Business Interest Deductions: What the IRS Rule 163(j) Means for You

Businesses of all sizes need to borrow money from time to time, whether it be to purchase new equipment or to expand operations.

At the same time, business loans can come with hefty interest obligations. The good news? Many businesses are able to deduct interest expenses when it comes time to file their tax returns — which can reduce the total amount of taxes owed.

In recent years, however, there have been some notable changes to business interest deductions — particularly as it relates to limitations on which businesses can claim these deductions. If your business has interest expenses that you plan to report on a tax return, then there are some things you should know.

Understanding the Section 163(j) Limitation

According to the Internal Revenue Service (IRS), “taxpayers can deduct interest expense paid or accrued in the taxable year.” When Section 163(j) applies, however, there are limits on the amount of deducted business interest expenses that a taxpayer or business can claim in a taxable year.

What are these limits? Per the IRS, business interest expense deductions “cannot exceed the sum of:

1. the taxpayer's business interest income for the taxable year;
2. 30% of the taxpayer's adjusted taxable income (ATI) for the taxable year; and
3. the taxpayer's floor plan financing interest expense for the taxable year.”

More specifically, this limitation applies to all businesses and individual taxpayers who have business interest expenses (with the exception of small businesses meeting certain requirements).

The Impact of the CARES Act and TJCA

While Section 163(j) may seem simple enough, changes in recent years have led to some confusion for business owners and taxpayers. Specifically, the Tax Cuts and Jobs Act (TCJA) of 2017 and the CARES Act of 2020 led to some notable changes that affected many businesses and their tax planning.

For example, when the CARES Act passed, a new 50% of adjusted taxable income (ATI) was applied for the 2019 and 2020 tax years. During these years, ATI could be calculated with add-backs for depreciation and amortization. However, these provisions expired at the end of 2021, resulting in many businesses and taxpayers facing stricter limitations on the interest expense deductions they could claim.

Likewise, when the TCJA was enacted in 2017, other amendments were made to business interest expense limitations. In addition to expanding the overall scope of Section 163(j), this law allowed many businesses that couldn't previously claim interest expense deductions to take advantage of the option.

Strategies to Minimize Taxes

With all this in mind, what are some steps your business can take to minimize its tax burden while still closely following the provisions of Section 163(j)? One of the lesser known options to keep in mind is that of opting out of Section 163(J) by making the switch to a different depreciation method. Specifically, the Alternative Depreciation System (ADS) depreciation method allows businesses to extend their asset recovery periods while eliminating bonus depreciation. However, because this switch is not easily reversible, it is important to assess the long-term financial impact before making a decision.

Another option to consider is raising future capital through equity rather than direct borrowing, as this can minimize interest expenses.

Regardless of the tax strategy your business pursues, the most important thing to keep in mind is that all businesses subject to Section 163(j) are required to file IRS Form 8990 in order to properly report their interest expenses. Likewise, keeping detailed records of all business interest paid will help to ensure that this form is filled out accurately and completely, which can minimize the chances of errors that could lead to an audit.

Looking for More Guidance?

Regulations surrounding business interest expense deductions can be complicated, especially when it comes to understanding the Section 163(j) limitation with recent changes in effect. At the same time, understanding these regulations is critical to filing your business taxes accurately, minimizing your taxes owed and avoiding a potential audit.

If you're still looking for some additional guidance when it comes to reporting your business interest expenses on this year's tax return, it's not too late to consult with an experienced tax professional. Specifically, working with a tax professional who has experience preparing tax returns for businesses with interest deductions to claim can help you protect your company's finances while filing with renewed confidence.    

To learn more about LGT and how we can serve you, contact us here.