Paying interest on a business line of credit, a mortgage on your factory or office building, or on business credit cards is a common expense for many businesses. Until now, generally interest expense was fully deductible (except for limits for corporations with a high debt-to-equity ratio). While the Tax Cuts and Jobs Act made a number of favorable changes in tax rules for businesses, there have been some new limits and restrictions. One such new limit is the allowable deduction for business interest without regard to the debt-to-equity ratio.
30 percent limit
Referred to as the "30 percent limit," it applies after December 31, 2017, to the deduction for business interest expense, whether the business is a C corporation or a pass-through entity. It does not matter when the debt was incurred. The IRS says that for C corporations, all interest expense is treated as business interest. This hard and fast rule doesn't apply to other entities (e.g., interest payments by a partnership may be investment interest).
Technically, the deduction for business interest expense, which is figured on new Form 8990, is capped at the total of:
- Business interest income
- 30 percent of adjusted taxable income for the year (defined below)
- Floor plan financing (the type of interest used by car dealerships to finance their inventory, not discussed further here)
Adjusted taxable income. This is a taxpayer's taxable income figured without regard to the following:
- Income, gain, deduction, or loss not properly allocable to a trade or business
- Any net operating loss (NOL)
- The qualified business income (QBI) deduction
- Depreciation, amortization, or depletion in tax years beginning before January 1, 2022
For example, say a business has the following items of income and expense: $25X from the sale of goods ($95X gross receipts minus $70X cost of goods), $5X interest income, $10X interest expense, and $10X for depreciation. This boils down to $10X of taxable income before the application of the interest expense limit. Adjusted taxable income needed to figure this limit is $30X (taxable income before the interest expense limit ($10X), plus addbacks for net interest expense ($10X) and depreciation ($10X)). Adjusted taxable income of $30X multiplied by the 30 percent referenced earlier means the business interest deduction limit in this example is $9X. In other words, $1X of the $10X interest expense is not currently deductible.
Treatment of disallowed interest. Interest that cannot be currently deducted because of the 30 percent limit is carried forward. There is no limit on the carryforward; it is treated as interest in succeeding years until it is used up.
Partnerships and S corporations. The 30 percent limit is figured at the entity level. A partner's share of interest income is limited to the extent of the partner's share of business interest income over business interest expense. Part II of Form 8990 is used to figure "excess taxable income" of partnerships. For partnerships, the excess interest is allocated to partners and is carried over at the partner level and used when and to the extent excess taxable income is allocated to the partner. The partner reduces his or her basis in the partnership when the interest is incurred even if it isn't currently deductible.
Any interest not currently deductible by an S corporation is carried forward by the entity and treated as interest expense in the subsequent year, and offset by interest income in that year. The disallowed deduction does not reduce the shareholder's basis in the S corporation stock. Part III of Form 8990 is used to figure "excess taxable income" of S corporations.
Businesses exempt from the cap
There are some businesses are not barred from deducting all of their interest:
Small business exemption. Businesses that meet a $25 million gross receipts test can deduct all of their interest; they are automatically exempt from the 30 percent limit. The gross receipts test is satisfied if average annual gross receipts for the three prior years do not exceed $25 million.
Exception for farming and real estate businesses. Farming businesses and real estate businesses that don't meet the small business exception can still deduct all of their interest if they elect to do so. Once the election is made, it's irrevocable.
But if this election is made, then they must figure depreciation on their newly acquired property with a recovery period of 10 years or more using what's known as the alternative depreciation system. This results in slower write-offs than those allowed under the general depreciation system. For example, 100 percent bonus depreciation cannot be used.
Utilities companies. Like small businesses, they are automatically exempt from the business interest limitation.
Time for a review
Given rising interest rates that make borrowing more costly and the new 30 percent limit that makes borrowing less favorable taxwise, businesses should review their capital needs and consider whether borrowing money is the best way to go.