Companies with large amounts of tax depreciation could be impacted greatly.
Background and Basics of the Business Interest Deduction Limitation
As part of the new tax law (Tax Cuts and Jobs Act), there is a new interest limitation for businesses with gross receipts greater than $25 million (*see more details of this limitation below). This was effective for tax years starting after December 31, 2017. A company’s interest expense can be limited if the amount exceeds the sum of 30% of the taxpayer’s adjusted taxable income (ATI) for the taxable year. The level of deductibility for interest expense is determined by calculating 30% of ATI. This applies to net business interest expense, which is the excess of business interest expense over business interest income.
The deduction is not lost though; any amount that exceeds 30% of a business’s ATI for the taxable year will be carried forward to the next year for S – corporations. The excess will be added to the next year’s business interest expense and used in the calculation for ATI and the new limitation. However, for partnerships, the excess interest expense will be allocated to each partner in the same way that the partnership’s non-separately stated taxable income or loss would be. So the interest expense that is limited will not be carried forward at the business level; it will be used on the partner level in succeeding years.
Another part of the limitation is that the net business interest expense cannot exceed the taxpayer’s floor plan financing interest. This indebtedness refers to debt that is used to finance the acquisition of motor vehicles held for sale or leased and is secured by that acquired property. Any excess taxable income is allocated to shareholders and partners and is handled on the individual level.
There is an exemption for small businesses whose average annual gross receipts do not exceed $25 million for the prior three taxable years. Companies will have to take into account related parties for the purpose of determining this threshold. Any company that has gross receipts under $25 million for the prior three taxable years on average, will not be limited in their business interest expense and do not need to do the limitation calculation.
How is “Adjusted Taxable Income” calculated?
The calculation for adjusted taxable income (ATI) can change depending on the taxable year. For years beginning after December 31, 2017 and before January 1, 2022, ATI is figured without regards to any deductions allowable for deprecation, amortization, depletion or business interest expense. It is very similar to EBITDA. All of these expenses are added back to the business taxable income. An example would be: taxable income $300,000 + $100,000 depreciation + $50,000 amortization + $200,000 interest expense = $650,000 adjusted taxable income. This means that up to $650,000 worth of interest expense would be allowed as an expense in that current year.
Change in Calculation of “Adjusted Taxable Income” after 12/31/2021
For taxable years beginning after December 31, 2021, ATI will include the deductions for depreciation, amortization, and depletion, but not interest expense. This is similar to EBIT. Only the business interest expense will be added back to the business taxable income. Going with the same example as before the new calculation would be taxable income $300,000 + $200,000 interest expense = $500,000 adjusted taxable income. The difference in adjusted taxable income comes from the $100,000 depreciation and $50,000 amortization that is not added back. This means that only $500,000 worth of interest expense would be allowed in this year as opposed to the $650,000 from above, a reduction of $150,000.
The impact of this change will be seen by many businesses that purchase large amounts of fixed assets each year. Planning for this and considering the implications early is very important for companies that purchase large amounts of equipment each year. See the expanded examples below to understand this change in the calculation.
Now vs. Tax years beginning after 12/31/2021
These calculations are based on S corporations and the ability to carryover excess interest expense the following years. The difference for partnerships would be that the excess interest expense would be allocated to each partner and used at the individual level in succeeding years.
As the example calculation shows, when the depreciation add back is no longer allowed starting with taxable years beginning after December 31, 2021 the interest expense deduction will be much more limited; this will result in larger carryovers for business interest expense. The more significant the current year depreciation is in comparison to taxable income, the more limited interest expense will be. Meaning, the companies that significantly reduce their taxable income by way of accelerated depreciation methods for tax, will be more impacted by the limitation of interest expense calculation for years beginning after December 31, 2021.