It’s in Your Interest: New §163(j)s Limitations on Business Interest Deductions
The Tax Cut and Jobs Act of 2017 made a plethora of changes to the Internal Revenue Code,1 some of which dramatically shifted how the United States taxes business entities and income. While much discussion has focused on the so-called “repatriation tax” on profits of foreign subsidiaries of U.S. companies, certain new exemptions and deductions for foreign-derived profits, and various changes to the taxation of individual taxpayers, not nearly as much discussion has focused on the changes in §163(j) of the code affecting the deductibility of interest expenses by businesses. Nevertheless, lawyers representing businesses, particularly transactional lawyers, should be cognizant that new rules on the deductibility of business interest can affect a whole host of clients. This article provides the non-tax lawyer some of the highlights (or low-lights, as the case may be) of new §163(j).
For decades, businesses and tax lawyers have found significant advantages to using debt in the capital structure of a business alongside equity. From a business perspective, the owners of a business may prefer (in certain circumstances) debt to common or preferred equity because the business owners may give up less of the control of the business or its future profits to the debt holders. For some businesses, debt (and, correspondingly, payment of interest) can be an essential part of the business model. For example, debt is integral to many operators of real estate businesses and private equity firms because financing is used to acquire new assets or improve existing assets. Likewise, many new businesses (including non-private equity businesses) use a leverage strategy as a way to fuel business growth. Further, interest expense paid on debt, unlike preferred or common dividends, are deductible for a business. Thus, the economic cost of the interest expense payments is mitigated by the tax deductibility of such payments.
Practitioners quickly discovered that they could play a sort of “arbitrage” when advising the U.S. business seeking foreign investment or the foreign investor looking to invest in the U.S. In some circumstances, investments could be structured using a combination of debt and equity. If structured properly, interest on the debt would be deductible for U.S. tax purposes for the business but would not be subject to tax in the U.S. to the investor. If the investor’s home jurisdiction does not tax the interest, the investor has effectively “stripped” the earnings (that is, profits) from the U.S. business without having to pay any tax at all on the earnings to the extent of such interest payments. In response to these types of transactions, Congress enacted §163(j), which targeted interest paid on loans made to U.S. businesses by foreign related-party lenders. However, old §163(j) applied only to corporations and still provided opportunities for a taxpayer to calibrate its debt to strip significant earnings out of the U.S. or avoid the application of 163(j) altogether. In response to these issues, Congress completely rewrote §163(j). These revisions, as discussed below, will affect significantly a wide swath of taxpayers — not just taxpayers trying to “strip” earnings out of the U.S. without paying tax on such earnings. In particular, these revisions could have significant negative tax effects on businesses that have made the business judgment to use debt from unrelated lenders to advance their business agenda.
The first change Congress made was to apply §163(j) to all taxpayers, not just corporations. Under the old law, inbound investors could invest in the U.S. through a partnership structure. If there were no corporations in the ownership structure, the §163(j) limitations would not apply. If the ultimate beneficial owners were resident in a treaty-favorable jurisdiction, the taxpayers could remove significant earnings from the U.S. with no U.S. tax using a highly leveraged, flow-through investment structure. In contrast, new §163(j) now applies to all taxpayers regardless of form: corporations, partnerships, sole proprietorships, and subchapter S corporations.2
Further, the limitations imposed by the previous version of §163(j) only applied to a corporation’s disqualified interest if 1) the corporation’s ratio of debt to equity exceeded 1.5 to 1 and; 2) the corporation’s net interest expense exceeded 50 percent of the corporation’s adjusted taxable income.3 Disqualified interest was interest paid to a related party when the related party was not subject to U.S. income tax on the interest or paid to an unrelated party but a related party guaranteed the debt and no gross basis tax is imposed on such interest.4 If all interest was owed to unrelated lenders, old §163(j) imposed no limitation on such interest’s deductibility.5 Now, the provision disallows any interest expense incurred by the taxpayer if the interest expense exceeds the sum of 1) business interest income; 2) 30 percent of the taxpayer’s adjusted taxable income; and 3) the floor plan financing interest of the taxpayer.6 In this context, adjusted taxable income (ATI) is akin, though not the same as, a taxpayer’s EBITDA (earnings before interest, taxes, depreciation, and amortization). As the statute spells out, ATI is the taxable income of the taxpayer without regard to:
1) Income, gain, deduction, or loss that is not properly allocable to a trade or business;
2) Business interest or business interest income;
3) Net operating loss deductions;
4) Deduction under 199A (the pass-through deduction); and
5) For taxable years beginning before January 1, 2022, any deduction for depreciation, amortization, or depletion.7
For tax years beginning after December 31, 2021, depreciation, amortization, and depletion are deducted from ATI before determining the limitation, thus, the limitation imposed by §163(j) will shrink for tax years beginning after December 31, 2021.8 Congress has dealt a blow to businesses that are highly leveraged. If an ATI does not grow or the business does not pay down its debt, the business could face having significant amounts of deductions for interest expense disallowed after 2021.
Sensitive to the use of debt by small businesses, Congress exempted from the application of this provision small businesses. Specifically, Congress exempted from application of the §163(j) taxpayers that have gross receipts that do not exceed $25 million.9 The heading for this section could be misleading at first glance; it reads “exemption for certain small businesses.” Looking at the top line of a business’ tax return or income statement does not answer the question as to whether a taxpayer’s gross receipts do not exceed $25 million. Rather, a business’ gross receipts must be counted together with any other entity, with which the business shares 50 percent or greater common ownership.10 Because of this requirement, two seemingly unrelated businesses — either because they do not share common management or operations, or because they have separate legal tax structures (such as separate corporations or separate partnership structures) — may actually be considered a single entity for purposes of applying the limitations of §163(j).
Even if the taxpayer’s gross receipts do no exceed $25 million, taking into account all taxpayers sharing 50 percent or greater common ownership, the taxpayer may still be subject to §163(j) if the taxpayer is considered a “tax shelter.” A taxpayer may be considered a “tax shelter” even if it was set up for valid purposes and not as a nefarious scheme to avoid income tax. For purposes of §163(j), a tax shelter includes any partnership, among other entities, where 35 percent or more of the losses of the partnership are allocable to limited partners.11 This definition is loaded with several questions: Who is a limited partner in the context of a limited liability company? Who constitutes a limited entrepreneur? When are 35 percent or more of the losses “allocable” to limited partners or limited entrepreneurs?
A full review of these questions and how they may or should be answered is beyond the scope of this article but some observations are in order. In other contexts, any person who actively participates in the management of an enterprise will not be treated as a limited partner, while someone who is not regularly and substantially involved in the day-to-day management or operations will be considered a limited partner.12 In addition, the U.S. Treasury and the Internal Revenue Service (IRS) have provided some limited guidance as to when losses are considered allocable such that an entity should be considered a tax shelter. In Treas. Reg. 1.448-1T(b)(3) and PLR 8911011, the U.S. Treasury and the IRS indicated that a taxpayer will not be considered a tax shelter, for purposes of 448 (the section of the code to which §163(j) points for determining whether a business is a “small business”), for a year in which it has profits; only for a year in which it has losses. Thus, for a taxpayer with less than $25 million in gross receipts that is profitable, the taxpayer will not be subject to §163(j) even if more than 35 percent of its losses would have been allocated to passive investors if losses had been sustained. But when losses are sustained with 35 percent of such losses being allocated to passive investors, the entity may be considered a tax shelter. Any reader who represents start-up, emerging, or real estate businesses could see many of their clients falling into the category of a “tax shelter” under the foregoing principles. Thus, it is important for practitioners to make sure any such clients review their debt structures to ensure all interest expense deductions are captured.
Beyond the start-up and emerging business category, the rules of §163(j) and the exemptions therefrom should be carefully reviewed in the context of investments made into the U.S. by foreign investors. For many years, Florida has been an attractive market for foreign investment, often European or Latin American investors looking to access the U.S. market, particularly the U.S. real estate market. Among other investment structures, practitioners long have used leveraged investment structures to lower the effective U.S. tax rate applicable to such an investment.13 In such a structure, the investor funds it’s investment with a combination of debt and equity. As operating profits from the investment are earned, interest is paid on the investor’s loan and, to the extent the cash profits exceed accrued interest, principal. The interest would generate a deduction at the investment level, reducing the taxable operating profits and, if structured properly, the interest could be paid without any U.S. withholding tax; payments of principal do not generate any tax deductions directly14 and usually are not subject to U.S. income tax, whether withholding or otherwise.
New §163(j) will significantly impact this investment structure and will increase the due diligence or structuring a foreign investor should conduct. First, the foreign investor should examine the investment structure to determine if it will be subject to one or more exemptions from the rules of §163(j). As noted above, seemingly unrelated businesses could be considered related for the purpose of disallowing interest deductions if the two businesses share common ownership. Thus, if the investment sponsor proposes or the investor believes that the investment will qualify for the “small business exemption,” the investor should conduct reasonable due diligence to ensure that the investment does not need to be aggregated together with any other investments or investment structures such that, for purposes of §163(j), the investment’s gross receipts will exceed $25 million. Such due diligence must include a review of the investors own portfolio, a review of the sponsor’s ownership position in this and any other entity, and the ownership position of any other investor in this or any other entities. Further, even if the investment’s gross receipts should not exceed $25 million, the foreign investor should determine if the investment could be considered a tax shelter under the principles described above. If so, the investor could face a significant limitation on the interest expense deductions it was otherwise relying on to reduce its overall effective U.S. taxable income. Finally, if the investment is real estate in nature, the investor should consider whether the election for real estate businesses (described below) is applicable.
As we have already briefly discussed, real estate businesses often generate significant tax losses for investors often arising from (among other items) depreciation and interest expense deductions. For these firms, Congress provided a “get out of jail free” card: real estate trades or businesses within the meaning of 469(c)(7)(C) can elect out of treatment of §163(j)15 if the real estate trade or business elects to use the alternative depreciation system.16 Generally, the code provides for two basic depreciation schemes: 1) an accelerated depreciation system;17 and 2) a straight-line depreciation system (referred to as the “alternative depreciation system”).18 Instead of allowing 100 percent expensing for capital assets used in a business in the year of acquisition, the amount used to acquire such property by a business is recovered through depreciation deductions. These deductions are designed to match the recognition of the expense to the periods in which the assets are consumed or used by the business. Theoretically, this matches the expensing of the acquisition price of the assets with the periods in which the income generated by the assets is recognized by the business (referred to generally as the “matching principle”).19
The accelerated depreciation system contained in §168 provides higher depreciation deductions in the periods immediately after the depreciable asset is acquired, declining in later periods until the entire cost to acquire the asset is depreciated. Irrespective of the matching principle, the accelerated depreciation system includes certain types of “bonus” or special depreciation deductions whereby a taxpayer can expense the full cost to acquire certain types of property in the year acquired (or year of acquisition and the year or two after acquisition) rather than expensing the property over a longer period of time.20
Land is not depreciable under the theory that it is never “consumed.”21 Buildings upon land are depreciable but, even under the accelerated depreciation system, must use straight-line depreciation and are not eligible for bonus depreciation under §168(k). In particular, residential real property has a recovery period of 27.5 years under the accelerated depreciation system while non-residential real property has a recovery period of 39 years.22 The alternative depreciation system extends residential real property’s recovery period to 30 years and non-residential real property to 40 years.23
For most real estate businesses, the vast majority of depreciation deductions recognized by a real estate business will be for real property — that is, buildings upon land depreciated on a straight-line basis over a long period of time, not personal property that is depreciated over a shorter period of time and on an accelerated schedule. Thus, a qualifying real estate trade or business that elects out of application of §163(j) by electing to have the alternative (think straight-line) depreciation system apply to it often does not give up much: the type of property it acquires (land and buildings) would not be entitled to accelerated, including bonus, depreciation.24 Further, the slightly shorter depreciation schedule provided under the normal depreciation system would provide only a marginal increase in annual depreciation deductions. Therefore, a taxpayer operating a real estate trade or business, which might be subject to the interest limitations of §163(j) should consider electing out of the application of §163(j); the appropriate calculus in such a case is whether the interest deductions afforded the taxpayer by opting out of the provisions of §163(j) exceeds the annual depreciation the taxpayer foregoes by doing so.
First, unlike with the predecessor version, the new limitation limits the deductions for any business interest, irrespective of whether it is paid on debt held by a related party or an unrelated party. Second, the deductibility of interest is limited to 30 percent of a business’ EBITDA (and, in 2022, EBIT). Third, while small businesses are exempt from this exacting limitation, two traps for the unwary exist: 1) a business’ size considers both the business’s gross receipts but also the gross receipts of any 50 percent or greater owner; and 2) pass-throughs that allocate significant losses to passive investors might not be able to take advantage of the “small business” exception. Fourth, a real estate business may be able to benefit from electing out of the entire interest limitation provision if it is willing to use the alternative depreciation system. These are just some of the impacts of this new interest limitation provision. There are a number of impacts of the new §163(j) to discuss but this column does not provide space for all of them. Taxpayers with significant interest deductions should discuss their facts and circumstances with their tax advisors.
1 All references made to the Internal Revenue Code shall mean that of 1986 as amended.
2 I.R.C. §163(j)(1).
3 I.R.C. §163(j) (effective for tax years beginning before January 1, 2018).
4 I.R.C. §163(j)(3) (effective for tax years beginning before January 1, 2018).
5 Under certain common law tax principles, debt could be recharacterized as equity and any interest payments on such recharacterized debt treated as distributions in respect of stock or other equity, but there was no statutory limitation on deduction of business interest outside of the rules of I.R.C. §163(j).
6 For most taxpayers, this writer deals with 3) is immaterial because floor plan financing interest really only applies to certain motor vehicle dealers.
7 I.R.C. §163(j)(8).
8 I.R.C. §163(j)(8)(A)(v).
9 I.R.C. §163(j)(3).
10 I.R.C. §163(j)(3) applies the gross receipts test of I.R.C. §448(c) to determine if the client has less than $25 million in gross receipts. I.R.C. §448(c) directs the taxpayer to subsections (a) and (b) of I.R.C. §52, which include certain rules to determine if multiple entities should be considered a “single employer.” I.R.C. §52 treats as a single employer any entity that has 50 percent or greater common ownership. I.R.C. §448(c) aggregates together entities treated as a single employer under I.R.C. §414(m) or (o). I.R.C. §414(m), business entities are considered related if they satisfy the rules of I.R.C. §267 or I.R.C. §707(b). Under I.R.C. §267 and §707(b), two entities are related if they share greater than 50 percent common ownership.
11 New I.R.C. §163(j)(3) the practitioner to follow a path through various code sections to determine what constitutes a “tax shelter.” I.R.C. §163(j) directs the reader to I.R.C. 448(a)(3). I.R.C. 448(d)(3), for purposes of I.R.C. §448, uses I.R.C. §461(i)(3)’s definition of “tax shelter,” which includes, among other things, any “syndicate” under I.R.C. §1256. Under I.R.C. §1256, “the term ‘syndicate’ means any partnership or other entity (other than a corporation which is not an S corporation) if more than 35 percent of the losses of such entity during the taxable year are allocable to limited partners or limited entrepreneurs (within the meaning of I.R.C. §461(k)(4)).” The reference to I.R.C. §461(k)(4) is to the definition of limited entrepreneur, which defines a limited entrepreneur as a person who has an interest in an entity other than as a limited partner and does not actively participate in the management of the enterprise.
12 The IRS has tried to argue that all such partners or members generally are “limited partners” because such persons do not have general liability for the liabilities of the partnership. Where the taxpayer was trying to avoid application of I.R.C. §469’s passive activity rules, the taxpayer argued that as a member of a limited liability company, he should be treated as a “general partner” and, thus, exempt from the application of I.R.C. §469. See generally Thompson v. United States, 87 Fed. Cl. 728 (2009). However, taxpayer-lawyers tried to argue that, despite the fact that they were actively engaged in the business of a law practice organized as a LLC, they should be treated as limited partners for tax purposes and, thus, exempt from the self-employment tax imposed by I.R.C. §1402. See generally Renkemeyer, Campbell & Weaver, LLP et al. v. Commissioner, 136 T.C. 137 (2012).
13 If foreign investor purchased an investment, for example, in a privately held U.S. C corporation, the operating profits from that investment would be subject to U.S. income tax at a rate of over 54.5 percent. Under today’s rates, not taking any state or local tax into account, the effective tax rate would be 44.7 percent (21 percent corporate income tax and 30 percent withholding tax). One structure that reduces this tax is the “leveraged” investment structure.
14 When a taxpayer uses debt to finance acquisitions of depreciable or amortizable property, the cost of purchasing such property (which would include the principal on the debt) is deducted through cost-recovery deductions such as depreciation or amortization. Likewise, when debt is used to finance operations, such as through purchasing inventory or pay operating expenses, the principal of such debt is “deducted” through the deductions for items such as cost of goods sold or deductions for operating expenses. Thus, while payments of principal are not directly deductible, the principal may indirectly generate deductions through the uses of the borrowing.
15 See I.R.C. §163(j)(7)(A)(ii).
16 See I.R.C. 163(j)(10)(A) (cross referencing I.R.C. §168(g)(1)(F)).
17 See I.R.C. §168(a), et al.
18 See I.R.C. §168(g), specifically I.R.C. §168(g)(2).
19 For a general explanation of the matching principle, see Wikipedia, https://en.wikipedia.org/wiki/Matching_principle.
20 See I.R.C. §168(k).
21 The code does provide for deductions for “depletion” of natural resources. Still, there is no depreciation or depletion afforded to land in general.
22 See I.R.C. §168(c).
23 See I.R.C. §168(g)(2).
24 The TCJA’s changes to I.R.C. §168 included allowances for “qualified improvement property,” which usually includes certain improvements to the interior of a building or certain equipment affixed to the exterior of a building. Such property, in some cases, would be eligible for bonus depreciation deductions. But such improvements also qualify for a separate depreciation scheme provided for in the I.R.C. 179 expensing. Although I.R.C. 179 expensing has certain limitations, it is applicable irrespective of whether the taxpayer uses the accelerated depreciation system or the alternative depreciation system. Thus, an election to use the alternative depreciation system may still provide the taxpayer with much of the bonus depreciation it desires through the use of I.R.C. 179 expensing.
MICHAEL DANA is a director with Cohen & Grigsby’s business services group. He advises clients regarding U.S. federal and state income tax issues especially in connection with entity formation; cross-border transactions; structuring joint ventures, mergers and acquisitions; and business operations.
This column is submitted on behalf of the Tax Law Section, Michael D. Minton, chair, and Benjamin A. Jablow, Christine Concepcion, and Charlotte Erdman, editors.