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Calculating Deductions for Business Interest Expenses

Calculating Deductions for Business Interest Expenses

One of the more intricate provisions of the Tax Cuts and Jobs Act (TCJA) is the new limitation of business interest expenses. At first glance, this limitation seems simple, but the devil is in the details.

Here is an explanation and example of how to calculate the business interest expense deduction under the new law and why it is essential to check with a tax professional. The new limitation takes effect for fiscal years from 2018.

 

The Annual Limit on Business Interest Expenses.

Assuming your business does not qualify for a business interest expense limit exception, the deduction for the year of tax cannot exceed:

  • 30% of adjusted taxable income (ATI)

  • Any floor plan financial interest

  • Corporate interest income


5 Step Process

To calculate the annual limit on the deduction of business interest expense, proceed as follows:

1. Calculate the business interest income and business interest expense. (Interest charges to finance the floor plan must be calculated separately.)

2. Identify taxable income adjustments to calculate access to information for your business. Parameters include:

  • Remove any element of income, profit, deduction, or loss that cannot be attributed to a business,

  • Extract commercial interest income and commercial interest expenses,

  • Add any deductions for net operating losses (NOL),

  • Add the new deduction of up to 20% of qualifying business income from a business transfer entity, such as a sole proprietorship, a partnership, a limited liability company (LLC), or an S corporation; and

  • Add allowable deductions for depreciation and depletion for years beginning in 2022.

3. Calculate the ATI. Adjustments that would otherwise increase regular taxable income (such as corporate interest income) are deducted in the access to information calculation. Adjustments that would otherwise reduce ordinary taxable income (such as depreciation) are included in the access to information calculation. The ATI cannot be less than zero.

4. Multiply the ATI by 30%.

5. Calculate the company's interest expense limit. It is equal to the sum: 

  • Interest income on companies (from step 1),

  • 30% of adjusted taxable income (from step 4) 

  • Any financial interest in the floor plan (from step 1).

The amount of business interest expense not accepted is equal to the difference between the company's total corporate interest expense and the deductible amount calculated in step 5. This amount is carried forward indefinitely to future years and is treated as interest expense committed in the transfer year.


Example:

To illustrate how these calculations work, assume that ABC is a C corporation. For 2019, ABC has $ 200,000 corporate interest income, $ 2.5 million in corporate interest expense, and 10 million dollars from ATI. Suppose the small business exception does not apply, and the business is not interested in the floor plan.

For 2019, ABC can all deduct $ 2.5 million from commercial interest expense. This amount is below the deductible limit of $ 3.2 million. The limit is equal to the amount: company interest income ($ 200,000) or 30% of ATI's $ 10 million ($ 3,000,000).

For 2020, ABC has $ 200,000 business interest income, $ 1.2 million in corporate interest expense, and only $ 1 million in access to information. The business can only deduct $ 500,000 from business interest expenses in 2020. Why? ABC's business interest expense for 2020 is limited to company interest income ($ 200,000) or 30% of the $ 1 million ($ 300,000) ATI.

Interest expense of $ 700,000 not authorized in 2020 ($ 1.2 million - $ 500,000) will be carried forward to future years.

This example shows that limiting a business's interest expense is more likely to affect a business when it is having a bad year. The good news is that unauthorized interest is carried over for years to come and can, therefore, be deducted when things improve.


The Transition Rule Adds Complexity.

Under a transitional rule, depreciation and depletion deductions are added to the access to information calculation for fiscal years beginning before 2022. For fiscal years beginning in 2022 and beyond, depreciation deductions, depreciation and exhaustion will not be added.

Therefore, for fiscal years beginning before 2022, the benefit of generous tax depreciation benefits, such as the 100% premium depreciation in the first year and the generous deductions provided in Section 179, will not reduce the ATI. For years after 2022, taking advantage of these exemptions will reduce access to information, thus increasing the likelihood of interest rate constraints coming into play. This can be particularly problematic if you are going into debt to buy depreciable assets.


Special Rules for Partnerships and S Corporations

The rules for limiting interest expense deductions are increasingly complicated for corporations operating as corporations, LLCs treated as corporations for tax purposes, and small businesses.

The restriction is calculated at the entity and owner level. The special rules prevent double counting of income when calculating the owner's ATI to restrict its level.


Important Note: The base of a partner in the interest of the partnership or the base of an LLC member in the interest of the LLC (external base) is reduced (but not less than zero) by any commercial interest not authorized assigned to the partner (member). After the sale of the participation fee (LLC), the partner (member) increases the external base by the amount of any base reduction attributable to unsuccessful business interest charges that have not yet been deducted. Similar rules apply to corporate interest expenses incurred by small businesses.


Are You Entitled to an Exception to Interest Expense Limitation?

The following companies are exempt from the interest expense limitation rules under the Tax Cuts and Jobs Act (TCJA):

• Small businesses with average annual gross revenues of $ 25 million or less in the three fiscal years ending in the previous fiscal year.

• Qualifying real estate companies that choose to forgo the ability to pay corporate interest and use the Alternative Depreciation System (ADS) to depreciate their qualifying non-residential, residential rental, and improvement properties. This exemption is available to eligible real estate companies with an average gross annual income greater than $ 25 million.

• Eligible farms that waive the commercial interest expense limit and use ADS to depreciate assets used in agriculture with depreciation periods in the Accelerated Cost Recovery System (MACRS) of 10 years or more. This exemption is available to eligible farms with an average gross annual income greater than $ 25 million.


How Does The Small Business Exception Work? 

Suppose you run your business as a C corporation for the calendar year. Your business had gross revenue of $ 20 million in 2016, $ 25 million in 2017, and $ 29 million in 2018. So your average gross annual revenue was $ 24.67 million in the last three years. It's below the $ 25 million limits. Therefore, for fiscal 2019, your business qualifies for the small business exception and is exempt from the 2019 interest rate limit rules.

On the other hand, if you started your business in 2017, the average annual gross income test for fiscal 2019 would be based only on the average annual gross income for 2017 and 2018. A company with a variable annual gross income close to the dollar The 25 million US dollars may be eligible except for small businesses for some years, but not for others.


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