New Tax Law Limits Business Interest Expense Deductions

Under the Tax Cuts and Jobs Act (TCJA), starting with tax years beginning in 2018, manufacturers with more than $25 million in average annual gross receipts will generally be able to deduct less interest expense than they could have deducted under prior law. Here are some details about this new limitation.

Nuts and bolts

In general, businesses can deduct “ordinary and necessary” expenses incurred in operating a business, including raw materials, labor and overhead expenses. However, under the TCJA, business interest expense deductions for tax years starting in 2018 and beyond will be limited to the sum of: 1) business interest income, 2) 30% of adjusted taxable income (ATI), and 3) interest on any floor-plan financing (for vehicle dealers).

Businesses with $25 million or less in average annual gross receipts for the preceding three tax years are exempt from the limitation, however. (Farming and real estate ventures with average annual gross receipts in excess of $25 million also can elect out of the limitation in exchange for lower depreciation deductions, but these options to elect out generally don’t apply to manufacturers.)

The limitation on deducting business interest expense could have an adverse effect on larger, capital-intensive firms that borrow money to purchase equipment, machines, computers and other fixed assets.

Calculating ATI

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.

ATI starts with taxable income calculated without considering the business interest expense limitation. 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), and
• Adding back deductions for depreciation, amortization and depletion for tax years beginning before 2022.

For tax years beginning in 2022 and beyond, depreciation, amortization and depletion deductions will no longer be added back in calculating ATI, which will reduce the interest expense deduction limit for companies with depreciation deductions. (See “Calculating deductible interest expense under the new limitation.”)

Indefinite carryforwards

What happens to the interest expense that’s disallowed under the limitation rule? It’s not forgone; rather, it’s carried forward indefinitely to future tax years. Then it’s treated as business interest expense incurred in the carryforward year.

The interest expense limitation could impact whether larger manufacturers decide to pay cash or take out loans for equipment purchases — or lease these items. This decision also might be affected by rising interest rates and the new accounting rule for leases that goes into effect for public companies in 2019 and private companies a year later.

The updated accounting rule requires companies to report leased assets on their balance sheets. Compared to the current accounting treatment, this could adversely affect a company’s debt ratios and loan covenants.

Digesting the new rules

The TCJA brings sweeping changes to the tax code — and not all the changes are positive for businesses and their owners. The new limitation on business interest expense deductions could be especially unfavorable to larger manufacturers with significant debt on their balance sheets. Contact your tax advisor to understand how the new limitation on deductible business interest is likely to affect your business.

Calculating deductible interest expense under the new limitation

Widgets Makers is a manufacturer with $35 million in average annual sales for the last three tax years. For 2018, Widgets has ATI of $4.5 million after adding back $2 million of business interest expense and $1 million of depreciation. Widgets is a C corporation, so it can’t take the qualified business income (QBI) deduction. How much interest expense can Widgets deduct in 2018?

The company’s 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, let’s assume the same facts for 2022 — when the add-back for depreciation, amortization and depletion deductions is no longer permitted. How much interest expense will Widgets be allowed to deduct in 2022?

For 2022, Widgets’ ATI will equal $3.5 million, because the $1 million of depreciation isn’t added back in 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.

For example, assume the same basic facts for 2023, except Widgets has only $900,000 of interest expense for 2023. 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). Plus 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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