of” rule.
The 2018 proposed regulations did not allow an add-back to ATI for depreciation and amortization that is required to be capitalized into inventory under Section 263A. Commenters to the 2018 proposed regulations pointed out that this seemed contrary to the intent of the code and put manufacturers at a disadvantage. Treasury agreed, and the final regulations now allow the add-back.
Treasury agreed with commenters to the 2018 proposed regulations that “the application of Section 1.163(j)-1(b)(1)(ii)(C) and (D) to the same consolidated group member would result in an inappropriate double inclusion, and that proposed Section 1.163(j)-1(b)(1)(ii)(C) should not apply to a former group member with respect to depreciation deductions claimed by the member in a former group.” The final regulations provide anti-duplication rules “to ensure that neither [Treas. Reg.] Section 1.163(j)-1(b)(1)(ii)(C) nor [Treas. Reg.] Section 1.163(j)-1(b)(1)(ii)(D) applies if a subtraction for the same economic amount already has been required under either provision.”
Definition of business interest expense
The final regulations revise the definition of “disallowed business interest expense” to reflect that “solely for purposes of Section 163(j) and [the regulations thereunder], disallowed business interest expense is treated as ‘paid or accrued’ in the taxable year in which the expense is taken into account for federal income tax purposes (without regard to Section 163(j)), or in a succeeding taxable year in which the expense can be deducted by the taxpayer under Section 163(j), as the context may require.”
This definitional change eliminates situations where “disallowed business interest expense” was treated as paid or accrued in a future taxable year for purposes of Section 163(j)(8)(A)(ii), and then would have to be added back to tentative taxable income in determining ATI for that taxable year (and for all future taxable years to which it is carried forward under Section 163(j)(2)), “thereby artificially increasing the taxpayer’s Section 163(j) limitation.”
The final regulations also clarify that “amounts allowable as a deduction after application of the Section 163(j) limitation but disallowed by Section 465 [at-risk] or 469 [passive activity losses] are not business interest expense subject to the Section 163(j) limitation in subsequent taxable years.” In other words, they will not be subject to the ATI limitations once again.
The final regulations do not apply Section 163(j) to business interest expense or business interest income incurred on intercompany obligations, though they provide one limited exception related to repurchase premium on obligations that are deemed satisfied and reissued.
Multiple trades or businesses within an entity
The final regulations define “trade or business” as a trade or business within the meaning of Section 162.
The final regulations provide, consistent with the 2018 proposed regulations, that “maintaining separate books and records for all excepted and non-excepted trades or businesses is one indication that a particular asset is used in a particular trade or business.”
Whether the Section 163(j) limitation is a method of accounting
Commentators to the 2018 proposed regulations questioned whether the business interest expense limitation of Section 163(j) was a method of accounting. The preamble to the final regulations clarifies that the Treasury Department and the IRS do not view the Section 163(j) limitation as a method of accounting.
General gross receipts test and aggregation
“The Treasury Department and the IRS are aware that the aggregation rules set forth in Section 52(a) and (b) and Section 414(m) and (o) are complex,” they note in the final regulations, and so they have provided a “Frequently Asked Questions” that explains the basic operation of the rules.
Small business exemption and tax shelters
The final regulations clarify the definition of the term “syndicate” by adopting the definition in Treas. Reg. Section 1.448-1T(b)(3), referring to losses actually allocated.
General rules applicable to C corporations (including REITs, RICs, and members of consolidated groups)
The Treasury Department and the IRS have determined that “non-consolidated entities generally should not be aggregated for purposes of applying the Section 163(j) limitation,” and that “controlled partnerships generally should not be treated as aggregates because Section 163(j) clearly applies at the partnership level.”
Two examples were added in proposed Treas. Reg. Section 1.163(j)-2(h).
Basis adjustments for partners with EBIE when disposing a partnership interest
The 2018 proposed regulations only provided an increase in basis by the excess business interest expense (EBIE) amount of a partner for partners that disposed of all or substantially all of a partnership interest. The final regulations take a “pro rata” approach, whereby a partner disposing of a partnership interest increases his or her basis in the partnership interest by the portion of EBIE equal to the proportion of his or her partnership interest being sold or exchanged.
Partnerships and S corporations not subject to Section 163(j)
Under the 2018 proposed regulations, a partner or S corporation shareholder that holds an interest in an exempt entity was required to include the business interest expense of that exempt entity into account when calculating its own business interest expense limitation. Effectively this meant that partners or S corporations shareholders who were themselves subject to section 163(j) had to “re-test” business interest expense from partnerships or S corporations that were otherwise exempt. Commenters believed this was contrary to the code section, and Treasury ultimately agreed. The final regulations provide that business interest expense from an exempt partnership or S corporation is not included in the owner’s calculation.
EBIE from a partnership that subsequently elects to not be subject to Section 163(j)
Ambiguity surrounded the treatment of EBIE allocated to a partnership or S corporation in one year, when the entity subsequently elected out of Section 163(j). The final regulations state that the EBIE from a partnership that elected out is not treated as business interest expense paid or accrued in the succeeding taxable year, which could effectively suspend the deduction of EBIE until disposition of the partnership interest. The preamble stated that Treasury intended to address similar rules for S corporations, but such update was not made.
Triple net leases deemed “trades or businesses” for Section 163(j) purposes
Under the 2018 proposed regulations, Section 163(j) only applied to interest expense resultant from activities of a trade or businesses as defined in Section 162. The final regulations define “trade or business” more broadly by adopting the definition provided under Section 469, and in doing so include triple net leases as trades or businesses for Section 163(j) purposes, enabling these taxpayers to elect out of Section 163(j) treatment should they wish.
Taxpayers engaged in rental real estate that are unsure if their business activities rise to the level of a “trade or business” are nonetheless permitted to make a protective election to treat their activities as an electing real property trade or business. Additionally, eligible businesses may elect out of Section 163(j) on a protective basis, even if the taxpayer would be exempt from the Section 163(j) limitation under the gross receipts test. Protective elections such as these are still irrevocable and subject to the taxpayer’s various limitations, notably treatment of depreciation.
Other items of note in the final regulations
The finals regulations contain myriad other items of note, including: an addback for deductible trust distributions, as well as charitable deductions of trusts or estates provided when computing the trust or estate’s ATI; application of Section 163(j) to controlled foreign corporations and foreign persons with effectively connected income; certain exceptions to anti-abuse rules stated in the 2018 proposed regulations; a proposed revenue procedure providing a safe harbor for certain taxpayers operating residential living facilities to be treated as a real property trade or business for Section 163(j) purposes; clarification that Section 163(j) applies to all tax-exempt entities that are subject to tax under Section 511; confirmation that allocations pursuant to the 11-step calculation meet the requirements of Section 704(b); and changes to rules governing the allocation of items to an excepted trade or business.
Items still being considered and subject to future guidance
Interaction with Section 250: The final regulations do not contain the rule from the 2018 proposed Treas. Reg. Section 1.163(j)-1(b)(37)(i) that would coordinate the application of Sections 163(j) and 250. “Until such additional guidance is effective, taxpayers may choose any reasonable approach (which could include an ordering rule or the use of simultaneous equations) for coordinating taxable income-based provisions as long as such approach is applied consistently for all relevant taxable years,” the final regulations say.
Interaction with Section 108: The Treasury Department and the IRS say in the final regulations that they have determined that the interaction between Section 163(j) and Section 108 (i.e. addressing income from the discharge of indebtedness) “requires further consideration and may be the subject of future guidance.”
Intercompany transfers of partnership interests: The Treasury Department and the IRS note that they continue to study the proper treatment of intercompany transfers of partnership interests that do not result in the termination of the partnership.
Debt financed distributions
Under the proposed regulations, debt proceeds, and associated interest expense, of pass-through entities must be allocated by applying a rule similar to the optional allocation rule under Notice 89-35 and is determined as follows.
Amounts are grouped into one of three separate types of interest expense, each subject to different treatment. The first type of interest expense is “debt financed distribution interest expense,” allocated according to the use of the proceeds by the owner. The second type is “expenditure interest expense,” determined according to how the proceeds were allocated among the expenditures. The third type is “excess interest expense,” determined by allocating the proceeds pro rata among all the assets of the pass-through entity, based upon the entity’s adjusted basis in the assets.
The 2018 proposed regulations required the partnership to first test all interest expense under the general rules of Section 163(j) to determine business interest expense it could allocate to its partners. For those partners that did not materially participate, the interest would further be subject to Section 163(d), which applies to business investment expense. The new proposed regulations address this inherent contradiction of treating interest as business interest and investment interest for certain partners.
Under the newly proposed regulations, trading partnerships must bifurcate interest expense from trading activities between those partners that materially participate in the activity and those partners that are passive investors. Only the interest expense allocable to the partners that materially participate is subject to the business interest expense limitation of Section 163(j) at the partnership level. The portion of interest expense allocable to the passive investors is only subject to the investment interest expense rules under Section 163(d) at the partner level.
Self-charged interest: lending activities between a partner and a partnership
Business interest expense can result from loans made by partners to partnerships in which the partner has a direct interest. The 2018 proposed regulations did not address the issue of “self-charged” interest, although the preamble did state that self-charged interest should not impact a taxpayer’s Section 163(j) calculation.
Under the newly proposed regulations, the borrowing partnership treats the interest expense as business interest expense otherwise subject to Section 163(j). The lending partner treats interest income attributable to the loan as excess business interest income (EBII) from the borrowing partnership to the extent of that partner’s allocation of EBIE from that partnership in the taxable year. This will enable the loaning partner to deduct that excess interest expense to the extent of the interest income attributable to that loan.
Treatment of EBIE in tiered partnerships
The proposed regulations adopt an “entity approach,” stating that EBIE from a lower-tier partnership (LTP) allocated to an upper-tier partnership (UTP) remains at the UTP level, and is not allocated to its partners. If an LTP allocates EBIE to a UTP, then that UTP reduces its basis in the LTP. However, the partners of the UTP only reduce their basis in the UTP when the UTP recognizes the EBIE from the LTP as business interest expense paid or accrued. The UTP’s EBIE from the LTP is treated as a nondepreciable capital asset with a fair market value of zero and tax basis equal to the UTP’s reduction in basis in the LTP.
Other items of note in the proposed regulations
The proposed regulations provide guidance on numerous other topics, including: the application of Section 163(j) to controlled foreign corporations and foreign persons with effectively connected income; definitions of “development” and “redevelopment” used in the determining a real property trade or business; and determining the status of certain tax shelters.
Applicability datesBoth the final and newly proposed regulations apply for taxable years beginning 60 days after they are published in the Federal Register (generally, Jan. 1, 2021, for calendar-year taxpayers). Additionally, both the final and proposed regulations may be applied to tax years beginning after Dec. 31, 2017, as long as they are applied consistently.
What does CohnReznick think?
Patrick Duffany, JD, CPA, Managing Partner, Tax
Brian Newman, CPA, Partner, Practice Leader, Federal Tax Services
Travis Butler, Director, National Tax Services
Stephen Gregory, JD, Director, National Tax Services
Michael Billet, CPA, JD, National Tax Services
Subject matter expertise
CPA, JD, Managing Partner - Tax
CPA, Partner, Practice Leader, Federal Tax Services
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