The regulations provide guidance to taxpayers on:
- how to calculate the limitation,
- what constitutes interest for purposes of the limitation,
- which taxpayers and businesses are subject to the limitation and
- how the limitation applies in consolidated groups, partnerships, international and other contexts.
The business interest deduction limitation was enacted by the 2017 TCJA and later modified by the CAREs Act. Under TCJA, the amount of business interest expense that may be deducted in the current year is limited to the sum of:
(1) the taxpayer’s business interest income for the taxable year;
(2) 30% of the taxpayer’s adjusted taxable income (ATI) for the taxable year; and
(3) the taxpayer’s floor plan financing interest expense for the taxable year.
Business interest that is not deductible may be carried forward indefinitely. There are exceptions for small businesses with average annual gross receipts of $26 million or less for the three previous years, for real property and farming businesses that elect out and regulated utilities. Note that the 2020 $26 million gross receipts amount is indexed for inflation each year.
The CAREs Act increased the business interest expense limitation from 30% of taxable income to 50% of taxable income for 2019 and 2020, with special rules for partnerships.
Final Regulations Reflect Public Comments
The 575-page final regulations make several important changes to the proposed version based on comments received by the IRS. First, the IRS changed the term “taxable income” to “tentative taxable income” to refer to the starting point in calculating adjusted taxable income (ATI). This change is designed to prevent confusion because the term “taxable income” has a different meaning in other areas of the Code. Tentative taxable income is determined in the same manner as taxable income but is computed without regard to the interest limitation and without regard to disallowed business interest expense carryforwards.
The final regulations also change the computation of ATI. Many commenters requested that the addback of deductions for depreciation, amortization and depletion when computing ATI should include amounts that are required to be capitalized into inventory under Code Section 263A. The proposed regulations did not allow this, but the IRS changed its position. The final regulations allow any depreciation, amortization, or depletion that is capitalized into inventory during taxable years beginning before January 1, 2022, to be added back to tentative taxable income when calculating ATI, regardless of the period in which the capitalized amount is recovered through the cost of goods sold.
Example: If a taxpayer capitalized an amount of depreciation to inventory in the 2020 taxable year, but the inventory is not sold until the 2021 taxable year, the entire capitalized amount of depreciation is added back to tentative taxable income in the 2020 taxable year. The capitalized amount of depreciation is not added back to tentative taxable income when the inventory is sold and recovered through the cost of goods sold in the 2021 taxable year. Under these facts, the entire capitalized amount is deemed to be included in the calculation of the taxpayer’s tentative taxable income for the 2020 taxable year, regardless of the period in which the capitalized amount is actually recovered.
Interest Definition Changed
The final regulations also narrow the definition of “interest” to exclude several items such as debt issuance costs, loan commitment fees and hedging rules. However, in some circumstances, the anti-avoidance rules may apply to require income, deduction, gain or loss from a hedging transaction to be taken into account, the regulations state.
The proposed regulations supplement the final regulations and include clarifications on applying the business interest limitation to U.S. shareholders of controlled foreign corporations (CFCs) and foreign persons with effectively connected income. The rules also explain how passthrough entities allocate business interest expense. Finally, the IRS explains the CAREs Act special rules for interest expense allocated to a partner and the election to substitute the 2019 ATI for the taxpayer’s 2020 ATI in determining the taxpayer’s interest limitation for 2020.
The final regulations take effect 60 days after being posted and generally apply to 2020. For the proposed regulations, the taxpayer may rely on some aspects until they are finalized. Also, the proposed rules are not retroactive, but the IRS will allow taxpayers to apply them to tax years beginning in 2018.
When there is an opportunity to apply regulations retroactively, certain taxpayers should consider doing so. The new regulations generally are more favorable then the 2018 versions. For example, the final regulations allow depreciation, depletion and amortization that is capitalized into inventory prior to 2022 as an add-back when computing ATI. In particular, capital-intensive businesses are helped by this rule and may want to consider filing amended returns.
If you have questions about the new rules and how they apply for your business please contact your Frazier & Deeter tax advisor.