Tax Code Section 163(j) had long imposed limitations on certain corporate taxpayers' ability to take a tax deduction for certain "disqualified interest" expense paid to a related party if the related party was not subject to US income tax on receipt of the interest payment. Section 163(j) was modified by the 2017 Tax Cuts and Jobs Act to apply to all taxpayers whose average gross receipts exceed $25 million a year (adjusted for inflation) and imposed a deduction ceiling for business interest at 30% of a taxpayer's "adjusted" taxable income (defined below), regardless of whether or not the interest was paid to a related party. The CARES Act (H.R. 748) increases this ceiling to 50% for tax years beginning in 2019 and 2020, potentially reducing tax bills by a significant amount.
The benefit of this change is that taxpayers may be able to deduct more interest expense in 2019 and 2020 and potentially also reduce estimated tax payments for the remainder of the year. If overpayments had been made for 2019, then refunds should be considered.
Overview of Code Section 163(j) – creating limits on certain interest expense payments
To understand the relief afforded by the CARES Act, an overview of the pre-amendment Code Section 163(j) is helpful.
Under the most recent version of Code Section 163(j), any taxpayer's deduction for business interest (that is, interest paid or accrued on business-related debt) is generally limited to 30% of the taxpayer's adjusted taxable income ("ATI"), which consists of all business-related income, but calculated without regard to business interest or business interest income, net operating loss deductions, the Code Section 199A 20% deduction for qualified business income, or, for tax years beginning before January 1, 2022, any deductions for depreciation or amortization.
The effect of the 163(j) limitation is to defer (not permanently disallow) any interest expense in excess of the 163(j) limitation. Any net business interest that cannot be deducted because of this 30% ATI ceiling is carried forward indefinitely, to be deducted in future tax years (again subject to the same limitation).
However, there are some exceptions and clarifications to the 30% ATI ceiling under 163(j):
The limitation does not apply to taxpayers who meet the "gross receipts test," which means that their average annual gross receipts for the previous three years did not exceed an inflation-adjusted $25 million (for 2019, the figure is $26 million). Gross receipts include total sales (net of returns and allowances) and all income received for services, as well as all of the taxpayer's investment income, whether business-related or not.
The 163(j) limitation applies to net business interest, as taxpayers are permitted to offset business interest expense with business interest income before applying the 30% ATI limitation, such that lending businesses that both receive and pay interest may not be significantly impacted.
The 163(j) limitation does not apply to real estate trades or businesses or farming businesses that elect out, and certain regulated utilities are exempt from the 163(j) limitations.
In the case of partnerships (as opposed to corporations and sole proprietorships), the 163(j) limitation applies in the first instance at the partnership level, rather than at the individual partner level. This means that the partnership, when computing its entity-level taxable income, can take a full deduction for business interest if it meets the gross receipts test (e.g., 3 year average of income under $25 million (inflation-adjusted)) or is a real estate or farming partnership that elects out of the 163(j) limitation. However, if the partnership's deduction is limited by the 30% ATI ceiling, then the partners are proportionately allocated the "excess" business interest ("EBIE"), which they can deduct on their own tax returns in future years to the extent of their allocable share of the partnership's "excess taxable income" ("ETI") in those years (that is, the allocable income of the partnership beyond the amount needed to fully deduct its business interest, given the 30% ATI ceiling).
CARES Act Relief – increasing the tax deduction available
For tax years beginning in 2019 and 2020, the CARES Act generally increases the ATI ceiling in Section 163(j) from 30% to 50%. Additionally, the CARES Act permits all taxpayers to compute their 50% ATI ceiling for 2020 using the ATI figure from their last tax year beginning in 2019. (For partnerships, this election must be made at the partnership level.)
In light of the continuing economic disruptions from COVID-19, many businesses will likely have substantially lower income in 2020 than in 2019. Thus, for many businesses, this ATI-substitution election will provide an even higher ceiling for deductible business interest than would the 50% ceiling alone.
For partnerships, the increased ceiling applies only to tax years beginning in 2020. However, unless a partner elects out, the partner can take a deduction on its own 2020 tax return for 50% of any excess business interest that it was allocated in 2019, regardless of the partnership's 2020 excess taxable income or the partner's own 2020 ATI. (The other 50% will be subject to the usual rule—that is, it will be deductible only to the extent of the partner's allocation of the partnership's excess taxable income for 2020.)
The increase in the 163(j) limitation for 2019 and 2020 could result in or increase a net operating loss for either year if the taxpayer has significant depreciation or amortization losses for those years. Any net operating loss created (or made available) may be carried back for up to 5 years to obtain a cash refund under the new 5-year carryback provision for net operating losses added by the CARES Act. For corporate taxpayers, this could create a rate arbitrage opportunity in that a corporation that is currently taxed at a 21% rate could carry back losses to years when it paid income tax at a 35% rate. Similarly, individual taxpayers may be able to carry back losses to years when they paid tax at the higher rate brackets applicable prior to the 2017 Tax Cuts and Jobs Act.
Taxpayers may want to recalculate any estimated tax payments made or being made to account for this increased tax deduction that would reduce payments necessary.
Practitioners believe the unique timeline for partnerships was designed to avoid large partnerships, which have already filed their Forms K-1 using the pre-CARES Act limitation amounts, having to reissue large numbers of Forms K-1.
If you have any questions or would like further information, please contact your regular Withers attorney or any of the contacts listed on this page.
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