Inferring Commercial Interest: The Problem for 2022: 2022: Articles: Resources: CLA (CliftonLarsonAllen)
- The revised section 163(j) imposed a limit on the business interest expense deduction, but this limit cap was temporarily lowered by the CARES Act.
- This temporary pandemic relief ends for 2021 and the limitation becomes even more restrictive in 2022 for capital-intensive businesses, which could negatively impact your tax position.
- There is an exception for small businesses subject to a certain gross receipts threshold.
- Agribusiness, real estate and other businesses are encouraged to carefully consider their tax situation before considering any choices or changes.
the Tax Cuts and Jobs Act 2017 section 163(j) revised by imposing a limit on the deduction of business interest expenses for years beginning after December 31, 2017. Section 163(j) limits business interest payments for taxpayers whose gross receipts s amount to $25 million ($26 million for 2019, 2020, and 2021, and $27 million for 2022). The amount of deductible professional interest expenses may not exceed the sum of:
- The taxpayer’s business interest income,
- 30% of the taxpayer’s adjusted taxable income (RAI), and
- Taxpayer floor plan financing interest.
Any business interest expense not allowed as a deduction due to the limitation in section 163(j) is generally carried forward and treated as business interest paid or accrued in the following tax year.
In response to the COVID-19 crisis, the Coronavirus Aid, Relief and Economic Security Act (CARES Act) temporarily eased the burden of this limitation. Taxpayers could choose to use 50% of the ATI limitation for 2019 and 2020 (rather than the 30%) and use their 2019 ATI to calculate their 2020 business interest limit. the CARES Act allowed many companies to fully deduct their interest.
The commercial interest limitation has returned with a vengeance in 2022: the limitation has returned to 30% of the ATI – and depreciation, amortization and depletion are no longer added into the ATI calculation after the tax year 2021. These changes may limit your business interest deduction even if you have not previously been subject to this limitation.
Selected planning ideas
Benefit from the small business exception
Certain businesses qualify for a “small business exception” in section 163(j). To qualify, the gross receipts of the business must be below the gross receipts thresholds and the business cannot be a “tax shelter”.
For this purpose, a “tax shelter” is defined as a flow-through entity (such as a partnership or S corporation) if more than 35% of the tax year’s losses are allocated to limited partners or limited contractors. A “limited entrepreneur” is an owner who does not actively participate in the management of the entity. Active participation is determined based on facts and circumstances.
Partnerships facing these “tax shelter” rules may need to take certain tax planning measures, such as adopting a carefully drafted special attribution provision so that no more than 35% of total losses are attributed to sponsors. Be sure to consider the effects this special allowance may have on the partners’ economic agreement.
Another planning alternative is for sponsors or contractors to actively participate in the business to avoid sponsor or contractor status. Taxpayers with losses should consult their tax advisors and carefully consider their situation to avoid the tax shelter trap that could subject them to the limitation of section 163(j).
Some farming and real estate businesses may consider making a one-time, irrevocable election to opt out of the Section 163(j) limitation.
However, such taxpayers would then be required to use the Alternative Depreciation System (ADS) for certain classes of assets, which has longer amortization periods and lower annual depreciation deductions than those provided by the rules. ordinary depreciation. In addition, the affected assets are not eligible for additional depreciation deduction.
On the other hand, companies that make this choice will be exempt from business interest limitation rules – which can be substantial if the company expects a steady decline in net income, or even losses, due to its deductions for amortization.
If you have already evaluated the election but have decided not to opt out, re-evaluate the election in light of recent rule changes, such as the inability to add depreciation back into the ATI calculation and the possibility of use a 30-year depreciation period for rental residential property under ADS (instead of 40 years as was the case until recently).
The main sectors affected
Most production farming falls under the small business exception, but an increasing number of farms have sufficient gross revenues or could be classified as a tax shelter. For those that do not fall under the exception, operations that have high investment income and/or are heavily indebted may be subject to the limitation.
As noted above, operations may choose not to be covered by section 163(j). However, since agriculture is cyclical, consider electing through a long-term lens. The loss of the modified accelerated cost recovery system and the additional depreciation of certain asset classes to deduct commercial interest costs could be beneficial in the short term, but could become problematic over time. Large farms can be phased out of the Section 179 deduction and rely on additional depreciation to reduce taxable income. Removing section 163(j) could remove one of the biggest tools farmers use to normalize farm income.
Real estate businesses that choose not to comply with the limitation in Section 163(j) must depreciate their current and future residential rental properties, non-residential real estate properties and qualified improvement properties using the ADS, meaning a slightly longer amortization period for residential and non-residential properties. Other asset classes – such as land improvements, 5-year and 7-year properties – continue to be depreciated according to regular depreciation rules and may be eligible for additional depreciation.
- Non-residential real estate — Amortization period changes from 39-year life to 40-year life
- Qualified Enhancement Property — No longer eligible for bonus amortization under ADS and amortization term is extended from 15 years to 20 years
- Residential real estate — The amortization period is reduced from 27.5 years to 30 years
Before making this choice, real estate businesses should consider the cost-benefit analysis of the reduced depreciation expense due to the extended depreciation period of their assets and the benefit of additional business interests beyond the limit. Contact your tax advisor to find out if your business is eligible for this election.
Other industries and businesses
Although the real estate and agricultural sectors are the most affected by the limitation of commercial interest, other highly indebted companies may be affected by this limitation without the possibility of withdrawing. This includes manufacturing and distribution and consolidated companies as well as international business holdings.
The limitations of section 163(j) also apply to controlled foreign corporations (CFCs). An SEC is a foreign corporation in which more than 50% of its stock (by vote or value) is owned by US shareholders. Like domestic subchapter C corporations, a CFC’s interest expense is considered business interest and therefore is not subject to the section 163(j) exemptions applicable to interest. of investment.
Section 163(j) non-deduction of interest expense rules, when applied to CFCs, are extremely complex and may affect a US shareholder’s Subpart F and worldwide income inclusions low tax intangibles. A US shareholder holding shares in multiple CFCs must generally apply the Section 163(j) denial rules on a CFC-by-CFC basis; however, the shareholder may choose to treat certain CFCs as a single group. Consult an international tax advisor for assistance with these calculations.
How can we help you
Be careful when deciding to make tax choices and consider all facets of your business activity. Proactive and personalized planning is the key to helping you manage your tax obligations and identify new savings opportunities. Our tax specialists can help you assess your options and make informed decisions.