Partnership Aspects of Final and Proposed Regulations on Business Interest Expense Deduction Under Section 163(j)
Final regulations issued by the IRS on July 28, 2020, on the Section 163(j) business interest expense deduction limitation largely adopt the proposed regulations published on December 28, 2018, but do make major revisions to some controversial rules included in the 2018 proposed regulations. Accompanying proposed regulations address complex issues—such as particular aspects of the 163(j) limitation as applied to partnerships—that warrant additional study and comments from the public.
Section 163(j) Background
Section 163(j) applies broadly to all business interest expense regardless of whether the related indebtedness is between related parties or incurred by a corporation, and regardless of the taxpayer’s debt-to-equity ratio. Section 163(j) provides a limitation on the deduction for business interest expense of all taxpayers, including partnerships, unless a specific exclusion applies, and generally limits the amount of business interest expense that can be deducted in the current year. In the context of partnerships, the 163(j) limitation applies at both the level of the partnership and the individual partners.
Section 163(j) Regulation Impact
Taxpayers, especially manufacturers and producers of property, may see an increase in their ability to deduct business interest expense under Section 163(j), because the final regulations now provide that depreciation, amortization and depletion capitalized into inventory can be added back for purposes of calculating adjusted taxable income.
The final regulations narrow the definition of “interest” in the Section 163(j) context, with the result that commitment fees, debt issuance costs, guaranteed payments for the use of capital under Section 707(c), and hedging gains and losses are generally no longer considered interest to which Section 163(j) may apply. However, the regulations modify the anti-avoidance rule by introducing “a principal purpose” standard.
The final regulations bring some welcome news for taxpayers that wish to make the real property trade or business election. Small business taxpayers and taxpayers that are unsure whether their rental real estate activities rise to the level of a trade or business can make an election to be treated as conducting electing real property trades or businesses if certain requirements are met.
To more accurately account for the types of expenditures made by passthrough entities, the proposed regulations would provide rules tailored to passthrough entities and they include complex rules for determining the Section 163(j) limitation in tiered partnerships and on interest expense associated with debt-financed distributions made by a pass-through entity.
Taxpayers generally may elect to apply both the final and proposed regulations before their effective dates, provided the regulations are applied consistently.
Of interest to partnerships, the final and proposed regulations provide much-needed guidance around a number of areas including:
- Guaranteed payments for the use of capital
- Partnership-level calculation and allocation of section 163(j) excess items
- Basis adjustments upon disposition of partnership interests
- Debt-financed partnership distributions
- Self-charged lending transactions
- Passive investors in trading partnerships
- Treatment of Excess business interest expense in tiered partnerships
- Basis and carryforward components of excess business interest expense
- Ant-loss trafficking rules
- Partnerships not subject to section 163(j)
- Rules regarding effective dates of the proposed and final regulations
Download the alert, which provides an in-depth analysis of how the final and newly proposed regulations affect partnerships.
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