James ORilley of Doeren Mayhew

By Jim O’Rilley, CPA, MST – Shareholder, Doeren Mayhew

Although the Tax Cuts and Jobs Act of 2017 brings a favorable lower tax rate to corporations, the Act also includes some new unfavorable rules affecting them as well. One of these is the broad limitation on the deductibility of business interest expense. Limiting the ability for many businesses to deduct interest expense paid or accrued, the new rule does not allow interest deductions to the extent net interest expense exceeds an adjusted earnings-based threshold. But, this new rule doesn’t just apply to corporations, it applies to all business types, so everyone should take note of the changes.

The New Limits

Starting in tax year 2018, businesses will generally not be able to deduct business interest expenses, which is considered any interest paid or accrued on indebtedness properly allocable to a trade or business, exceeding the sum of the following:

  • Business interest income
  • 30 percent of the adjusted taxable income of the business
  • The floor-plan financing interest of the business

For S corporations, partnerships and limited liability corporations that are treated as partnerships for tax purposes, this limit is applied at the entity level rather than at the owner level.

Figuring Out What Your Business Interest Limitation Amount Is

Wondering how to determine what your business’s magic number is when it comes to how much business interest you can deduct this year? To compute that number, you must adjust your business’s taxable income by excluding the following:

  • Any item of income, gain, deduction or loss which is not properly allocable to the trade or business
  • Business interest income and expense
  • Any net operating loss deduction
  • New “qualified business income deduction” (i.e., the 20 percent income reduction for certain pass-through entities)
  • The amount of depreciation, amortization or depletion for tax years beginning before Jan. 1, 2022

For tax years beginning in 2018 through 2021, the computation of adjusted taxable income should approximately reflect a business’s earnings before interest, taxes, depreciation and amortization (EBITDA).  For tax years beginning after 2021, the adjusted taxable income would then be the approximate earnings before interest and taxes (EBIT). As a result, in general adjusted taxable income should decrease, ultimately reducing the maximum amount of deductible business interest expense.

However, businesses will be able to carry forward any unused business interest expense indefinitely. The carry forward amount will be treated as additional interest expense in the succeeding taxable year.

Exceptions to the Rule

The new business interest expense limitation will not apply to businesses with average annual gross receipts of $25 million dollars or less. To find out if this exception applies to your business, you will need to average the three preceding taxable years’ gross receipts.

Some other taxpayers might also find themselves exempt from the new interest deduction limitation related to:

  • A trade or business performing services as an employee
  • Electing real property trade or business, such as real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business
  • An electing farm business
  • Electrical energy, water or sewer disposal service
  • Gas or steam through a local distribution system
  • Transportation of gas or steam by pipeline

The Impact to My Business

Even with a lowered tax rate, applying the new limitations on interest deductions may result in unfavorable tax liabilities for your business. With new lower limitations tying the amount of deductible business interest to your adjusted taxable income, an unsuccessful revenue year could mean more tax liability by reducing the amount of interest your business can deduct that year. It is likely the new limitations will also negatively impact corporations and investors of flow-through businesses that finance acquisitions with debt.

To discuss your business’s individual facts and the inner workings of this limitation as it applies to your specific situation, please contact a Doeren Mayhew tax advisor.

Want to reach the author? Email Jim O’Rilley or contact him at 248.244.3171.