Partnership Aspects of 2021 Final Regulations on Deduction of Business Interest Expense
Partnership Aspects of 2021 Final Regulations on Deduction of Business Interest Expense
On January 5, 2021, Treasury and the IRS issued a second set of final regulations on the deduction of business interest expense (the 2021 final regulations) that provide additional rules to reflect changes to Internal Revenue Code Section 163(j) made by the Tax Cuts and Jobs Act (TCJA) and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). These final rules implement certain aspects of the proposed regulations that were published in September 2020 (the 2020 proposed regulations) concurrently with the first set of final regulations (the 2020 final regulations). The 2020 final regulations largely adopted the 2018 proposed regulations, with revisions to certain controversial rules. The new 2021 final regulations similarly follow the 2020 proposed regulations, with a few significant changes.
Section 163(j) generally limits the amount of business interest expense (BIE) that can be deducted in the current taxable year. The amount allowed as a deduction for BIE, or the Section 163(j) limitation, is limited to the sum of (1) the taxpayer’s business interest income (BII) for the taxable year, (2) 30% of the taxpayer’s adjusted taxable income (ATI) for the taxable year and (3) the taxpayer’s floor plan financing interest expense for the taxable year. The CARES Act increases the amount of the Section 163(j) deduction from 30% of ATI to 50% for taxpayers other than partnerships for taxable years beginning in 2019 and 2020 (although the taxpayer can elect to continue to use the 30% of ATI). For partnerships, the increased 50% ATI rule only applies to taxable years beginning in 2020. For taxable years beginning in 2019, 50% of a partnership’s EBIE allocated to a partner may be treated as deductible interest expense in the partner’s first taxable year beginning in 2020. Additionally, partnerships may elect to use 2019 ATI instead of 2020 ATI for purposes of computing the partnership level Section 163(j) limitation amount.
ATI is the taxable income of the taxpayer computed without regard to items not properly allocable to a trade or business; BIE and BII; net operating loss (NOL) deductions; deductions for qualified business income under Section 199A; deductions for depreciation, amortization and depletion with respect to taxable years beginning after December 31, 2017, and before January 1, 2022, and various other less common adjustments provided by the IRS.
The Section 163(j) limitation rules apply only to interest attributable to a trade or business, whether active or passive. They do not apply to investment income or investment expense, home mortgage interest or personal interest. The term “trade or business” is generally defined with reference to Section 162 but does not, for purposes of Section 163(j), include the trade or business of performing services as an employee, an electing real property trade or business, an electing farming business or certain utilities. Also excepted from these rules are taxpayers (other than tax shelters) that meet the small business exemption amount, which are defined as taxpayers that have average annual gross receipts for the prior three years of $26 million or less (as adjusted for inflation).
For partnerships, the business interest deduction limitation is applied at the level of the partnership and a partner’s ATI is increased by the partner’s share of excess taxable income (ETI) and excess business interest income (EBII). The amount of partnership BIE exceeding the Section 163(j) limitation is carried forward at the partner level as excess business interest expense (EBIE).
The 2021 final regulations address several partnership-related areas including trading partnerships, self-charged lending transactions and certain CARES Act partnership rules; however, they reserve guidance on a number of areas pending further study. This alert provides an analysis of how the new regulations affect these areas for partnerships.
The 2021 final regulations adopt the provisions contained in the 2020 proposed regulations with respect to trading partnerships. Under these rules, a partnership engaged in a trade or business activity of trading personal property (including marketable securities) is required to bifurcate its interest expense from a trading activity between partners that materially participate in the trading activity and partners that are passive investors. The Section 163(j) limitation is then applied solely to the portion of the interest expense that is allocable to the materially participating partners. The portion of interest expense from a trading activity allocable to passive investors is subject to the investment interest expense deduction limitation under Section 163(d) at the partner level. In addition to the bifurcation of interest expense, the 2021 final regulations require the separate allocation of other items of income, gain, loss and deduction from trading activities to materially participating partners and passive partners.
The 2021 final regulations provide relief to partners of trading partnerships that do not materially participate in the trading activity but had their share of EBIE subjected to the Section 163(j) limitation notwithstanding that the EBIE was also subject to the Section 163(d) limitation at the partner level. This treatment was consistent with language contained in the preamble to proposed regulations that were published in 2018. A transition rule in the final regulations permits passive investors in a partnership engaged in a trading activity to deduct EBIE allocated to them from the partnership in any taxable year ending prior to the effective date of the final regulations without regard to the amount of ETI or EBII that may be allocated by the partnership to the partner in the first taxable year ending on or after the effective date of these final regulations.
For purposes of the transition rule, any EBIE that is no longer subject to disallowance under Section 163(j) solely as a result of this transition rule will not be subject to limitation or disallowance under Section 163(d). In such case, the partnership treated the interest expense as BIE for purposes of calculating its limitation under Section 163(j). The treatment of interest expense by the partnership as BIE in prior years is not affected by this transition rule. Accordingly, the rule in Section 163(j)(5) that interest expense cannot be treated as both BIE and investment interest expense would still apply, and the BIE of the partnership cannot be treated as investment interest expense of the partner in future years.
Self-Charged Lending Transactions
The 2021 final regulations adopt the rules contained in the 2020 proposed regulations with respect to lending transactions between a partnership and a partner.
In the case of a lending transaction between a partner and partnership in which the lending partner owns a direct interest (self-charged lending transaction), any BIE of the borrowing partnership attributable to the self-charged lending transaction is BIE of the borrowing partnership. However, to the extent the lending partner receives interest income attributable to the self-charged lending transaction and also is allocated EBIE from the borrowing partnership in the same taxable year, the lending partner may treat such interest income as an allocation of EBII from the borrowing partnership in that taxable year, but only to the extent of the lending partner’s allocation of EBIE from the borrowing partnership in the same taxable year. In cases where the lending partner is not a C corporation, to the extent that any interest income exceeds the lending partner’s allocation of EBIE from the borrowing partnership for the taxable year, and such interest income otherwise would be properly treated as investment income of the lending partner for purposes of Section 163(d) for that year, the excess amount of interest income will continue to be treated as investment income of the lending partner for that year for purposes of Section 163(d).
CARES Act Partnership Rules
The 2021 final regulations provide special rules for partners and partnerships for taxable years beginning in 2019 or 2020 as enacted by the CARES Act. The regulations provide that 50% of any EBIE allocated to a partner for any taxable year beginning in 2019 is treated as BIE paid or accrued by the partner in the partner’s first taxable year beginning in 2020. The amount that is treated as BIE paid or accrued by the partner in the partner’s 2020 taxable year is not subject to a Section 163(j) limitation at the partner level. The 2021 final regulations further provide that if a partner disposes of its interest in the partnership in the partnership’s 2019 or 2020 taxable year, the amount treated as BIE paid or accrued by the partner is deductible by the partner and thus does not result in a basis increase. In a clarification from the 2020 proposed regulations, the 2021 final regulations provide that a partner may elect to not have this provision apply with respect to each partnership interest held by the partner on an interest by interest basis.
The 2021 final regulations also prescribe a simplified method when a partnership uses its 2019 Section 704 income, gain, loss and deduction amounts in determining its 2020 allocable ATI.
Final Regulations Reserve Comment on Key IssuesFor partnerships struggling to comply with the complexity of the statute, there are a number of items contained in the 2020 proposed regulations that remain unresolved by the 2021 final regulations. Treasury and the IRS continue to study aspects of the 2020 proposed regulations and these items are retained in proposed form and may be relied on to the extent provided in the Applicability Dates section of the preamble to the 2021 final regulations.
The 2021 final regulations reserve comment on the following items affecting partnerships:
- Debt-financed partnership distributions
- Partnership deductions capitalized by a partner
- Partner basis adjustments upon liquidating distributions
- Partnership basis adjustments upon partner dispositions
- Tiered partnerships
No timeline is provided by Treasury and the IRS as to when further guidance will be promulgated for these matters.
The 2021 final regulations apply to taxable years beginning on or after the date that is 60 days after the regulations are published in the Federal Register. Taxpayers and their related parties are permitted to retroactively apply the 2021 final regulations to a taxable year beginning after December 31, 2017 and before the 2021 final regulations are otherwise applicable, if the 2020 final regulations are also consistently applied to those taxable years.
It is mentioned in the preamble to the 2021 final regulations that the rules will take effect on the date the regulations are filed with the Office of the Federal Register for public inspection (instead of 60 days after the regulations are published in the Federal Register). The means that the effective dates of the final regulations will be 60 days earlier than the applicability dates. For the avoidance of doubt, the effective dates do not control when the rules are applied; instead, the applicability dates summarized herein control.
To the extent that a rule in the 2020 proposed regulations was not finalized under the 2021 final regulations, taxpayers and their related parties may rely on the rules in the 2020 proposed regulations for a taxable year beginning on or after the date that is 60 days after the date the 2021 final regulations are published in the Federal Register, provided they consistently follow all of the rules in the 2020 proposed regulations that are not finalized to that taxable year and each subsequent taxable year beginning on or before the date the Treasury decision adopting that rule as final is applicable or other guidance regarding continued reliance is issued. It is worth noting that when the 2020 proposed regulations were published, taxpayers and their related parties were generally permitted to rely on the 2020 proposed regulations retroactively to a taxable year beginning after December 31, 2017 as long as certain consistency reequipments are met.
The 2020 proposed regulations contain special effective date rules regarding certain proposed provisions. Taxpayers are recommended to look closely into such special effective date rules before retroactively adopting the 2020 proposed regulations.
Please contact a member of BDO’s Partnership Tax team for additional information about the implications of these new regulations for partnerships.