Year 2018 is well underway and companies are grappling with how to comply with the in-force Tax Cuts and Jobs Act’s vague statutory language and an underfunded IRS. The IRS offered some help this month by releasing Notice 2018-28, explaining aspects of how the new business interest limitations will work. The Notice promises new regulations and provides immediate guidance in a few key areas relating to interest carried forward from 2017, consolidated groups, earnings and profits computations, and how the limitation affects partners and S Corporation shareholders.
Note that the rules described below may be relied upon by taxpayers pending issuance of new proposed regulations.
New Interest Deduction Limits
The TCJA limits the corporate net interest deduction. The deduction for any tax year cannot exceed the sum of:
(1) the taxpayer’s interest income;
(2) 30% of the taxpayer’s adjusted taxable income; and
(3) the taxpayer’s floor plan financing interest.
Any business interest that is not deductible because of the interest limitation may be carried forward indefinitely.
Taxpayers with average annual gross receipts of $25 million or less for the three previous years are not subject to the interest limitation. Real estate and farming businesses can elect out of the limitation.
Taxpayers with disallowed interest carried forward from 2017 will be allowed to use the interest deduction in 2018, but will be subject to the new TCJA disallowance rules. That means the 30% deduction limitation will apply to interest from past years. In addition, no excess limitation carryforward from prior years will be allowed after 2017. Prior law allowed an “excess limitation” equal to 50% of a corporation’s adjusted taxable income over its net interest expense to be carried forward for three years.
Under the Notice, affiliated groups that file a consolidated return will have the limitations imposed at the group level, that is, on an aggregate basis. For example, a consolidated group’s taxable income for purposes of calculating the 30% will be its consolidated taxable income, with intercompany debt obligations disregarded.
Under prior law, affiliated groups that did not file a consolidated return were still treated as affiliated under the so-called “super affiliation” rules. These rules were abolished by the TCJA. The forthcoming IRS regulations will provide special rules for the allocation of business interest in affiliated groups not filing a consolidated return.
The IRS also is working on regulations to address other consolidated group issues, relating to: allocating the interest limitation among group members; how to treat disallowed interest deduction carryforwards when a member leaves the group; and what happens to disallowed interest deduction carryforwards of a member that joins the group. Special rules also will be published for consolidated groups with real estate or farming businesses.
Earnings & Profits
The Notice clarifies that the disallowance and carryforward of a deduction for a C corporation’s business interest expense will not affect whether or when the expense reduces the C Corporation’s earnings and profits.
No Double-Counting for Passthroughs
The IRS also warns in the Notice that partners in partnerships and S corporation shareholders cannot interpret the new business interest limitations to “double count” business interest. Thus, for example, when calculating a partner’s annual deduction for business interest, a partner cannot include his or her share of the partnership’s business interest income for the taxable year except to the extent of the partner’s share of the excess of: (i) the partnership’s business interest income; over (ii) the partnership’s business interest expense.
Base Erosion Minimum Tax
The proposed regulations also will address the interaction of the interest limitation with new Code §59A, the “Base Erosion and Anti-Abuse Tax (BEAT).” This tax is imposed on large corporations and operates much like an alternative minimum tax by requiring corporations to add back to taxable income deductible payments made to related foreign persons. The Notice indicates that interest carried forward from 2017 will be subject to the new base erosion rules.