Final IRC Section 163(j) Regulations Ease Compliance for Small Businesses

On July 28, 2020, the Internal Revenue Service (IRS) issued final regulations under IRC Section 163(j), which limits the amount of business interest a taxpayer can deduct. Surprisingly, the final regulations significantly change requirements for partnerships and S corporations that are eligible for the “small business exemption.” As a result, such small businesses and their owners should find it easier to comply with IRC Section 163(j).

What Is IRC Section 163(j)?

Enacted as part of the 2017 Tax Cuts and Jobs Act (TCJA), IRC Section 163(j) generally limits the amount allowed as a deduction for business interest expense to the sum of:

1. the taxpayer’s business interest income for the tax year;
2. 30 percent of the taxpayer’s adjusted taxable income (ATI); and, if applicable,
3. the taxpayer’s floor plan financing interest expense.

Any business interest expense not allowed as a deduction for any taxable year as a result of IRC Section 163(j) is carried forward and treated as business interest paid or accrued in the next taxable year.

However, the limitation exempts some small businesses. Specifically, IRC Section 163(j)(3) says that the interest deduction limit does not apply to a taxpayer, other than a tax shelter as described in IRC Section 448(a)(3), with average annual gross receipts of no more than $25 million (indexed for inflation) for the previous three years. This exemption from IRC Section 163(j) is referred to as the “small business exemption.”

For partnerships, the limitation on the deduction for business interest expense must be applied at the partnership level. A partner’s ATI must be increased by the partner’s share of the partnership’s excess taxable income, but not by the partner’s distributive share of the partnership’s income, gain, deduction, or loss. The same rules apply to S corporations and S corporation shareholders.

Finally, the deduction limit does not apply to certain “excepted” trades or businesses. The excepted trades or businesses are those of providing services as an employee, electing real property businesses, electing farming businesses and certain regulated utility businesses.

Treatment of Small Businesses Changed from the Proposed to the Final Rule

Under the proposed regulations, if a partner or S corporation shareholder had been allocated business interest expense from a small business (i.e., from an entity not subject to IRC Section 163(j) by reason of the small business exemption), that business interest expense would nonetheless be subject to the partner’s or S corporation shareholder’s IRC Section 163(j) limitation. Specifically, the proposed regulations provided that a small business

• “does not take its deduction for business interest expense into account in determining its non-separately stated taxable income or loss. Therefore, if a partner or an S corporation shareholder [were] allocated business interest expense from an exempt entity, that allocated business interest expense [would be] subject to the partner’s or S corporation shareholder’s section 163(j) limitations. Additionally, a partner or S corporation shareholder [would have had] to include items of income, gain, loss, or deduction of such exempt entity when calculating its ATI.”

Commenters argued that this proposal was inconsistent with IRC Section 163(j)(4)(A), which requires the testing of partnership-level business interest expense at the partnership level, not the partner level. Surprisingly, the IRS agreed. As a result, the final regulations provide that business interest expense of an exempt partnership or S corporation is not subject to the Section 163(j) limitation at the partner or shareholder level. Consequently, there is no need for an exempt entity to separately state its business interest expense. Instead, it can include the business interest expense in determining its non-separately stated taxable income or loss.

As in the proposed regulations, a partner or S corporation shareholder of an exempt entity must include its share of non-excepted trade or business items of income, gain, loss, and deduction of such exempt entity when calculating its ATI. However, if a partner or S corporation shareholder is allocated a net loss from an exempt entity, that net loss does not reduce the partner’s or shareholder’s ATI.

Need Help Understanding What This Means for You?

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Visit weaver.com for more thought leadership on today’s topics and stay tuned for more information on deducting business interest expense under the new Section 163(j) or the TCJA in general.

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