On July 28, 2020, the IRS issued final regulations for the interest expense deduction. These comprehensive regulations run over 600 pages, covering changes introduced by the Tax Cuts and Jobs Act (“TCJA”) in 2017 that limit the deductibility of interest expense by businesses in all industries. This interest limitation is more likely to impact businesses that are highly leveraged, as well as those that generate little taxable income or a loss. More information below:
Background on TCJA Change
The TCJA ushered in numerous tax changes and reforms, many of which were favorable to businesses. Nonetheless, there were several offsets that burdened businesses with complicated provisions that repealed or limited certain deductions, including the limitation on the deductibility of interest expense by businesses. Please note, this limitation generally only applies to businesses with prior average annual gross receipts of > $25,000,000 (indexed for inflation).
Prior to the TCJA, businesses were not limited in their ability to deduct interest expense. Congress, under the TCJA, concocted an interest limitation with a new formula based on the term, Adjusted Taxable Income, or “ATI.” In a sense, ATI is somewhat like “EBITDA.”
Adjusted Taxable Income (ATI)
ATI is determined by starting with a company’s taxable income for the year and making certain adjustments. The primary positive adjustments to taxable income were depreciation and amortization deductions, as well as the interest deduction itself. On the other hand, a negative adjustment applied for any gains on property disposals in which depreciation had been claimed after 2017.
The basic formula limited the interest expense deduction of a business to 30% of its ATI. If its interest expense for the year exceeds this threshold, the excess gets carried forward indefinitely to be claimed in future tax years. Please note, while the TCJA imposed the 30% limit on ATI, in early 2020, Congress passed the CARES Act. The CARES Act provided an economic stimulus to individuals and businesses impacted by the COVID-19 pandemic and included a change that enhanced the interest expense deductibility. Thus, the expense deduction increased the 30% factor to 50% for tax years 2019 and 2020. It reverts to 30% in 2021 and thereafter.
For businesses with significant levels of tax depreciation (including 100% bonus depreciation), which is typical of manufacturers and distributors, the formula results in a much higher ATI. The higher the ATI, the more opportunity for a business to fully deduct its interest expense.
Changes Made in the Proposed Regulations
The proposed regulations issued in November of 2018 crafted an unusual treatment for the depreciation adjustment mentioned above. The IRS surprised many when it determined that depreciation would not be added back if it was capitalized into inventory. Capitalizing tax depreciation into inventory, as you may know, is common for manufacturers and distributors. The end result? Even though manufacturers might incur significant amounts of tax depreciation in the year, the depreciation will not be added back for ATI purposes since it was required to be capitalized into inventory. This proposed IRS treatment was controversial when unveiled, as it could produce an interest deductibility limitation for many manufacturers and distributors.
Let’s look at an example.
ABC Manufacturing Company incurred interest expense of $800,000 in 2019 along with tax depreciation of $1,000,000. The tax depreciation was capitalized into the company’s inventory and relieved as part of cost of goods sold when the inventory products were sold. ABC also generated taxable income of $1,000,000 for the year before deducting any interest expense. ABC’s interest calculation works as follows:
Taxable Income (before interest deduction)
ATI Adjustments:
Add-back for tax depreciation
ATI
50% Factor for 2019
Interest Deduction Limitation for Year
Disallowed Interest Expense
–
Final Taxable Income for ABC in 2019
$1,000,000
–
-0- (per proposed regs)
$1,000,000
50%
$500,000
$300,000 ($800,000-500,000)
–
$500,000
As seen in this example, ABC was unable to deduct $300,000 of interest expense in 2019 even thought it incurred significant level of tax depreciation in the year.
Revisions Made in Final Regulations
The IRS made a number of changes in the final regulations for deducting interest expense. One such change involved this treatment of tax depreciation that was capitalized into inventory. The IRS reversed course in these final regulations and permitted tax depreciation to be added back to ATI as an adjustment—even if the depreciation was capitalized into inventory. This favorable change should allow more interest expense to be deducted by a taxpayer. Let’s look at the same example from above:
Taxable Income (before interest deduction)
ATI Adjustments:
Add-back for Tax Depreciation
ATI
50% factor for year
–
Interest Deduction for year
Disallowed Interest Expense for year
Final Taxable Income for year
$1,000,000
–
1,000,000 (per final regs)
$2,000,000
50%
$1,000,000
$800,000
-0-
$200,000
Manufacturers and distributors should be aware of this key change in 2020 to make sure they are now applying the favorable treatment found in the final regulations. They may also be able to deduct any prior years’ disallowed interest expense that imposed the treatment from the proposed regulations or consider amending 2018 or 2019 tax returns that followed such treatment.
As noted, these comprehensive final regulations contained several other revisions from the proposed regulations. One other key change involves the classification of debt issuance costs. The final regulations removed debt issuance costs from the definition of “interest” for purposes of this limitation as was provided in the proposed regulations. This was another welcome change in the final regulations.
There is a lot for manufacturers and distributors to digest in these final regulations for interest deductibility. With these complicated changes, however, came some favorable revisions that may make these new rules a little less onerous. Please contact your Sikich advisor with any questions or for assistance.
About our authors
Jim Brandenburg
Jim Brandenburg, CPA, has extensive experience and knowledge in corporate and partnership tax law, mergers and acquisitions and tax legislation. His expertise includes working with owners of closely held businesses to identify tax planning opportunities and assist them in implementing these strategies.
Jenny Kramer
Jenny Kramer, CPA, is a partner that has been helping closely-held businesses and their owners with their tax planning and compliance needs since 2005. She specializes in taking the time to understand her clients’ overall business strategies so that she can provide a clear understanding of the tax implications of their goals and develop tax planning opportunities that will coincide with and enhance their objectives.
