Business Interest Expense for M&D

As a result of the Tax Cuts and Jobs Act (TCJA) and beginning in 2018, the new Internal Revenue Code Section 163(j) will limit the ability of a business to deduct its business interest expense if the taxpayer has average gross receipts over $25 million.  This limitation could lead to higher taxes for companies in capital-intensive industries.

Background:

In prior years, business interest expenses were generally fully deductible as long as the related loan proceeds were used for business purposes such as purchasing raw material, labor, and any other overhead expenses.  The TCJA introduced a new limitation on how much business interest expense a taxpayer with gross receipts exceeding $25 million can deduct.  Effective January 1, 2018, business interest expense deductions will be limited to the sum of:

• Business interest income
• 30% of adjusted taxable income, and
• Floor-plan financing interest (for auto dealerships)

Taxpayers with less than $25 million of gross receipts in the three proceeding years are exempt from this limitation. Other exemptions are available for farming and real estate businesses, but those exemptions generally do not apply to manufacturers.

Adjusted taxable income

Since manufacturers generally do not earn business interest income and floor-plan financing does not apply, most of the limitations will be placed on 30% of adjusted taxable income (ATI).

ATI calculation starts with taxable income without regards to:

• Any non-business related income such as interest and dividend from investments;
• Any capital gains/losses from the sale of investment properties;
• Any other expenses or deductions related to investment activities;
• Any net operating loss;
• Any qualified business income deductions allowed under section 199A; and
• Any depreciation, amortization, or depletions related to the business through December 31, 2021.

After 2021, depreciation, amortization, and depletion will no longer need to be added back to ATI.  Since depreciation expenses are a significant portion of the cost of goods sold for most manufacturers, this could lead to lower allowable interest expense deduction.

The example below will show how the loss of depreciation add back could affect the amount of deduction a company will be allowed to take:

What happens to the disallowed deductions?

The business interest expense disallowed in the current year can be carried forward indefinitely to future years.  The carryforward interest expense will be treated as the expense is incurred in the carryforward year and will be subject to the 30% ATI limits.

What's the impact?

This business interest deduction could impact manufacturers with significant depreciation expense and interest expense. Many might choose to lease instead of taking out loans to purchase equipment. With rising interest rates and new accounting standards requiring companies to recognize operating lease assets and liabilities on the balance sheet, this approach could adversely affect a company's debt to asset ratios.

Not all changes with the new tax code are favorable for businesses and taxpayers.  This further business interest expense deduction limitation will undoubtedly be unfavorable to companies with a large amount of business-related debt.

Give one of our tax advisors a call for a more in-depth analysis of how this will affect your business.