Decoding Interest: A Comprehensive Guide to the Business Interest Expense Limitation

Navigating the complexities of tax regulations can be daunting, especially when it comes to understanding deductions and limitations. For businesses, one critical area is the deduction of interest expenses. The Tax Cuts and Jobs Act (TCJA) of 2017 brought significant changes to Section 163(j) of the Internal Revenue Code, which governs the limitation on the deduction for business interest expense. Further amendments were introduced by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) in March 2020. This guide aims to clarify the intricacies of the Section 163(j) limitation, focusing on what constitutes “interest” in this context and how these regulations impact businesses.

This comprehensive guide addresses frequently asked questions about the Section 163(j) limitation, incorporating updates from the TCJA and the CARES Act, and provides insights from the final regulations issued by the Treasury Department and the IRS in September 2020 and January 2021.

Understanding the Basics of Business Interest Expense Limitation

What is the Section 163(j) Limitation on Business Interest Expense?

Generally, businesses can deduct interest expenses incurred during a taxable year. However, the Section 163(j) limitation restricts the amount of business interest expense that can be deducted annually. This limitation ensures that businesses cannot excessively reduce their taxable income through interest deductions.

The deductible business interest expense in a taxable year is capped at the sum of:

1. Business Interest Income: The interest income generated by the taxpayer’s business during the taxable year.
2. 30% of Adjusted Taxable Income (ATI): A percentage of the taxpayer’s ATI for the taxable year. Notably, under the CARES Act, this percentage was temporarily increased to 50% for taxable years beginning in 2019 and 2020.
3. Floor Plan Financing Interest Expense: Interest expense specifically related to financing the acquisition of motor vehicles held for sale or lease.

It’s important to note that the CARES Act introduced temporary modifications, including the potential application of a 50% of ATI limit for 2019 and 2020, and provided elections regarding ATI calculations. Revenue Procedure 2020-22 offers detailed guidance on ATI elections and specific rules for partnerships affected by these changes.

Who is Subject to the Section 163(j) Limitation?

For taxable years commencing after December 31, 2017, the Section 163(j) limitation broadly applies to all taxpayers with business interest expense. This wide net includes various business structures and sizes.

However, there are key exceptions:

• Exempt Small Businesses: Businesses meeting the gross receipts test outlined in Section 448(c) are exempt. This provision is designed to relieve smaller businesses from the complexities of this limitation.
• Certain Electing Trades or Businesses: Specific businesses can elect to be exempt from the limitation, although this election comes with certain trade-offs.
• Certain Excepted Trades or Businesses: Certain categories of businesses are specifically excluded from the limitation, recognizing their unique operational characteristics.

Understanding whether your business falls under these exceptions is crucial in determining your applicability to the Section 163(j) limitation.

Decoding the Gross Receipts Test for Section 163(j) Exemption

The gross receipts test, defined under Section 448(c), is a critical criterion for determining if a small business is exempt from the Section 163(j) limitation.

A business generally meets this test if it satisfies two conditions:

1. Not a Tax Shelter: The business must not be classified as a tax shelter as defined in Section 448(d)(3).
2. Average Annual Gross Receipts Threshold: The business must have average annual gross receipts of $25 million or less for the three preceding tax years.

This $25 million threshold is adjusted annually for inflation to maintain its real value over time.

Here’s how the inflation-adjusted amounts have evolved:

• 2019-2021: $26 million
• 2022: $27 million

This inflation adjustment ensures that the small business exemption remains relevant despite economic changes. Businesses need to monitor their average annual gross receipts against these thresholds to determine their exemption status each year.

Example: Navigating Gross Receipts and the Section 163(j) Limitation

Consider a business whose average annual gross receipts for 2018-2020 exceeded $26 million, making it subject to the Section 163(j) limitation in 2021. However, in 2021, a significant decrease in gross receipts lowered the average for 2019-2021 to below $27 million.

Will this business be subject to the Section 163(j) limitation for the 2022 taxable year?

No. Despite being subject to the limitation in 2021, the business becomes exempt for the 2022 taxable year because it now meets the gross receipts test. Any business interest expense disallowed in 2021 due to the limitation is carried forward to 2022. Crucially, this carryforward is no longer subject to the Section 163(j) limitation in 2022 due to the changed exemption status. Thus, the business does not need to calculate the Section 163(j) limitation for 2022.

This example highlights the dynamic nature of the gross receipts test and its year-by-year application. It’s essential to reassess eligibility annually based on the rolling three-year average of gross receipts.

Excepted Trades or Businesses: Carving Out Exemptions

Certain trades or businesses are designated as “excepted,” meaning they are specifically carved out from the Section 163(j) limitation. These exceptions recognize the unique nature of these sectors and aim to prevent unintended economic impacts.

Which Businesses Qualify as “Excepted”?

The categories of excepted trades or businesses are explicitly defined in the tax code:

1. Services as an Employee: The trade or business of providing services as an employee is excepted. This ensures that wage earners are not affected by business interest limitations related to their employment.
2. Certain Real Property Trades or Businesses (Electing): Eligible real property businesses can elect to be excepted. This election is particularly relevant for those in the real estate sector, but it comes with specific depreciation implications.
3. Certain Farming Businesses (Electing): Similar to real property, qualifying farming businesses can elect to be excepted. This acknowledges the unique capital and cyclical nature of the farming industry.
4. Certain Regulated Utility Trades or Businesses: Businesses operating as regulated utilities are also excepted. This exception recognizes the essential services they provide and their regulated financial structures.

How to Elect for “Excepted” Status: Real Property and Farming Businesses

Eligible real property and farming businesses can proactively elect to be treated as “excepted trades or businesses.” This election is not automatic and requires specific procedural steps.

The election process involves:

• Following Procedures in Treas. Reg. §1.163(j)-9: This regulation outlines the detailed requirements for making the election.
• Attaching a Statement to the Tax Return: A formal statement must be attached to a timely filed federal income tax return (including extensions) for the election year.
• Referencing Relevant Revenue Procedures: Revenue Procedures such as 2018-59, 2020-22, and 2021-9 provide additional guidance and updates on the election process.

Key points about this election:

• Protective Election for Small Businesses: Even exempt small businesses can make this election, especially if there’s uncertainty about meeting the gross receipts test. This is a protective measure to avoid potential penalties if they are later deemed subject to the limitation.
• Irrevocable Nature: Once made, the election is generally irrevocable and binds the trade or business for all subsequent years, although there are limited circumstances for termination as detailed in Treas. Reg. §1.163(j)-9.

Required Information in the Election Statement:

1. Taxpayer Identification: Name, address, and Social Security Number (SSN) or Employer Identification Number (EIN).
2. Business Description: A detailed description of the electing trade or business, including the principal business activity code.
3. Election Statement: A clear statement indicating the election as either a real property trade or business (under section 163(j)(7)(B)) or a farming business (under section 163(j)(7)(C)).

Consequences of Electing “Excepted” Trade or Business Status

Electing to be an “excepted real property trade or business” or an “electing farming business” has significant depreciation consequences. These businesses must use the Alternative Depreciation System (ADS) for certain assets, and these assets become ineligible for bonus depreciation under Section 168(k).

Specific Depreciation Implications:

• Excepted Real Property Trade or Business:
  • Nonresidential Real Property: Must be depreciated using ADS.
  • Residential Rental Property: Must be depreciated using ADS.
  • Qualified Improvement Property: Must be depreciated using ADS.
• Electing Farming Business:
  • Property with a 10-year or Longer Recovery Period: Must be depreciated using ADS.
  • Ineligibility for Bonus Depreciation: Such property is not eligible for bonus depreciation under Section 168(k).

These depreciation adjustments can impact a business’s overall tax strategy. Businesses must carefully weigh the benefits of being excepted from the interest limitation against the less favorable depreciation rules. Revenue Procedures 2019-08, 2020-22, 2020-25, and 2021-9 provide further details on these implications.

Determining the Section 163(j) Limitation: Key Components

Calculating the Section 163(j) limitation involves understanding several key components, starting with the definition of “interest” itself.

Defining “Interest” for Section 163(j) Purposes

The definition of “interest” under Section 163(j) is broad and crucial for accurately applying the limitation. Treas. Reg. §1.163(j)-1(b)(22) provides the governing definition for both interest expense and interest income in this context.

General Definition:

Generally, “interest” encompasses any amount paid, received, or accrued as compensation for the use or forbearance of money. This must arise from:

• Debt Instruments: Instruments or contractual arrangements, including series of transactions, treated as debt instruments under Section 1275(a) and Treas. Reg. §1.1275-1(d).
• Other Code Provisions: Amounts treated as interest under other provisions of the Internal Revenue Code or its regulations.

Expansive Scope and Special Rules:

Treas. Reg. §1.163(j)-1(b)(22) expands on this definition, including:

• Anti-Avoidance Rules: Provisions designed to prevent taxpayers from structuring transactions to circumvent the interest definition.
• Specifically Included Amounts: A list of other amounts explicitly treated as interest, such as:
  • Certain amounts of bond premium.
  • Factoring income.
  • Certain dividends from regulated investment companies (RICs).

This comprehensive definition ensures that various forms of financing costs and returns are appropriately considered “interest” for the purposes of the Section 163(j) limitation, preventing narrow interpretations that could undermine the rule’s intent.

Business Interest Expense: What Counts?

Business interest expense is a core element in the Section 163(j) calculation. It’s defined as interest expense that is properly allocable to a trade or business that is not an excepted trade or business. Floor plan financing interest expense is also categorized as business interest expense.

Key Components:

• Allocable to a Non-Excepted Trade or Business: The interest expense must directly relate to the operations of a trade or business that does not fall under the “excepted” categories (employee services, electing real property/farming, regulated utilities).
• Floor Plan Financing Interest: Interest paid on debt used to finance the acquisition of motor vehicles for sale or lease, secured by that inventory, is always considered business interest expense, regardless of whether the underlying business is excepted.

To accurately determine business interest expense, businesses must properly allocate interest expenses to their various trades or businesses, distinguishing between excepted and non-excepted activities.

Business Interest Income: Offsetting Expenses

Business interest income plays a crucial role in mitigating the impact of the Section 163(j) limitation. It is defined as interest income that is includable in gross income and properly allocable to a trade or business that is not an excepted trade or business.

Key Characteristics:

• Includable in Gross Income: The interest income must be recognized as part of the business’s taxable gross income.
• Allocable to a Non-Excepted Trade or Business: Similar to business interest expense, the income must be derived from a non-excepted trade or business.

Businesses with both interest expenses and interest income from their non-excepted trades or businesses can net these amounts, potentially reducing the amount of interest expense subject to the limitation. Proper allocation is essential when a business engages in both excepted and non-excepted activities.

Calculating Adjusted Taxable Income (ATI) for the Limitation

Adjusted Taxable Income (ATI) is a cornerstone of the Section 163(j) limitation calculation. It’s a modified version of taxable income, designed to reflect a business’s economic income more accurately for the purpose of this limitation.

ATI Calculation Process:

Starting Point: Begin with taxable income for the taxable year, calculated as if the Section 163(j) limitation did not exist.

Adjustments (Additions):

Several items are added back to taxable income to arrive at ATI:

• Business Interest Expense: This is added back because the limitation itself is on business interest expense, so it needs to be added back to measure income before this deduction.
• Net Operating Loss (NOL) Deduction: NOL deductions are added back to reflect income before considering prior year losses.
• Qualified Business Income (QBI) Deduction (Section 199A): The deduction for QBI is added back to reflect income before this deduction.
• Depreciation, Amortization, or Depletion (for tax years before 2022): For taxable years beginning before 2022, these deductions are added back. Crucially, for tax years beginning after January 1, 2022, these are NOT added back. This change significantly impacts ATI calculations in later years.
• Capital Loss Carrybacks or Carryovers: These are added back to reflect income before these capital loss adjustments.
• Deductions/Losses Not Allocable to Non-Excepted Trades or Businesses: Any deductions or losses not properly attributed to a non-excepted trade or business are added back, ensuring ATI focuses on the relevant business activities.

Adjustments (Subtractions):

Certain items are subtracted from taxable income:

• Business Interest Income: This is subtracted, consistent with the idea of netting interest income and expense.
• Floor Plan Financing Interest Expense: Subtracted to align with its treatment in the overall limitation formula.
• Depreciation, Amortization, or Depletion on Disposed Property (for tax years before 2022): For property sold or disposed of in taxable years starting on or after January 1, 2022, subtract the greater of allowed or allowable depreciation, amortization, or depletion for taxable years beginning before 2022. This adjustment relates to the add-back of these deductions in prior years.
• Income/Gain Not Allocable to Non-Excepted Trades or Businesses: Income or gain not properly allocable to a non-excepted trade or business is subtracted, maintaining focus on the relevant business segment.

Post-2022 Simplification:

For taxable years after January 1, 2022, a significant simplification occurs: deductions for depreciation, amortization, or depletion are no longer added back when calculating ATI. This reduces complexity and generally increases ATI, potentially allowing for greater interest expense deductions.

Specific Taxpayer Adjustments:

Certain types of taxpayers may have other specific ATI adjustments. Treas. Reg. §1.163(j)-1(b)(1) provides details on these specific cases.

CARES Act Election: Substituting 2019 ATI for 2020

The CARES Act introduced a provision allowing taxpayers to elect to substitute their Adjusted Taxable Income (ATI) from the last taxable year beginning in 2019 for their 2020 ATI. This was a temporary relief measure aimed at businesses whose income was negatively impacted by the economic downturn in 2020.

How the Election Works:

• Purpose: To provide a more favorable ATI figure for calculating the Section 163(j) limitation in 2020, especially for businesses with reduced income in 2020 compared to 2019.
• Applicable Year: This election specifically applies to any taxable year beginning in 2020.
• Short Taxable Years: Modifications apply for short taxable years to ensure fair application of the substitution.

Making the Election:

• Form 8990: Taxpayers making this election should complete line 22 (adjusted taxable income) on Form 8990, leaving lines 6 through 21 blank.
• No Formal Statement Required: Unlike some other tax elections, no separate formal statement needs to be attached to the return. Simply completing Form 8990 as instructed is sufficient.
• Reference Revenue Procedure 2020-22: Section 6.02 of Revenue Procedure 2020-22 provides additional details and rules regarding this election under Section 163(j)(10), as amended by the CARES Act.

This election offered a valuable opportunity for businesses to potentially increase their deductible business interest expense in 2020 by using a potentially higher 2019 ATI figure.

Floor Plan Financing Interest Expense: Specific Category

Floor plan financing interest expense is a distinct category within business interest expense, specifically related to the financing of vehicle inventory.

Definition:

Floor plan financing interest expense is defined as interest paid or accrued on floor plan financing indebtedness.

Floor Plan Financing Indebtedness:

This type of debt has specific characteristics:

• Purpose: It is used to finance the acquisition of motor vehicles.
• Inventory Type: These motor vehicles must be held for sale or lease by the business.
• Security: The debt must be secured by the acquired inventory (the motor vehicles).

Example Scenario:

Consider an automobile dealership. If the dealership takes out a loan to finance its inventory of cars, and this loan is secured by the cars themselves, the interest paid on this loan is floor plan financing interest expense.

Distinction:

It’s crucial to distinguish floor plan financing interest from other types of business interest. For example, if the automobile dealership in the example above also has a loan secured by its office equipment, the interest on the office equipment loan is not floor plan financing interest expense. It would simply be categorized as general business interest expense, subject to the broader Section 163(j) rules.

Floor plan financing interest expense is treated favorably under Section 163(j) as it is included in the calculation of deductible interest expense, effectively increasing the allowable deduction.

Disallowed Business Interest Expense: Carryforward Provision

When the Section 163(j) limitation prevents a business from deducting its full business interest expense in a given year, the disallowed amount is not lost forever. Instead, it is carried forward to future taxable years.

Carryforward Mechanism:

• Disallowed Business Interest Expense Carryforward: The amount of business interest expense that cannot be deducted in the current year due to the Section 163(j) limitation becomes a “disallowed business interest expense carryforward.”
• Carryforward to Next Taxable Year: This carryforward is moved to the subsequent taxable year.

Limitation in Future Years:

The carryforward is not automatically deductible in the next year. It remains subject to the Section 163(j) limitation in the carryforward year. This means that if the limitation still applies in the subsequent year, the carryforward may again be limited.

Special Rules for Pass-Through Entities:

Specific rules apply to partnerships and S corporations regarding the carryforward of disallowed business interest expense. These rules are designed to address the flow-through nature of these entities and ensure proper application of the limitation at both the entity and owner levels.

The carryforward provision provides some relief to businesses experiencing the Section 163(j) limitation, allowing them to potentially deduct previously disallowed interest expense in future years, depending on their financial performance and the ongoing applicability of the limitation.

Businesses with Both Excepted and Non-Excepted Trades: Allocation Rules

Businesses that operate both excepted and non-excepted trades or businesses face the complexity of allocating interest expense and income between these different categories. Proper allocation is essential to correctly apply the Section 163(j) limitation only to the non-excepted business portion.

General Allocation Principle:

Interest expense and income properly allocable to an excepted trade or business are not subject to the Section 163(j) limitation. Similarly, income, gain, deduction, or loss items allocable to an excepted trade or business are excluded from the Section 163(j) limitation calculation.

Allocation Requirement:

Therefore, businesses must meticulously allocate tax items between their excepted and non-excepted trades or businesses to accurately determine the Section 163(j) limitation applicable to their non-excepted activities.

Treas. Reg. §1.163(j)-10 Guidance:

Treas. Reg. §1.163(j)-10 provides specific rules and methodologies for allocating various tax items. The primary method involves comparing the basis of assets used in excepted trades or businesses to the basis of assets used in non-excepted trades or businesses.

Asset Basis Comparison:

Generally, the allocation is based on the relative basis of assets. This means determining what proportion of assets are used in excepted versus non-excepted activities and applying this proportion to interest expense and income.

Tracing for Nonrecourse Debt (Limited Cases):

In limited circumstances, direct tracing of interest expense paid on certain nonrecourse debt may be permissible. This method is more direct but has specific conditions and is not always applicable.

Accurate allocation is crucial for businesses with mixed operations to ensure they correctly apply the Section 163(j) limitation only to the relevant portion of their business interest expense.

Section 163(j) and Pass-Through Entities: Partnerships and S Corporations

The application of the Section 163(j) limitation to partnerships and S corporations involves specific rules that account for their pass-through nature. The limitation is generally applied at the entity level for both partnerships and S corporations, but the consequences and carryover mechanisms differ.

Partnerships:

• Limitation at Partnership Level: The Section 163(j) limitation is applied directly at the partnership level. The partnership calculates its limitation based on its business interest income, 30% of its ATI, and floor plan financing interest expense.
• Deductible Interest and Non-Separately Stated Income: Business interest expense that is deductible after applying the limitation is factored into the partnership’s non-separately stated taxable income or loss.
• Excess Business Interest Expense (EBIE): Any business interest expense disallowed at the partnership level due to the limitation is termed “Excess Business Interest Expense” (EBIE).
• Partner Allocation of EBIE: EBIE is allocated to each partner in the same manner as the partnership’s non-separately stated taxable income or loss.
• Partner Carryforward of EBIE: Partners carry forward their share of EBIE.
• EBIE Deduction in Future Years: In subsequent years, a partner can treat their carried-forward EBIE as business interest expense they paid or accrued, but only to the extent they are allocated “excess taxable income” or “excess business interest income” from the same partnership.
• Excess Taxable Income and Excess Business Interest Income:
  • Excess Taxable Income: The portion of the partnership’s ATI that exceeded what was needed to deduct its business interest expense.
  • Excess Business Interest Income: The amount by which the partnership’s business interest income surpassed its business interest expense.
  • These excess amounts are also allocated to partners in the same way as non-separately stated income/loss.
  • Allocation of excess taxable income increases a partner’s ATI.
  • Allocation of excess business interest income increases a partner’s business interest income.
• Partner-Level Limitation on EBIE Deduction: Once EBIE is treated as business interest expense at the partner level, it becomes subject to the partner’s own Section 163(j) limitation, if applicable.

S Corporations:

• Limitation at S Corporation Level: Similar to partnerships, the Section 163(j) limitation is applied at the S corporation level.
• Carryover at S Corporation Level: Business interest expense disallowed at the S corporation level is not allocated to shareholders. Instead, it is carried over at the S corporation level to its succeeding taxable years.
• Shareholder Allocation of Excess Items: S corporations allocate “excess taxable income” and “excess business interest income” to their shareholders on a pro-rata basis.

Regulatory Guidance:

Treas. Reg. §1.163(j)-6 provides comprehensive rules and definitions for applying Section 163(j) to partnerships and S corporations. Treas. Reg. §1.163(j)-6(f)(2) specifically outlines the steps for allocating deductible business interest expense and excess items for partnerships.

CARES Act Relief for Partners (2020 Only):

For taxable years beginning in 2020 only, the CARES Act provided temporary relief for partners:

• 50% EBIE Rule (Default): Unless a partner elected out, they could treat 50% of their allocable share of a partnership’s EBIE from 2019 as an unlimited interest deduction in their first taxable year beginning in 2020.
• Remaining 50% EBIE Carryforward: The remaining 50% of the 2019 EBIE remained subject to the standard Section 163(j) limitation carryforward rules at the partner level.
• Revenue Procedure 2020-22: Revenue Procedure 2020-22 details the rules for partnerships under the CARES Act, including this 50% EBIE rule and election procedures.

Important Note: The CARES Act amendments for partnerships were temporary, applying only to taxable years beginning in 2019 and 2020. They do not extend to taxable years beginning in 2021 and later.

Business Interest Expense and Section 704(d) Basis Limitation for Partners

For partners, business interest expense interacts with the Section 704(d) basis loss limitation rules, which can further restrict the deductibility of losses, including interest expenses, at the partner level.

Separate Section 704(d) Loss Class:

Treas. Reg. §1.163(j)-6(h) establishes a separate Section 704(d) loss class specifically for business interest expense. This class includes:

• Deductible Business Interest Expense: Both current year deductible business interest expense and business interest expense of an exempt entity (allocated to the partner).
• Prior Year Suspended Business Interest: Business interest expense suspended under Section 704(d) in prior years.
• Current Year Excess Business Interest Expense (EBIE): EBIE allocated to the partner in the current taxable year.
• Prior Year Suspended EBIE (Negative Section 163(j) Expense): EBIE from prior years that was suspended under Section 704(d).

Ordering Rules within the 704(d) Limitation:

When applying the Section 704(d) limitation to this specific loss class, a specific ordering rule applies:

• Deductible Business Interest First: Any deductible business interest expense within this class is taken into account before any EBIE or negative Section 163(j) expense. This means deductible interest is prioritized within the 704(d) limitation.

Example in Regulations:

Example 7 in Treas. Reg. §1.163(j)-6(o)(7) provides a detailed illustration of how these rules interact in practice.

Applicability Date:

This provision generally applies to taxable years beginning on or after November 13, 2020. See Treas. Reg. §1.163(j)-6(p) for the specific applicability date details.

This interaction between Section 163(j) and Section 704(d) adds another layer of complexity for partners, requiring careful consideration of basis limitations when dealing with business interest expense from partnerships.

Consolidated Groups of Corporations and Section 163(j)

For consolidated groups of corporations, the Section 163(j) limitation is applied on a consolidated basis, treating the entire group as a single entity for this purpose.

Single Consolidated Limitation:

A consolidated group calculates a single Section 163(j) limitation for the entire group, rather than each member corporation calculating its own separate limitation.

Aggregation of Interest and Income:

• Consolidated Business Interest Expense: This is the sum of each member’s business interest expense.
• Consolidated Business Interest Income: This is the sum of each member’s business interest income.

Consolidated ATI Calculation:

The consolidated group calculates its Adjusted Taxable Income (ATI) based on the group’s taxable income as determined under Treas. Reg. §1.1502-11. Importantly, this calculation is done without regard to any carryforwards or disallowances under Section 163(j). This ensures that the ATI calculation is based on the group’s underlying economic income before considering the interest limitation itself.

By applying the limitation at the consolidated level, intercompany transactions and balances are effectively netted out, and the limitation reflects the overall interest expense of the consolidated economic unit.

Foreign Corporations and the Section 163(j) Limitation

The Section 163(j) limitation is not exclusive to domestic corporations; it also extends to certain foreign corporations, particularly those with U.S. business activities or U.S. shareholders.

Applicability to Foreign Corporations:

The limitation applies to any foreign corporation whose classification is relevant under Treas. Reg. §301.7701-3(d)(1) for a taxable year, beyond just classifications solely under Section 881 or 882 (which deal with certain types of fixed, determinable, annual, or periodical income and effectively connected income).

Controlled Foreign Corporations (CFCs):

As a result of this broad applicability, Section 163(j) generally applies to any foreign corporation that is a Controlled Foreign Corporation (CFC).

General Application to CFCs:

Generally, Section 163(j) applies to a CFC in a manner similar to its application to a domestic C corporation.

CFCs as Partners:

If a CFC is a partner in a partnership, the Section 163(j) limitation is applied to the partnership as if the CFC were a domestic C corporation partner.

ATI and Limitation Calculation for CFCs:

Treas. Reg. §1.163(j)-7 provides specific rules for determining the ATI and calculating the Section 163(j) limitation for CFCs, taking into account their unique international tax context.

CFC Groups and Safe Harbor Election:

• CFC Group Election: If a CFC group election is in effect, a single Section 163(j) limitation is computed for the entire CFC group, similar to consolidated groups of domestic corporations. Treas. Reg. §1.163(j)-7(c) outlines these rules.
• Safe-Harbor Election: If a CFC or CFC group qualifies for a safe-harbor election, none of the CFC’s or CFC group members’ business interest expense is disallowed in a taxable year for which the election is made. This can provide significant simplification and relief.

Foreign Corporations Engaged in U.S. Trade or Business:

Section 163(j) also applies to any foreign corporation (or other foreign person) engaged in a U.S. trade or business.

Proposed Regulations for U.S. Trade or Business:

Prop. Reg. §1.163(j)-8 provides proposed rules for determining ATI and calculating the limitation for foreign corporations (and other foreign persons) engaged in a U.S. trade or business.

Coordination with Effectively Connected Income (ECI) Rules:

For foreign corporations with a U.S. trade or business, the proposed regulations coordinate the application of Section 163(j) with the rules for allocating interest expense to income effectively connected with a U.S. trade or business. This ensures that the interest limitation is properly integrated with the broader framework for taxing foreign businesses operating in the U.S.

CARES Act: Temporary Relief Measures

The CARES Act, enacted in response to the COVID-19 pandemic, included several temporary changes to Section 163(j) aimed at providing businesses with increased deductibility of interest expense during the economic downturn.

Temporary Changes Introduced by the CARES Act

The CARES Act amendments to Section 163(j) were designed to be temporary, primarily affecting taxable years 2019 and 2020. These changes offered potentially significant benefits to taxpayers during those years.

Key Temporary Changes:

1. Increased ATI Percentage (2019 and 2020):

   • 50% ATI Limit: The CARES Act retroactively increased the ATI percentage for taxable years beginning in 2019 and 2020 to 50%, up from the standard 30%. This meant businesses could deduct more interest expense relative to their ATI in these years.
   • Election to Use 30% ATI Limit: Taxpayers were given the option to elect out of the 50% ATI limit and instead use the original 30% ATI limit. This election might be beneficial in certain specific scenarios, although less common.
   • Election Method: To elect the 30% limit, taxpayers simply filed their return using the 30% ATI limitation instead of the 50%. No formal statement was required to be attached to the return. Revenue Procedure 2020-22 provides guidance on this.

2. Election to Substitute 2019 ATI for 2020 ATI:

   • 2019 ATI Substitution for 2020: Taxpayers were allowed to elect to substitute their ATI from the last taxable year beginning in 2019 for their ATI in 2020.
   • Purpose: This was intended to help businesses whose ATI was significantly lower in 2020 due to the pandemic’s economic impact. By using the potentially higher 2019 ATI, they could increase their deductible interest expense in 2020.

CARES Act Changes Specifically for Partnerships and Partners

In addition to the general changes, the CARES Act included specific temporary rules tailored to partnerships and their partners.

Partnership-Specific Temporary Rules:

1. 50% EBIE Rule for Partners (2020):

   • 50% Deduction of 2019 EBIE: For taxable years beginning in 2020, partners could treat 50% of their allocable share of a partnership’s Excess Business Interest Expense (EBIE) from 2019 as an interest deduction without limitation. This was a significant one-time relief measure.
   • Applicable Year: This applied in the partner’s first taxable year beginning in 2020.
   • Election Out: Partners could elect out of this 50% EBIE rule if it was not beneficial for their specific tax situation.
   • Remaining 50% EBIE Carryforward: The remaining 50% of the 2019 EBIE continued to be subject to the standard Section 163(j) limitation carryforward rules at the partner level.

2. 30% ATI Limit for Partnerships in 2019:

   • No 50% ATI for 2019 Partnerships: The CARES Act’s increased 50% ATI limitation did not apply to partnerships for taxable years beginning in 2019. Partnerships were subject to the original 30% ATI limitation in 2019.

3. Partnership Election for 30% or 50% ATI in 2020:

   • Partnership Choice for 2020: For taxable years beginning in 2020 only, partnerships were given a choice. They could elect to use either the 30% ATI limitation or the 50% ATI limitation.
   • No Formal Statement Required: Similar to the individual taxpayer election, no formal statement was needed to be attached to the return. Revenue Procedure 2020-22 provides details.

4. Partnership Election to Substitute 2019 ATI for 2020 ATI:

   • Partnership ATI Substitution: Partnerships were also allowed to elect to substitute the partnership’s ATI from 2019 for its ATI in 2020 when determining the Section 163(j) limitation for taxable years beginning in 2020.
   • Election Method: Partnerships made this election by timely filing Form 1065 (including extensions), or by filing an amended Form 1065 or administrative adjustment request. Again, no formal statement was required; Revenue Procedure 2020-22 provides details.

Temporary Nature of CARES Act Changes:

It is crucial to remember that all of these CARES Act amendments were temporary, applying only to taxable years beginning in 2019 and 2020. They do not apply to taxable years beginning in 2021 and later. For years after 2020, the Section 163(j) limitation generally reverts to the rules in place before the CARES Act, with the standard 30% ATI limitation (for most taxpayers) and without the 2019 ATI substitution options.

Making Elections Under the CARES Act

For taxpayers and partnerships seeking to utilize the temporary relief measures provided by the CARES Act, understanding how to make the necessary elections is essential.

Guidance Document:

Revenue Procedure 2020-22 provides detailed information and instructions on how to make the various elections available under the CARES Act amendments to Section 163(j).

Types of Elections and Procedures:

Revenue Procedure 2020-22 outlines the specific procedures for making elections such as:

• Taxpayer Election to Use 30% ATI Limitation (instead of 50% for 2019/2020).
• Taxpayer Election to Substitute 2019 ATI for 2020 ATI.
• Partner Election to Opt-Out of the 50% EBIE Rule (for 2020).
• Partnership Election to Use 30% ATI Limitation in 2020 (instead of 50%).
• Partnership Election to Substitute 2019 ATI for 2020 ATI.

Key Information in Revenue Procedure 2020-22:

The Revenue Procedure details:

• Eligibility requirements for each election.
• Specific steps to make each election (often involving actions on tax forms).
• Deadlines for making elections (generally tied to timely filing of tax returns).
• Whether formal statements are required (often not, with actions on tax forms being sufficient).
• Special rules and considerations for partnerships and partners.

Taxpayers and tax professionals should carefully consult Revenue Procedure 2020-22 to ensure they correctly and effectively make any desired CARES Act elections related to the Section 163(j) limitation.

This comprehensive guide provides a detailed overview of the Section 163(j) limitation on business interest expense, emphasizing the definition of “interest,” the various components of the limitation, exceptions, and the temporary changes introduced by the CARES Act. Understanding these rules is crucial for businesses to accurately calculate their deductible interest expense and optimize their tax positions.