Knowing What Counts Podcast

Interest Expense Limitations: What Your Business Needs to Know About IRC 163J

• Tim Provost, CPA • Episode 15

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The Interest Expense Dilemma: Breaking Down IRC 163j Limitations - Featuring: Estefania Cabrera, Senior Tax Associate

Tax planning can make or break your business strategy, and nowhere is this more evident than with interest expense deductions. In this eye-opening episode of Knowing What Counts, Senior Tax Associate Estefania Cabrera unravels the complex world of IRC Section 163J limitations – rules that could significantly impact how much of your business interest expense you can actually deduct.

Originally targeting foreign-owned companies using U.S. subsidiaries to lower tax bills through interest deductions, the Tax Cuts and Jobs Act of 2017 expanded these limitations to most U.S. businesses. We break down exactly how these rules work: limiting business interest deductions to 30% of adjusted taxable income plus 100% of business interest income. But who's affected? Estefania explains the small business exemption for companies with average gross receipts under $31 million and special elections available for farming and real estate businesses.

The conversation takes a practical turn as we explore how these limitations affect different entity types. For corporations, the process is straightforward with limitations applied and tracked at the corporate level. Partnerships face more complexity, with excess interest passed through to partners who must then track these amounts themselves. We also discuss a critical change after 2022 – the elimination of the depreciation add-back provision that creates a counterintuitive situation where taking more depreciation can actually reduce allowable interest deductions.

Avoid common pitfalls we see clients encounter: incorrectly assuming exemption status, partners losing track of excess interest carry-forwards, and businesses failing to properly combine related entities' gross receipts. Whether you should slow down depreciation, capitalize interest expenses, or elect out of limitations entirely depends on your specific situation. The key takeaway? These rules change annually with inflation adjustments, so staying connected with your tax advisor is crucial for effective planning. Don't wait until tax filing time to discover these limitations – by then, it's too late to implement strategic changes.

Visit TheMPGroupCPA.com or call 413-739-1800 to speak with our tax experts about optimizing your business interest deductions while remaining fully compliant with evolving tax regulations.

To learn more about MP CPAs visit:
https://thempgroupcpa.com/
MP CPAs
413-739-1800

Speaker 1:

Welcome to the Knowing what Counts podcast, the place where expert guidance meets smart financial decisions. Whether you're a high net worth individual or a thriving business, the experts at MPCPAs are here to help you protect and optimize your wealth. Let's get started, because success begins with Knowing what Counts.

Speaker 2:

Because success begins with knowing what counts Interest expenses can be a powerful tax tool, but IRC 163 limitations add complexity. Today, we dissect what these rules mean and how businesses can navigate them for smarter financial strategies. Welcome back everyone. I'm Sofia Yvette, co-host and producer, here in the studio today with Estefania Cabrera, Senior Tax Associate at MPCPAs. Estefania, how are you today? I'm good. How are you Good? Now, before we jump into today's topic deeper, can you introduce yourself?

Speaker 3:

Sure, my name is Estefania Cabrera. I go by Steph. I'm a senior associate here at MPCPAs. I've been with the firm for about five years now and I work on a wide range of tax returns from individuals, businesses, trusts and estate returns.

Speaker 2:

Wow, now getting into this a little more, what is Internal Revenue Code, section 163J, and why was it introduced?

Speaker 3:

So Section 163J in essence just limitsowned companies that used their US tax subsidiaries to essentially take out these large loans for the purpose of being able to deduct their business interest expense, thereby lowering their US tax bill. And in 2017, though, the rules were expanded under the Tax Cuts and Jobs Act, the TCJA Act, to apply to most US businesses, not just those with foreign ties, and the goal was ultimately to one cover some of the expenses associated with the TCJA Act by limiting how much business interest expense these businesses could deduct, and it also worked to encourage these businesses to focus more on equity financing versus debt financing, so issuing stock versus taking out more loans.

Speaker 2:

Now, how is your interest expense limited?

Speaker 3:

So it can be limited overall. The main driver is your adjusted taxable income. It's limited at 30% of your adjusted taxable income and you can take up to 100% of your business interest income and in certain cases mostly with car dealerships you can also take up to the floor plan financing interest. But again, that's mostly seen with dealerships car dealerships.

Speaker 2:

Understood. Now is everyone subject to the 163J limitation.

Speaker 3:

Luckily, not everyone. Like I mentioned earlier, it's mostly focused on reducing how much business interest expense. Larger businesses can deduct Any small business, which is any business that has, on average, over the last three years, gross receipts of $31 million or less, year's gross receipts of 31 million or less, and any farming real estate business can also opt out of being limited. But the counter to that is that they then have to be subject to the alternative depreciation system, which just means they have to depreciate slower and yeah, so mostly targeted at the larger businesses, not necessarily the smaller ones.

Speaker 2:

Now, how does 163J affect different types of taxpayers, such as partnerships, corporations and individuals Corporations?

Speaker 3:

these rules. Overall, the rules apply about the same in terms of the limitations. So everyone is still subject to that gross receipts rule of 31 million or less. But corporations these rules apply directly to the corporation. So the interest is limited at the corporation level and any limited interest is carried forward again at the corporation level and in the future if any interest income presents itself, it can be deducted to that carried over amount.

Speaker 3:

For partnerships, however, it's a little bit different. The limit is applied at the partnership level but the excess interest is then passed on to the partners as excess business interest expense. They'll see this often in those K-1s they receive and they can only deduct that in the future when that same partnership earns enough income. That then gets passed down to them. A little different there. As for individuals. Individuals when we refer to them we mean more like sole proprietorship, so people with like a Schedule C or sometimes maybe a landlord not as common, as it's kind of difficult to reach that 31 million limit for a sole proprietorship. But if they do, the rules apply similarly to the partnership in that it's limited at their level and it's up to them to track those limits so that they can take them in the future if any interest income frees up.

Speaker 2:

Now, how do non-cash items, such as depreciation or amortization, impact the calculation for the 163J?

Speaker 3:

So depreciation and amortization is this wonderful deduction that most businesses can take, where they can deduct a portion of the price of their fixed assets or amortizable assets. So that's a great deduction on base. Unfortunately, when related to the 163, it can be counterintuitive, because before 2022, businesses could add back all those depreciation deductions so that their ATI, adjusted taxable income, would be higher, so that 30% would be much higher, so they could take more of those business interest expense. Unfortunately, after 2022, that rule has been removed, so now you can no longer add those deductions back to your ATI, which means if you take more depreciation and amortization, you are in essence lowering how much of your business interest expense you can deduct.

Speaker 2:

Wow, now what happens to the interest expense?

Speaker 3:

that is limited, so, as I mentioned earlier, the main difference when it comes to corporations, individuals and partnerships is how those limitations are treated after they've been limited. So for corporations, like I mentioned, they are in charge of tracking these limitations. It kind of just carries over until the corporation is able to generate business interest income to take those additional deductions. But for partnerships, since it gets passed on to the partners, it it becomes their responsibility to track them. So they have to track those excess business interest expenses on their end and, like I mentioned earlier, it's up to them to then, when income becomes available from that partnership, to be able to deduct it. So it doesn't ever go away. It just kind of is different who is in charge of tracking it and how you manage it.

Speaker 2:

Understood. Now what are some common pitfalls or misconceptions about 163J compliance?

Speaker 3:

So some of the things we see commonly is certain people assuming that it does not apply to them.

Speaker 3:

Maybe certain businesses that have fluctuating income might have a good year one year and a lower year the next one. They often don't realize that it is an average your gross receipts of the average gross receipts for the last three years. So some businesses don't look back those three years to make sure to see if they qualify or not. Another one we see is that certain partners with investments in these partnerships aren't tracking their excess interest. They may lose track of it and they miss out on really great deductions down the line when business interest income presents itself and certain farming businesses or real estate businesses don't know that they can opt out of it or the trade-off to opting out of it. So sometimes they lose out on some great deductions like that. Or certain businesses, like I mentioned earlier, subsidiaries or other companies who should be combining their overall gross receipts don't know that they need to and oftentimes they are subject to this limitation and they just don't keep track of it or file the proper forms to keep up to date with that.

Speaker 2:

Understood. Now what planning strategies should businesses consider when facing 163J limitations?

Speaker 3:

Well, up to this point I've mentioned, I think, depreciation a little bit earlier. One of the things that we've discussed with some of our clients has been possibly slowing down depreciation. Of course, you're not going to be taking as much depreciation on one end, but it could free up quite a bit more of business interest expense. Another option we've looked into has been capitalizing your interest, which essentially means just reclassing your interest expense into possibly being part of inventory or equipment and it gets capitalized on that end. Or again, like I mentioned earlier, just making sure to see if, depending on the business type, if they qualify to elect out of this business interest limitation.

Speaker 2:

Now, is there any final advice you want to give people who may be dealing with 163 limitations?

Speaker 3:

Yes, I think the biggest advice I could provide is to keep up to date with the rules surrounding this limitation. It can be kind of tricky and the limit of what qualifies as a small business changes every year due to inflation adjustments, so it's always a good idea to just look it up, look up the limitation, make sure you're still well with under that limitation and, more than anything, keep in contact with your tax advisor, your CPA, to make sure that you're planning accordingly. Oftentimes we see people go throughout the year thinking that they're going to be able to get this very large business interest expense deduction and then it comes March or April and we realize that it's been limited by that 30% and we definitely don't want to come to that end, when nothing can be done, to realizing that the deduction is much smaller than we originally planned done to realizing that the deduction is much smaller than we originally planned.

Speaker 2:

Oh yeah, most definitely. Well, estefania, I really appreciate you being here today with me and for sharing those helpful insights with our listeners. We may catch you in your next episode. Have a fantastic rest of your day. Thank you so much.

Speaker 1:

Thanks for listening to the Knowing what Counts podcast. Ready to optimize your wealth and protect your future, visit TheMPGroupCPAcom or call 413-739-1800 to connect with our team of experts. Remember, success is about knowing what counts.