Tax Reform Introduces New Limitations on Business Interest Deduction

Among the many tax law changes established by the Tax Cuts and Jobs Act, a number of restaurant companies may be particularly impacted by the new limitation on the deduction of business interest expense under Section 163(j). The interest deduction will be limited to business interest income plus 30 percent of a business’s adjusted taxable income. Any interest deduction that will be disallowed in a tax year can now be carried forward indefinitely to succeeding tax years, where the taxpayer would have excess taxable income to take the deduction.
 
Business interest includes any interest paid or accrued on debt properly associated to a trade or business. This does not include investment interest under Section 163(d), which is subject to the typical limitations that have been in place for years.
 
Adjusted taxable income for the business interest limitation is defined as taxable income without the following items:
  • Net business interest income and expense (excluding tax-exempt municipal interest)
  • Depreciation, amortization, or depletion expense (for tax years before January 1, 2022)
  • Net operating loss deduction
  • Income or loss that is not attributable to the trade or business
  • Deduction of Qualified Business Income under Section 199A
 
For tax years beginning after January 1, 2022, deductions for depreciation, amortization, and depletion will not be add-back for adjusted taxable income. This may result in significant limitations for companies that have a large amount of fixed assets, like those in the restaurant industry.
 
For S-Corporations and partnerships, the limitation is applied at the entity level. Any disallowed interest would flow to the shareholders/partners as excess business interest on their K-1s. The excess business interest is then carried forward to a future tax year, where the shareholder/partner is able to use any excess taxable income allocated to them from the entity.
 
For entities in a tiered structure, the pass-through activity from the lower tier is not used in the calculation of the limitation for the entity at the upper tier. This prevents the income generated at the lower tiers from being doubled up and used in the adjusted taxable income computation to generate additional interest deductions at an upper tier.
 
In situations where C-Corporations with excess business interest carryovers are acquired, Section 382 limitations will need to be considered in order to determine the maximum carryover that can be taken in a year.
 
There are a few exceptions that would allow an entity to be exempt from applying the limitation. For example, qualifying small businesses may be exempt if they meet the $25 million gross receipts or less threshold over a three-year average covered under Section 448(c). It’s important to note that this exception is determined at the consolidated or combined level versus each individual entity; it is likely helpful for combined and consolidated groups to review the applicable rules. Similarly, real property and farming businesses can elect out of applying the limitation. However, the alternative depreciation system (ADS) method must be used by these types of businesses when determining taxable income.
 
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