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

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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

Episode Transcript

Speaker 1 (00:01):
Welcome to the Knowing what Counts podcast, the
place where expert guidancemeets smart financial decisions.
Whether you're a high net worthindividual or a thriving
business, the experts at MPCPAsare here to help you protect and
optimize your wealth.
Let's get started, becausesuccess begins with Knowing what

(00:22):
Counts.

Speaker 2 (00:23):
Because success begins with knowing what counts
Interest expenses can be apowerful tax tool, but IRC 163
limitations add complexity.
Today, we dissect what theserules mean and how businesses
can navigate them for smarterfinancial strategies.
Welcome back everyone.

(00:43):
I'm Sofia Yvette, co-host andproducer, 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 intotoday's topic deeper, can you
introduce yourself?

Speaker 3 (01:03):
Sure, my name is Estefania Cabrera.
I go by Steph.
I'm a senior associate here atMPCPAs.
I've been with the firm forabout five years now and I work
on a wide range of tax returnsfrom individuals, businesses,
trusts and estate returns.

Speaker 2 (01:20):
Wow, now getting into this a little more, what is
Internal Revenue Code, section163J, and why was it introduced?

Speaker 3 (01:39):
So Section 163J in essence just limitsowned
companies that used their US taxsubsidiaries to essentially
take out these large loans forthe purpose of being able to
deduct their business interestexpense, thereby lowering their
US tax bill.
And in 2017, though, the ruleswere expanded under the Tax Cuts

(02:02):
and Jobs Act, the TCJA Act, toapply to most US businesses, not
just those with foreign ties,and the goal was ultimately to
one cover some of the expensesassociated with the TCJA Act by
limiting how much businessinterest expense these
businesses could deduct, and italso worked to encourage these
businesses to focus more onequity financing versus debt

(02:26):
financing, so issuing stockversus taking out more loans.

Speaker 2 (02:31):
Now, how is your interest expense limited?

Speaker 3 (02:36):
So it can be limited overall.
The main driver is youradjusted taxable income.
It's limited at 30% of youradjusted taxable income and you
can take up to 100% of yourbusiness interest income and in
certain cases mostly with cardealerships you can also take up

(02:56):
to the floor plan financinginterest.
But again, that's mostly seenwith dealerships car dealerships
.

Speaker 2 (03:04):
Understood.
Now is everyone subject to the163J limitation.

Speaker 3 (03:09):
Luckily, not everyone .
Like I mentioned earlier, it'smostly focused on reducing how
much business interest expense.
Larger businesses can deductAny 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

(03:32):
million or less, and any farmingreal estate business can also
opt out of being limited.
But the counter to that is thatthey then have to be subject to
the alternative depreciationsystem, which just means they
have to depreciate slower andyeah, so mostly targeted at the
larger businesses, notnecessarily the smaller ones.

Speaker 2 (03:47):
Now, how does 163J affect different types of
taxpayers, such as partnerships,corporations and individuals
Corporations?

Speaker 3 (03:58):
these rules.
Overall, the rules apply aboutthe same in terms of the
limitations.
So everyone is still subject tothat gross receipts rule of 31
million or less.
But corporations these rulesapply directly to the
corporation.
So the interest is limited atthe corporation level and any
limited interest is carriedforward again at the corporation

(04:18):
level and in the future if anyinterest income presents itself,
it can be deducted to thatcarried over amount.
For partnerships, however, it'sa little bit different.
The limit is applied at thepartnership level but the excess
interest is then passed on tothe partners as excess business
interest expense.
They'll see this often in thoseK-1s they receive and they can

(04:40):
only deduct that in the futurewhen that same partnership earns
enough income.
That then gets passed down tothem.
A little different there.
As for individuals.
Individuals when we refer tothem we mean more like sole
proprietorship, so people withlike a Schedule C or sometimes
maybe a landlord not as common,as it's kind of difficult to
reach that 31 million limit fora sole proprietorship.

(05:01):
But if they do, the rules applysimilarly to the partnership in
that it's limited at theirlevel and it's up to them to
track those limits so that theycan take them in the future if
any interest income frees up.

Speaker 2 (05:13):
Now, how do non-cash items, such as depreciation or
amortization, impact thecalculation for the 163J?

Speaker 3 (05:23):
So depreciation and amortization is this wonderful
deduction that most businessescan take, where they can deduct
a portion of the price of theirfixed assets or amortizable
assets.
So that's a great deduction onbase.
Unfortunately, when related tothe 163, it can be
counterintuitive, because before2022, businesses could add back

(05:46):
all those depreciationdeductions so that their ATI,
adjusted taxable income, wouldbe higher, so that 30% would be
much higher, so they could takemore of those business interest
expense.
Unfortunately, after 2022, thatrule has been removed, so now
you can no longer add thosedeductions back to your ATI,
which means if you take moredepreciation and amortization,

(06:08):
you are in essence lowering howmuch of your business interest
expense you can deduct.

Speaker 2 (06:12):
Wow, now what happens to the interest expense?

Speaker 3 (06:16):
that is limited, so, as I mentioned earlier, the main
difference when it comes tocorporations, individuals and
partnerships is how thoselimitations are treated after
they've been limited.
So for corporations, like Imentioned, they are in charge of
tracking these limitations.
It kind of just carries overuntil the corporation is able to
generate business interestincome to take those additional

(06:40):
deductions.
But for partnerships, since itgets passed on to the partners,
it it becomes theirresponsibility to track them.
So they have to track thoseexcess business interest
expenses on their end and, likeI mentioned earlier, it's up to
them to then, when incomebecomes available from that
partnership, to be able todeduct it.

(07:02):
So it doesn't ever go away.
It just kind of is differentwho is in charge of tracking it
and how you manage it.

Speaker 2 (07:10):
Understood.
Now what are some commonpitfalls or misconceptions about
163J compliance?

Speaker 3 (07:18):
So some of the things we see commonly is certain
people assuming that it does notapply to them.
Maybe certain businesses thathave fluctuating income might
have a good year one year and alower year the next one.
They often don't realize thatit is an average your gross
receipts of the average grossreceipts for the last three
years.
So some businesses don't lookback those three years to make

(07:40):
sure to see if they qualify ornot.
Another one we see is thatcertain partners with
investments in thesepartnerships aren't tracking
their excess interest.
They may lose track of it andthey miss out on really great
deductions down the line whenbusiness interest income
presents itself and certainfarming businesses or real
estate businesses don't knowthat they can opt out of it or

(08:02):
the trade-off to opting out ofit.
So sometimes they lose out onsome great deductions like that.
Or certain businesses, like Imentioned earlier, subsidiaries
or other companies who should becombining their overall gross
receipts don't know that theyneed to and oftentimes they are
subject to this limitation andthey just don't keep track of it
or file the proper forms tokeep up to date with that.

Speaker 2 (08:25):
Understood.
Now what planning strategiesshould businesses consider when
facing 163J limitations?

Speaker 3 (08:34):
Well, up to this point I've mentioned, I think,
depreciation a little bitearlier.
One of the things that we'vediscussed with some of our
clients has been possiblyslowing down depreciation.
Of course, you're not going tobe taking as much depreciation
on one end, but it could free upquite a bit more of business
interest expense.
Another option we've lookedinto has been capitalizing your
interest, which essentiallymeans just reclassing your

(08:57):
interest expense into possiblybeing part of inventory or
equipment and it getscapitalized on that end.
Or again, like I mentionedearlier, just making sure to see
if, depending on the businesstype, if they qualify to elect
out of this business interestlimitation.

Speaker 2 (09:15):
Now, is there any final advice you want to give
people who may be dealing with163 limitations?

Speaker 3 (09:22):
Yes, I think the biggest advice I could provide
is to keep up to date with therules surrounding this
limitation.
It can be kind of tricky andthe limit of what qualifies as a
small business changes everyyear due to inflation
adjustments, so it's always agood idea to just look it up,
look up the limitation, makesure you're still well with

(09:43):
under that limitation and, morethan anything, keep in contact
with your tax advisor, your CPA,to make sure that you're
planning accordingly.
Oftentimes we see people gothroughout the year thinking
that they're going to be able toget this very large business
interest expense deduction andthen it comes March or April and
we realize that it's beenlimited by that 30% and we

(10:04):
definitely don't want to come tothat end, when nothing can be
done, to realizing that thededuction is much smaller than
we originally planned done torealizing that the deduction is
much smaller than we originallyplanned.

Speaker 2 (10:18):
Oh yeah, most definitely.
Well, estefania, I reallyappreciate you being here today
with me and for sharing thosehelpful insights with our
listeners.
We may catch you in your nextepisode.
Have a fantastic rest of yourday.
Thank you so much.

Speaker 1 (10:28):
Thanks for listening to the Knowing what Counts
podcast.
Ready to optimize your wealthand protect your future, visit
TheMPGroupCPAcom or call413-739-1800 to connect with our
team of experts.
Remember, success is aboutknowing what counts.