February 7, 2018
Mark W. Wolfgram
Bel Brands USA, Inc.
The Tax Cuts and Jobs Act is perhaps the biggest alteration to the tax code since 1986. The changes hit all aspects of the tax spectrum, leaving taxpayers and tax advisors scrambling to review the changes to determine what the impact will be. Today we’ll focus on the updated provisions related to interest expense.
One of the biggest question marks in tax reform was how to deal with the combination of cost basis recovery (i.e. depreciation) and interest expense. There were arguments that increasing the bonus depreciation rules while leaving the interest expense unchanged would encourage to “double-dip” by using debt financing to purchase new assets and creating dual depreciation and interest deductions. The Senate and House took different approaches in viewing this perceived problem. The Senate bill originally proposed creating a new test which would have measured domestic debt versus worldwide group debt to determine if the U.S. portion of debt was not greater than the entire worldwide group. Interest expense would have been limited had the U.S. debt level was more than 110% of the worldwide group debt level. Fortunately for taxpayers, a more straight-forward approach was ultimately agreed to in the final tax bill. Let’s look at the mechanics of how the new interest limitation will work.
Who was subject to the current interest limitation?
Section 163(j) currently limits the deductibility of interest expense only if a corporation meets two tests done on an annual basis. First, taxpayers must have interest expense in excess of 50% of an adjusted taxable income figure. Second, taxpayers must have a debt-to-equity ratio in excess of 1.5 times.
What is the new interest limitation?
Section 163(j) would be amended to limit the deductibility of interest expense for corporations. Taxpayers with interest expense in excess of 30% of an adjusted taxable income figure would find their expense limited.
What is adjusted taxable income?
The formula for adjusted income will change in 2018 and is schedule to change again in 2022. For 2018 through 2021, adjusted taxable income is defined as “normal” taxable income plus net operating losses, depreciation/amortization/depletion, and interest. This would be similar to the concept of EBITDA (“Earnings Before Interest, Taxes, Depreciation, and Amortization”) in financial statements. After 2021, the formula will be normal taxable income plus interest. This would be similar to the concept of EBIT (“Earnings Before Interest and Taxes”) in financial statements.
If a corporation’s interest expense is limited, how long can it be carried forward?
The bill would allow disallowed interest expense to be carried forward indefinitely.
Are there any exceptions to these new rules?
There are several exceptions worth mentioning. Taxpayers with three-year average annual gross receipts of $25 million or less are not subject to the limitation. Taxpayers in the real estate, farming, dealership, and regulated utility spaces also have exceptions which may apply.
Can we look at a simple 2018 example?
Corporation A, whose three-year average annual gross receipts exceed $25M, reported the following on their 2018 Form 1120:
Normal Taxable Income $1M
Adjusted taxable income is $26M ($1M + $20M + $5M). Interest expense would be limited if it exceeds 30% of $26M. Therefore, in 2018, no limitation would apply as the $5M of interest expense is less than the interest limitation threshold of $7.8M. The entire interest expense of $5M is deductible in 2018.
What happens to this example in 2022?
Assume the same facts as the 2018 example. Adjusted taxable income in 2022 would be $6M as depreciation is no longer added back to the limitation calculation. Interest expense would be limited if it exceeds 30% of $6M. Therefore, in 2022, a limitation of $3.2M would apply as the $5M of interest expense is greater than the interest limitation threshold of $1.8M. Only $1.8M of the $5M of interest expense is deductible in 2022. The remaining $3.2M of interest expense would be carried forward indefinitely.
Anything else corporations should keep in mind?
Two things which might not be obvious should be considered in relation to the new interest limitation rules.
The first is the new cost recovery rules and its impact on taxable income. The 100% bonus depreciation allowances could create swings in taxable income which should be monitored. For years before 2022, this may not matter as depreciation is added back to determine adjusted taxable income for this purpose (though corporations should monitor future depreciation as there will be much less MACRS depreciation than corporations are used to). But for years after 2021 where substantial amounts of depreciation might drive down normal taxable income the interest limitation could create a trap for those not used to being subject to the interest limitation. Of course, Congress could decide to change the rules before 2022 to avoid this change so this should be monitored.
The second is related to state income tax. Will states follow the federal limitation for interest expense? Many states use federal taxable income as the starting point for computing state taxable income. Will some states allow the entire interest expense? Or limit it even further than was done for federal income tax? Also, the limitation will be computed by corporations at the consolidated level. How does this translate to states which do not allow consolidated returns? How is the limitation allocated between entities? Definitely some uncertainty exists regarding the interest limitation’s impact here.
Please note that S corporation and partnerships are also impacted by these rules but that special rules apply. Taxpayers in those areas should review the rules carefully.
Like many of the new tax provisions, the interest expense limitation may be defined further by regulations and/or tax technical corrections. Watch this space for further updates.