One of those most relevant provisions for businesses in the 2017 Tax Cut and Jobs Act is often misunderstood: the limitation on how much interest expense can be deducted from taxable income. This is often referred to as the Section 163(j) limitation.

While many businesses are exempt from the limit on the deduction, others may be impacted in ways they don’t expect. This impact can be particularly consequential for businesses with high capital requirements and interest, such as those operating as start-ups or in real estate.

Section 163(j) Limitation: The Basics

As a general rule, businesses can deduct interest paid or accrued during the taxable year, just as they deduct other operating expenses. This includes interest on debt a business incurs to fund ongoing operations; purchase equipment, property, inventory, or raw materials; or finance business expansions.

In order to offset some of the revenue losses from the TCJA’s lower tax rates, the law revised Section 163(j) of the Internal Revenue Code, imposing new limits on how much interest companies can deduct. Unless a company qualifies for an exemption (as explained below), its allowable business interest expense deduction is limited to the sum of:

• 30% of its adjusted taxable income (ATI) for the year; plus
• Any business interest income for the year; plus
• Any floor plan financing interest expense

Technically, the Section 163(j) limitation applies to all companies that incur any business interest expense, but there are some major exemptions that allow many businesses to continue deducting the full amount of their business income expense.

Exemptions and Exceptions

The most common way that businesses avoid the interest expense limitation is often referred to as the “small business exemption.” A company qualifies for this exemption by meeting the “gross receipts test”—that is, its average annual gross receipts for the previous three tax years were $30 million or less. (This number is adjusted annually for inflation; $30 million is the number for 2024 returns.)

While the gross receipts test would appear to exempt almost all small-to-medium-sized businesses from the 30% of ATI limitation, the answer is not quite that simple. For example, the small business exemption is not available to any company that is considered a tax shelter or syndicate, as defined by Section 448(d)(3) of the tax code. Under this section, the term “syndicate” applies to many partnerships where a significant portion of ownership is held by passive investors, often through complex investment structures.

Such structures are relatively common in commercial real estate and other capital-intensive industries that incur significant interest expenses. Although the passive partners who invest in such enterprises might not regard them as tax shelters, they actually meet the definition under Section 448(d)(3), and thus do not qualify for the small business exemption.

In addition, the IRS applies aggregation rules to prevent businesses from breaking into smaller entities to qualify for the exemption unfairly. Under these rules, the gross receipts of all related entities must be combined (or aggregated) to determine if they meet the gross receipts test. If the aggregated gross receipts of these related entities exceed the threshold, none of the entities can use the small business exemption.

Outside of the small business exemption, Section 163(j) also allows elective exceptions to the interest limitation for some real estate and farming businesses. To claim this exception, however, a company must switch to the alternative depreciation system (ADS) for certain properties, which lengthens depreciation schedules and spreads deductions over a longer period. The affected properties are also ineligible for bonus depreciation. Before choosing this exception, management should carefully evaluate both the short-term and long-term consequences because the election is irrevocable.

Applying the Limitation

When a company subject to Section 163(j) incurs interest expenses that exceed the current 30% of ATI limitation, the excess interest expense does not just disappear. How it is handled depends on how the business is structured.

For a C corporation, the unclaimed portion of interest expense can be carried forward indefinitely, to be deducted in some future year when the company has sufficient income to allow it. If the C corporation is part of a consolidated group, both the limitation and the interest carryforward are calculated and applied across the group as a single entity.

The treatment is a bit more complex for pass-through entities. In a partnership, the business interest limitation is determined at the partnership level, but any interest expense above the limit is allocated among the partners and carried forward by them individually, not by the partnership itself. Partners can deduct this carryforward in future years if the partnership allocates them enough excess taxable income or business interest income to offset it.

In an S corporation, on the other hand, unused interest expense does not pass through to shareholders. Rather, it stays with the corporation, just as it does with a C corporation, to be carried forward and potentially deducted in future years.

Despite the fact that many small and medium-sized businesses are exempt from the Section 163(j) limitation, the details about excess interest expense can be nuanced. Companies with significant interest expense need to make sure they are in compliance with Sec 163(j) limitation.
For more information about this limitation and the TCJA, visit the IRS website at https://www.irs.gov/newsroom/basic-questions-and-answers-about-the-limitation-on-the-deduction-for-business-interest-expense

Dembo Jones professionals can help with any concerns regarding Sec. 163(j) rules, as well as with appropriate tax planning strategies.