Subject to certain exceptions1, historically under the Internal Revenue Code of 1986, as amended (the “Code”), there has generally been no limit on the deduction of business interest. However, the newly enacted Tax Cuts and Jobs Act (the “Act”), has fundamentally changed the business interest deduction. For a private equity fund and other taxpayers preparing financial models, it is important to consider the new limits on the deduction of business interest under the newly enacted Section 163(j) of the Code and other changes under the Act to accurately forecast the anticipated cash flow and the impact of the Act on a business or in connection with any potential acquisition. Starting in 2018, the new rules governing business interest under the Act have full and immediate effect, and do not grandfather any pre-existing debt.
Under new Section 163(j) of the Code, the business interest deduction is now generally limited to 30% of the taxpayer’s “adjusted taxable income”. A taxpayer’s “adjusted taxable income” is equal to a taxpayer’s taxable income as determined without taking into account:
i. any item of income, gain, deduction or loss which is not allocable to a trade or business;
ii. any business interest income or expense;
iii. any net operating losses;
iv. any deduction under the newly enacted “qualified business income deduction” under Section 199A of the Code; and
v. solely for tax years beginning before January 1, 2022, any deduction allowable for depreciation, amortization, or depletion.
Although taxable income is technically the starting point for determining a taxpayer’s “adjusted taxable income”, as a rough rule of thumb, for most taxpayer’s the “adjusted taxable income” will approximate the “EBITDA” of the business for the tax years between 2018 through 2021, and the “EBIT” of the business for any taxable period thereafter.
In applying new Section 163(j), there are a few items / exceptions to note. First, Section 163(j) applies to the taxpayer’s net interest expense and will only potentially apply to limit interest if a taxpayer’s business interest expense exceeds the taxpayer’s business interest income. Second, the interest expense limitation deduction will not apply to taxpayers with average gross receipts of $25 million or less during the preceding three (3) year period.2 In addition, the new rules will also not apply to certain regulated utilities, nor with respect to certain real property and farming businesses that elect out of the new rules.3 The new rules also create an exception in relation to interest incurred on floor plan financings, which will remain fully deductible.
Mechanically, in applying the above, the maximum allowable business interest expense deduction of a taxpayer for a taxable year cannot exceed the sum of:
A. the taxpayer’s business interest income; plus
B. 30% of the taxpayer’s adjusted taxable income; plus
C. the taxpayer’s floor plan financing interest (if any).
For example, if a taxpayer has $20 of business interest income, $60 of business interest expense, $100 of adjusted taxable income, and $0 of floor plan interest; then the maximum business interest expense deduction is equal to $50 (i.e. $20 of business interest income + $30 (30% X $100 of adjusted taxable income) + $0 floor plan interest). Under this example, $10 of the $60 of business interest expense would be disallowed.
However, under new Section 163(j), any disallowed business interest is treated as business interest paid in the succeeding taxable year (i.e. the taxpayer can carryforward the disallowed interest deduction until the taxpayer is permitted to deduct it). As a result, the $10 of disallowed interest from the example may still be deducted in a future tax year.
New Section 163(j) is generally applied at the entity level. However, with respect to a partnership, if interest is not deductible at the partnership level, the carryforward of any disallowed interest is done at partner level and a partner may only use the interest expense carryforward as an offset against the partner’s future share of the partnership’s unused excess taxable income limitation.
If a taxpayer determines that new Section 163(j) may limit a taxpayer’s future deduction of interest, one potential alternative structure may be to issue preferred equity in lieu of all or some portion of the debt. Although preferred equity is an imperfect solution and will not allow for an interest deduction, a holder of preferred equity generally would not be required to recognize interest / dividend income as the preference accrues on the preferred equity.
The Tax Cuts and Jobs Act fundamentally changed the tax rules applicable to the taxation of businesses in the U.S. Although the new 21% corporate tax rate is a welcome revision, the new Tax Cuts and Jobs Act contains numerous substantive differences relating to the manner in which tax is determined, including the new Section 163(j) limiting the deduction of business interest. In planning their business affairs and in modelling the activities of portfolio companies, private equity funds and other taxpayers would be wise to account for these changes.