Before passage of the Tax Cuts and Jobs Act, payments of business interest expense to a lender were fully deductible. Effective for tax years beginning after December 31, 2017, businesses will have limited ability to deduct its interest expense unless they can meet special criteria that would allow them to avoid the limitation. In this article, we will summarize how businesses may elect out of this limitation and what implications the new limitations bring to the construction industry.
Who is exempt?
Taxpayers that meet specific criteria may still qualify to deduct business interest expense fully. Below are five taxpayer categories that are automatically exempt from the 30% business interest limitation.
- Any business with average annual gross receipts for the prior three tax years that do not exceed $25 million
- An employee
- The business of furnishing or selling certain types of energy
- An electing farming business
- An electing real property trade or business
If a business can identify as a real property trade or business, they can elect to avoid the business interest limitation. A real property trade or business is described in Section 469(c)(7) and includes real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
How is the limitation calculated?
The limitation is calculated at the entity level and based on the sum of
- the business interest income for the taxpayer for that taxable year and
- 30 percent of the adjusted taxable income of the taxpayer.
What does this mean for construction firms?
Construction firms should think about applicable limitations, such as business interest expenses exceeding 30 percent of the adjusted taxable income. Remember, adjusted taxable income is computed without regard to:
- Income, gain, deduction or loss not allocated to a trade or business
- Any business interest expense or business interest income
- 20 percent pass-through deduction, Section 199A, enacted with tax reform
- Any net operating loss deduction
- Tax years before Jan. 1, 2022, deductions for depreciation, amortization or depletion
When a limitation is applicable, the disallowed business interest is treated as business interest paid or accrued in the subsequent taxable year. Applicable carryforward rules will depend on your filing status with the IRS.
S corporations and C corporations are expected to treat disallowed interest as business interest paid or accrued in the following year.
Partnerships are a little more complicated and won’t treat the disallowed business interest as a business interest paid or accrued. Instead, the entire business interest will reduce the basis for each partner. While this will reduce the basis in his or her interest in the partnership, the full deduction won’t pass through to their corresponding tax return due to limitations.
It will be imperative for taxpayers to determine if they are subject to the interest limitation. Proactive planning can lessen the impact this new provision will have on your bottom line. Call us today to evaluate your options.