Starting with tax years beginning in 2018, the Tax Cuts and Jobs Act (TCJA) will lower the ceiling for business interest deductions for manufacturers with more than $25 million in average annual gross receipts. These companies will generally be able to deduct less interest expense than they could have deducted under prior law.
What is changing?
Businesses can generally deduct “ordinary and necessary” expenses they incur, such as raw materials, labor and overhead expenses. However, the TCJA sets new limits on business interest expense deductions to the total of business interest income, 30% of adjusted taxable income (ATI), and interest on any floor-plan financing (for vehicle dealers).
There is an exemption from this limit for businesses with $25 million or less in average annual gross receipts for the preceding three tax years. (Farming and real estate ventures above the $25 million threshold also can elect out of the limitation in exchange for lower depreciation deductions, but manufacturers are generally not eligible for this opt-out.)
This new limit on interest deductions could have an adverse effect on larger, capital-intensive companies that borrow money to fund equipment, machines, computers and other fixed assets.
Calculating the limit
Manufacturers don’t usually earn much interest income or use floor-plan financing. So, their interest expense deduction will generally be limited to 30% of ATI. Defining ATI starts with taxable income calculated without considering the business interest expense limitation — in other words, subtracting the full amount of the interest expense. That amount is then adjusted by:
- Excluding any nonbusiness income, gains, deductions or losses
- Subtracting business interest income
- Adding back business interest expense
- Adding back any net operating loss (NOL) deduction
- Adding back the new deduction for up to 20% of qualified business income (QBI) from a pass-through business entity (such as a sole proprietorship, partnership, limited liability company or S corporation)
- Adding back deductions for depreciation, amortization and depletion for tax years beginning before 2022
Starting in 2022, depreciation, amortization and depletion deductions will no longer be added back when calculating ATI, which will reduce the interest expense deduction limit for companies with depreciation deductions.
Implications for decision-making
Fortunately, interest expense that’s disallowed under the new limitation can be carried forward indefinitely to future tax years. It will then be treated as a business interest expense incurred in the carryforward year.
The limit on interest expense deductibility could affect larger manufacturers’ decisions to pay cash or take out loans for equipment purchases — or even lease these items. Of course, other factors than deductibility will play into such decisions, such as rising interest rates and the new accounting rule for leases that takes effect for public companies in 2019 and private companies a year later. The updated lease accounting rule will require companies to report leased assets on their balance sheets, which could adversely affect a company’s debt ratios and loan covenants.
Just one of many tax law changes
The TCJA has brought sweeping changes to the tax code —not all of them positive for businesses and their owners. The limit on business interest expense deductions could be especially unfavorable to larger manufacturers with significant debt on their balance sheets.
If you have questions about how the TCJA is likely to affect your business, contact us. Weaver’s tax professionals can help you get the most benefit out of the new law.
Example: Calculating deductible interest expense under TCJA
Presume that Doodads Galore is a manufacturer with $35 million in average annual sales for the last three tax years. For 2018, Doodads has ATI of $4.5 million after adding back $2 million of business interest expense and $1 million of depreciation. Doodads is a C corporation, so it can’t take the qualified business income (QBI) deduction. How much interest expense can the company deduct in 2018?
Doodads’ interest expense deduction for 2018 is limited to $1.35 million (30% × $4.5 million of ATI). The $650,000 of disallowed interest expense ($2 million – $1.35 million) is carried forward to future tax years.
Now assume the same facts for 2022 — when the add-back for depreciation, amortization and depletion deductions is no longer permitted. How much interest expense can Doodads deduct in 2022?
For 2022, Doodads’ ATI will equal $3.5 million, because the $1 million of depreciation isn’t added back when calculating ATI. So, the company’s interest expense deduction for 2022 is limited to $1.05 million (30% × $3.5 million of ATI). The $950,000 of disallowed interest expense ($2 million – $1.05 million) is carried forward to future tax years.
Then assume the same basic facts for 2023, except Doodads has only $900,000 of interest expense in that year. The company’s ATI is $3.5 million (the same as for 2022). So, the company’s interest expense limitation for 2023 is $1.05 million (30% × $3.5 million of ATI).
In this case, the company can deduct all the interest incurred in 2023 ($900,000). In addition, it can deduct $150,000 of the disallowed interest expense carryforward from 2022. That results in a total allowable interest expense deduction of $1.05 million for 2023 ($900,000 + $150,000).
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