Businesses that hold inventory for sale to customers are in for a bit of good news. Late last month, the IRS released final regulations on the business interest expense limitation, and eased up on proposed guidelines that would have curtailed larger deductions for business interest expense by businesses that capitalize certain expenses under Section 263A’s Uniform Capitalization rules (UNICAP).
The final guidelines made a few other notable deviations from what was initially proposed, but the changes to the business interest expense limitation for businesses subject to UNICAP are among the most significant. The final regulations will help businesses with high equipment and facilities costs (such as many in the manufacturing sector) hold onto their interest expense deductions. These businesses are more likely to rely on debt financing in order to fund these costs, and so the final regulations will help reduce their tax burdens at a time when many are struggling to make ends meet.
The Rocky Beginnings of the Business Interest Expense Limitation
The current version of the business interest expense limitation materialized under the tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA) at the end of 2017. The law states that for tax years beginning after Dec. 31, 2017, business interest expense deductions under Section 163(j) are limited to the sum of:
- Business interest income;
- Floor plan financing interest; and
- 30% of adjusted taxable income (ATI).
Congress delegated to the IRS the responsibility to implement and clarify the new rules. The IRS released its first set of proposed regulations in 2018. The 2018 guidelines supplied many answers, but some were not what taxpayers wanted to hear. The section that clarified how to calculate ATI became a sticking point for manufacturers, retailers and wholesalers almost immediately.
Consistent with Section 163(j), the IRS proposed in 2018 that ATI be determined without regard to depreciation, amortization, and depletion deductions until the year 2022. By removing these deductions from the calculation, taxpayers report larger ATIs and therefore larger business interest expense deductions. But under the 2018 proposed rules, the IRS stripped a significant part of this benefit from businesses with expenses subject to UNICAP. The proposed regulations stated that depreciation costs capitalized under Section 263A were not considered eligible depreciation expenses when calculating ATI. Such costs could not increase ATI at the onset, when the depreciation was first capitalized, and also could not increase ATI when that depreciation was later recovered through costs of goods sold. Even though these depreciation expenses were otherwise deductible, they were disregarded and therefore never increased the taxpayer’s ATI.
Lobbying for Change
The manufacturing industry pushed back. Companies in the sector argued that by disregarding these particular UNICAP costs from the ATI calculation, the IRS was placing manufacturers and other businesses typically subject to UNICAP at a disadvantage. The manufacturing lobby, including a task force from the National Association of Manufacturers (NAM), argued that the IRS’s proposed limitation was “an artificial barrier to capital investment” that resulted in an additional tax on the manufacturing sector.
Combined with lobbying power from the energy sector, the dissenters won. The IRS removed this exception under the final regulations, allowing all depreciation costs to be considered in the ATI calculation, even if those costs were capitalized under Section 263A.
Good News During Tough Times
The final regulations can help manufacturers and others breathe a little easier, but businesses in all industries have something to celebrate. When President Trump signed the Coronavirus Aid, Relief, and Economic Security (CARES) Act in March, the business interest expense limitation was altered in two beneficial ways. First, the CARES Act increased the ATI limitation from 30% to 50% for tax years 2019 and 2020. Second, taxpayers were permitted to use their 2019 ATI figures to calculate their 2020 business interest expense limitations. This ensures that COVID-19-related revenue losses will have little impact on a business’s ability to deduct its business interest expense.
Still More Changes on the Horizon
When the IRS finalized the business interest expense regulations, it also released a new set of proposed regulations, a notice, and an FAQ document. In these texts, the IRS addresses the following issues:
- How to allocate excess business interest expense to owners of pass-through entities
- How to apply the limitation to U.S. shareholders of controlled foreign corporations and to foreign taxpayers with effectively connected income
- How to calculate the limitation in tiered partnership structures
- How to elect to use 2019 ATI numbers to calculate 2020 limitations
- How businesses that manage qualified residential living facilities can elect the real property trade or business exception
- How the aggregation rules apply for the gross receipts test
The IRS is currently taking comments on the proposed rules and will draft another set of final regulations after the 60-day public hearing is over.
Although the TCJA’s initial limitation on business interest expense was met with frustration in 2017, manufacturers and other businesses in traditionally debt-backed industries are happy to see some movement toward compromise.
If you have further questions about the final and proposed rule changes, contact us.
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