Question

Describe the computation of the limit placed on the business interest deduction. Is the disallowed interest ever deductible. Please explain in detail.

Answer 1

PART A - Business Interest Deduction

Businesses are allowed to deduct any interest paid or accrued on debt that is properly allocable to a trade or business, and is not considered investment income. Historically, this interest deduction has not been subject to many limitations.

Computing the limitation

Prior to 2018, taxpayers could generally deduct business interest, subject to a few relatively uncommon exceptions. Effective for tax years starting in 2018, a taxpayer’s deduction for net business interest is limited to 30 percent of adjusted taxable income, which is taxable income without taking into account:

• Non-business income, like gains from the sale of assets held for investment
• Business interest expense or business interest income
• Net operating loss deductions
• The new 20 percent qualified business income deduction
• Depreciation, amortization, or depletion

The limitation does not apply to investment interest. The adjustment for depreciation, amortization, or depletion applies only through 2021, so the limitation will be much more restrictive for capital-intensive businesses for tax years starting in 2022.

The deduction for floor plan interest — which is interest on debt incurred to finance a dealer’s purchase of motor vehicle inventory for sale or lease — is not limited. However, most businesses that have floor plan financing will not be able to claim the new 100 percent bonus depreciation deduction with respect to any of their asset purchases.

The limitation applies to all business entity types and is generally applied at the entity level. Any interest that is not deductible as a result of the limitation is carried forward indefinitely until it can be absorbed.

PART B - Is the disallowed interest ever deductible.

Pass-through entities apply the interest limitation at the entity level. If 30 percent of the adjusted taxable income of the pass-through entity exceeds the interest incurred by the entity, the excess passes through to the owner as “excess taxable income” and can be taken into account in computing the amount of business interest that can be deducted by the owner.

If an S corporation has interest expense in excess of the limitation, the excess carries over at the entity level until the corporation generates enough income to absorb the interest. If a partnership has interest in excess of the limitation, the excess interest is allocated to the partners with the excess interest carried over at the partner level until the partner is allocated excess taxable income from that entity.

The result is that an S corporation shareholder does not reduce its basis in the S corporation stock until the interest is deducted, but a partner reduces its basis in the partnership when the interest is incurred even if not yet deductible.

Exceptions

Real property trade or business

A “real property trade or business” may “elect out of” the 30% deductibility limitation, but then must depreciate its non-residential real property, residential rental property, and qualified improvement property over longer periods under the alternative depreciation system (“ADS”) rather than the general depreciation system (“MACRS”).^[2]

For this purpose, a “real property trade or business” is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

Both the management or operation of a hotel and the operation of a health care facility qualify as a real property trade or business. Further, the new 100% bonus depreciation deduction generally will not be available to taxpayers that make the election to not be subject to the interest deduction limitation rules. Once made, the election is irrevocable.

Gross Receipts less than $25 million

The business interest limitation does not apply to taxpayers with average annual gross receipts, over the prior 3-year period, that are $25 million or less. “Gross receipts” of an entity includes those of all “related” entities. In the case of a partnership or S corporation, the gross receipts test is applied at the partnership or S corporation level.

Lending businesses

Although there is no specific exclusion for a lending business, the interest deductibility limit does not apply unless business interest expense exceeds business interest income. Consequently, an entity engaged in a lending activity, such as a debt fund or mortgage REIT, should generally not be subject to this limitation.