Dec 02 IRS Provides Additional Guidance on Business Interest Limitation Rules in the Form of New Proposed Financial Regulations
The IRS has released long awaited guidance in terms of final regulations under Code Section 163(j), business interest expense deduction limitations which was initially introduced as part of the 2017 ”Tax Cuts and Jobs Act” (TCJA), and recently amended by the “Coronavirus Aid, Relief, and Economic Security” (CARES) Act.
Concurrently, the IRS issued New Proposed Regulations under section 163(j) that provides a number of important changes and clarifications to the originally issued Proposed Regulations.
Additionally, the IRS released the following related guidance:
- Notice 2020-59 – A proposed revenue procedure that provides a safe harbor allowing taxpayers engaged in a trade or business that manages or operates qualified residential living facilities to treat such trade or business as a real property trade or business solely for purposes of qualifying as an electing real property trade or business.
- On the IRS website, FAQs on the Section 163(j) small business exemption provide a general overview of the aggregation rules that apply for purposes of the gross receipts test, and that apply to determine whether a taxpayer is a small business that is exempt from the business interest expense deduction limitation.
Background:
Starting for tax year 2018 and going forward, the amount of business interest expense that can be deducted in the current taxable year is limited to the sum of:
- The taxpayer’s business interest income for the taxable year;
- 30% of the taxpayer’s Adjusted Taxable Income (ATI) for the taxable year (30% ATI limitation); and
- The taxpayer’s floor plan financing interest expense for the taxable year.
The disallowed interest expense (or referred to as Excess Business Interest Expense, “EBIE”) is carried forward and treated as business interest paid or accrued in the next taxable year.
Taxpayers with average annual gross receipts of $26 million or less is not subject to the provisions of Sec. 163(j) interest limitation (the $26 million threshold is in place for the 2019 & 2020 tax years and is indexed for inflation in 2021). However, the exception to this general rule is any taxpayer deemed to be a “tax shelter” will then be subject to Sec. 163(j) interest limitation notwithstanding the above-mentioned gross receipts exception.
One of the exceptions to the Small Business Exemption is in circumstances in which a taxpayer is deemed to be a “Tax Shelter”. A flow through entity is deemed to be Tax Shelter when the entity has losses and allocates at least 35% of those losses to limited partners (or in the case of Limited Liability Companies, this would include Limited Members that make no management decisions). The code refers to Tax Shelters as “syndicates” in which more than 35% of losses are allocated to limited partners who effectively have no active participation with the management of the business. Consequently, in a typical Private Equity deal which is heavily leveraged and all of the investors make no management decisions, would create a tax shelter status for the Private Equity Fund.
Under the CARES Act, the 30%-ATI limitation is increased to 50% for 2019 and 2020 tax years. However, this increase does not apply to partnerships. The interest limitation rules are applied differently for partnerships:
2019 Tax Year
- Partnership continues to use 30%-of-ATI limitation and EBIE is passed to the partners.
- Individual Partner level – No changes in terms of 30%-of-ATI limitation.
2020 Tax Year
- Partnership – Use 50%-of-ATI limitation;
- Partnership can elect 30%-of-ATI limitation instead of 50%;
- Partnership may elect to substitute tax year 2019 ATI on its 2020 Partnership return.
At the Individual Partner 2020 Federal tax filing, it can treat 50% of 2019 carried over disallowed interest expense as automatically paid or accrued on the partner’s 2020 tax year. The remaining 50% of 2019 disallowed interest expense is carried over by the individual partner.
Attached is a comparative analysis on 18 items between the initially Proposed and Final Regulations.
New Proposed Regulation Highlights
- Debt Financed Distributions
Owners of appreciated assets are oftentimes able to cash-out the equity by refinancing the property (this occurs frequently in rental real estate deals). When a partnership uses loan proceeds to make a distribution to its partners or members, the distribution is called a debt-financed distribution. Under the prior guidance, it was unclear the treatment and reporting of debt financed distributions.
New Proposed Regulations provides a multiple step calculation to determine the portion of the interest allocated to the partners or members, deemed to be interest from Debt Financed Distribution.
This new approach is consistent with the concept that money is “fungible” and first determines the portion of the debt distributed which should be considered debt financed proceeds and a portion of the distribution to the partners as non-debt financed proceeds.
It is best to go through an example to describe this new guidance:
Partnership consisting of two equal partners obtains a new loan of $100,000. The partnership makes a $50,000 distribution to each partner. The Partnership has $80,000 of operating expenditures in its real estate venture (which excludes depreciation and amortization expense). Interest rate on this loan is 10%, so $10,000 of total interest and $5,000 of interest is allocated to each partner. In conclusion, $1,000 of interest expense is allocated to each partner as debt financed distribution subject to interest tracing.
| New Loan Proceeds (only one loan) | 100,000 | |||
| Payoff Prior Loan Balance – N/A | – | |||
| Proceeds Net of Refinance Costs – Assume None | 100,000 | |||
| Refinance costs | – | |||
| Capital Expenditures | – | |||
| Operating Expenses – excluding depreciation and amortization | (80,000) | |||
| Total Capital & Operating Expenditures: | (80,000) | |||
| Deemed Debt financed distributions to Partners | 20,000 | |||
| Total Interest Expense | 10,000 | |||
| Interest Rate: | 10.00% | |||
| Debt Financed Distribution interest expense Formula: | ||||
| Partner 1 | Partner 2 | |||
| Total Interest Expense Allocated to Partners (A): | 10,000 | 5,000 | 5,000 | |
| Portion of debt distributed to Partners §1.163-14(d)(2)(ii)(A) | 100,000 | 50,000 | 50,000 | |
| Multiply | X | X | ||
| Distributed Debt Proceeds Rate | ||||
| Debt Financed Distributions to Partners | 20,000 | |||
| Total amount of debt proceeds distributed to Partners | 100,000 | 20.000% | 20.000% | |
| Multiply | X | X | ||
| Distributed Debt Proceeds Interest Rate | ||||
| Interest Sourced to Distributed Debt Proceeds | 10,000 | |||
| Total Debt | 100,000 | 10.000% | 10.000% | |
| Result | = | = | ||
| Allocated debt financed distribution interest expense (B): | 1,000 | 1,000 | ||
| Debt Financed Distribution Interest Expense – lesser of (A) or (B): | 1,000 | 1,000 | ||
| Allocation of Interest Expense to Each Partner | ||||
| Allocable interest expense | Partner 1 | Partner 2 | ||
| Debt financed distribution interest expense | ||||
| Interest Subject to Tracing . . . . . . . . . . . | 1,000 | 1,000 | ||
| Expenditure interest expense | ||||
| Business interest – Real Estate . . . . . . . . | 4,000 | 4,000 | ||
| – | – | |||
| Excess interest expense | ||||
| N/A . . . . . . . . . . . . . . . . …. | – | – | ||
| Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . | 5,000 | 5,000 | ||
Additional items mentioned in the new Proposed Regulations:
- Debt-Financed Acquisitions – Partner would allocate the proceeds from debt financed distribution that purchases another business entity or group of assets:
- In proportion to the relative adjusted tax basis of the entity’s assets reduced by any debt allocated to such assets, or
- Based on the adjusted basis of the entity’s assets in accordance with the methodology established under Final Regulations §1.163(j)-10(c)(5)(i).
- Treatment of Excess Business Interest Expense in Tiered Partnerships and Reporting.
- The New Proposed Regulations would take an “entity approach” to tiered partnerships by providing that if a lower-tier partnership allocates EBIE to an upper-tier partnership, the EBIE is carried forward by the upper-tier partnership (rather than that partnership’s partners), and basis reduction occurs only in the upper-tier partnership’s basis in the lower-tier partnership (and not in the basis of the partners in the upper-tier partnership). However, such EBIE would be treated as an expenditure of the partnership not deductible in computing its taxable income and not properly chargeable to capital account. From a practical standpoint, reporting of the interest expense that has been subsequently “released” as a deduction will be reported as part of a partnership’s taxable income/loss. This has already been taken into account on the company’s books, therefore it will be a book to tax difference item.
In Conclusion
The new guidance surrounding the complexity of Sec. 163(j) rules can create pitfalls for the unwary taxpayers that do not understand the nuances of these rules. As such, it is important that you reach out to your Sax advisor to address your specific circumstances, how these rules may affect your business and options to avoid or mitigate the Sec. 163(j) interest deductibility limitation.
About the Author
Michael Benguigui, CPA is a Senior Manager at Sax LLP and a member of the firm’s Tax and Real Estate Practices. He specializes in tax and accounting services for property owners, developers and private equity investors. Michael can be reached at [email protected].
