The Interest Deduction Under Tax Reform

One of the changes in the Tax Cuts and Jobs Act of 2017 is the interest expenses deduction limitation for businesses effective tax year 2018. Generally, interest expense related to business debt has been deductible. The tax law change impacts, primarily, those taxpayers whose average gross receipts are greater than $25,000,000 for the proceeding three tax years. This gross receipt figure is assessed every year on a rolling three-year basis. 

If a business meets the above criteria, for most this means that net business interest expense (interest expenses less interest income) in excess of 30% of the taxpayer’s adjusted taxable income will not be deductible. Adjusted taxable income will be defined for the next five years as earnings before interest, taxes and depreciation/amortization (EBITDA). After that, adjusted taxable income will be defined as earnings before interest and taxes (EBIT).

For businesses taxed as an S corporations or a partnership, this limit is applied at the entity level rather than at the owner level.    Any amounts that are disallowed can be carried forward indefinitely. In succeeding years, the amounts carrying forward will be treated as additional interest expense.

Note: This limitation only applies to business interest expense. Investment interest expense is still subject to its own limitation on investment interest expenses.

The IRS is allowing an election, to opt out of the new limitation of interest expense, that is irrevocable if you are in a farming trade or business or if you own real property. If opting for this election, the property must be depreciated on what is called the alternative depreciation system (“ADS”). The ADS method of depreciation is not eligible for bonus depreciation. The IRS is still in process of clarifying how the timing of this election will be handled.

You should start planning for this as soon as possible so you are not surprised with a tax liability for 2018. As always, it is best to consult your tax advisor.