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Editorial 9 MIN READ

The new § 163(j), four months in: the small-business exemption that most pass-throughs will hit by accident

A rewritten earnings-stripping statute, a 30 percent ATI cap on interest deductions, and a $25 million gross-receipts test most founders have never heard of

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 6 sections
  1. What the rewrite actually does
  2. The small-business exemption, in the statute's own words
  3. Partnerships: the second statute inside the statute
  4. The real-property election, at the 30-year price
  5. What remains unclear in May 2018
  6. Sources

or tax years beginning after December 31, 2017, IRC § 163(j) is no longer the earnings-stripping rule a handful of foreign-parented multinationals used to file around. It is a universal cap on the business interest deduction, set at 30 percent of adjusted taxable income, that applies to every taxpayer with a business unless an exemption fits.

The small-business exemption in § 163(j)(3) is the one almost everyone will need and almost no one will read carefully. It lifts the cap for a taxpayer that meets the § 448(c) gross-receipts test, which for 2018 is an average of $25 million or less over the three preceding tax years. That sentence contains four traps, and Treasury has not yet issued proposed regulations to walk anyone through them.

What the rewrite actually does

The pre-TCJA § 163(j) was targeted. It denied a deduction for interest paid by a U.S. corporation to a related foreign party where the U.S. corporation's debt-to-equity ratio exceeded 1.5 to 1 and its net interest expense exceeded 50 percent of adjusted taxable income. Practitioners called it the "earnings-stripping" rule. It caught inbound multinationals and almost nobody else.

Section 13301 of the Tax Cuts and Jobs Act (Pub. L. 115-97, signed December 22, 2017) struck that regime and replaced it with a general rule. Under § 163(j)(1), the deduction for "business interest" for any tax year is limited to the sum of (A) the taxpayer's business interest income, (B) 30 percent of the taxpayer's adjusted taxable income, and (C) the taxpayer's floor plan financing interest. Anything in excess is disallowed in the current year and carried forward indefinitely under § 163(j)(2).

"Adjusted taxable income" is defined in § 163(j)(8). For tax years beginning before January 1, 2022, it is taxable income computed without regard to any item not properly allocable to a trade or business, without regard to business interest or business interest income, without regard to net operating losses, without regard to the § 199A pass-through deduction, and without regard to depreciation, amortization, or depletion. After 2021, the addbacks for depreciation, amortization, and depletion go away, and the cap tightens on every asset-heavy business in the country.

The statute does not apply to "interest" in the tax-accounting sense generally; it applies to "business interest," which § 163(j)(5) defines as any interest paid or accrued on indebtedness properly allocable to a trade or business, excluding investment interest covered by § 163(d). Investment interest remains under its own regime.

There are carve-outs in the statute. Electing real-property trades or businesses can opt out under § 163(j)(7)(B). Electing farming businesses can opt out under § 163(j)(7)(C). Regulated utility businesses are carved out under § 163(j)(7)(A)(iv). Employees' services are not a trade or business under § 163(j)(7)(A)(i). And, for the rest of the economy, the small-business exemption under § 163(j)(3) is the only door out.

The small-business exemption, in the statute's own words

Section 163(j)(3) provides that the limitation "shall not apply to any taxpayer (other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting under section 448(a)(3)) which meets the gross receipts test of section 448(c) for such taxable year." Four things are doing work in that sentence.

First, the test is the § 448(c) gross-receipts test. Section 448(c)(1) sets the threshold at $25 million (or less) average annual gross receipts for the three preceding tax years. The $25 million is the figure that controls for a 2018 tax year; TCJA § 13102 set that threshold and provided an inflation adjustment under § 448(c)(4) starting for tax years beginning after 2018. A calendar-year 2018 filer measures 2015, 2016, and 2017 receipts against $25 million. A taxpayer that has not been in existence for three prior years uses the period of existence, per § 448(c)(3)(A), annualizing short years under § 448(c)(3)(B).

Second, the test is on gross receipts, not net income, not taxable income, not revenue as a founder thinks of it. Section 448(c)(3)(C) requires the aggregation rules of § 52(a) and § 52(b) (which borrow from § 414 controlled-group concepts) and § 414(m) and § 414(o). A founder with two small LLCs under common control adds them together before running the $25 million test. The aggregation rules are the reason a rollup that looks exempt often is not.

Third, the exemption is not available to a "tax shelter" within the meaning of § 448(a)(3). Section 448(d)(3) defines tax shelter by reference to § 461(i)(3), which in turn reaches (i) any enterprise (other than a C corporation) interests in which have been offered for sale in any offering required to be registered with a federal or state agency regulating the offering or sale of securities, (ii) any syndicate within the meaning of § 1256(e)(3)(B), and (iii) any tax shelter as otherwise defined in § 6662(d)(2)(C). The syndicate prong is the one that bites in practice. A syndicate is any partnership or other entity (other than a C corporation) in which more than 35 percent of the losses during the tax year are allocated to limited partners or limited entrepreneurs. A real estate partnership that throws off depreciation losses to passive investors can blow its syndicate test in a single year and lose its small-business exemption for the rest of the year, even if gross receipts are well under $25 million. The statute does not provide a cure. Practitioners have flagged this as the sharpest edge in § 163(j)(3), and Treasury has not yet addressed it.

Fourth, the exemption is tested each year. A taxpayer that crosses the $25 million threshold in a later year falls into the regime for that year without any transition relief. Business interest disallowed at that point is carried forward indefinitely under § 163(j)(2) and gets consumed in later years against that year's 30 percent of ATI cap, assuming ATI is positive.

Partnerships: the second statute inside the statute

Section 163(j)(4) applies the limitation at the partnership level and then pushes the economics down to the partners in a way that does not match how any other limitation in subchapter K works. Under § 163(j)(4)(A)(i), the limitation is applied at the partnership level, and any deduction for business interest is taken into account in computing the partnership's non-separately stated taxable income or loss. Excess business interest (the partnership's business interest in excess of the partnership's § 163(j) limit) is allocated to the partners under § 163(j)(4)(B), but a partner may not deduct excess business interest until a later year in which the partnership allocates the partner "excess taxable income" under § 163(j)(4)(C). "Excess taxable income" is defined in § 163(j)(4)(C) as the excess of (i) 30 percent of the partnership's ATI over (ii) the partnership's business interest less business interest income. In plain terms: interest disallowed at the partnership does not reappear at the partner as a general carryforward. It is parked at the partner and thaws only as the partnership generates future capacity.

Section 163(j)(4)(D) requires a partner's basis in its partnership interest to be reduced by excess business interest allocated to the partner. The partner gets the basis hit in the year of allocation, and the deduction only when capacity appears. Partnerships that distribute the interest-laden year-one allocation to a partner who then sells before ever getting deductions will find themselves in an arithmetic the statute does not smooth over. S corporations, per § 163(j)(4)(B)(ii), are treated more simply: the limitation is applied at the corporate level and any carryforward stays with the corporation.

The small-business exemption is tested at the partnership level for partnership interest and at the S corporation level for S corporation interest. A partnership with $30 million of gross receipts is caught even if no partner, standing alone, would be. The partners then live inside the excess-business-interest regime until the partnership itself generates excess taxable income.

The real-property election, at the 30-year price

Section 163(j)(7)(B) permits a "real property trade or business" (defined by reference to § 469(c)(7)(C), which covers any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business) to elect out of § 163(j) entirely. The election is irrevocable once made, per § 163(j)(7)(B). The price is in § 168(g)(1)(F) and § 168(g)(8), added by TCJA § 13204: an electing real property trade or business must depreciate its nonresidential real property, residential rental property, and qualified improvement property under the alternative depreciation system, with recovery periods of 40, 30, and 20 years respectively under § 168(g)(2)(C). The electing farmer variant under § 163(j)(7)(C) runs on a parallel track for property with a recovery period of 10 years or more.

The math of the election depends on the taxpayer's debt load, the composition of its depreciable base, and its expectation of future interest rates. A leveraged real estate partnership with long-lived asset basis and expected growing interest expense frequently finds the election attractive. A newer, less leveraged operator with shorter-lived assets often does not. The election is made on a timely filed original return and is not ordinarily curable by late filing. No Treasury guidance has yet described the election's mechanics, and practitioners are writing it into returns on the basis of the statutory text alone.

What remains unclear in May 2018

Four months into the new regime, several operational questions are live and unanswered. Treasury has not issued proposed regulations. The IRS's only § 163(j) guidance since enactment has been Notice 2018-28, 2018-16 I.R.B. 492, published April 2, 2018, which previewed selected rules Treasury intends to propose for C corporations, consolidated groups, and partnerships, and invited comments.

Notice 2018-28 announces that future regulations will treat all interest paid or accrued by a C corporation as business interest for § 163(j) purposes, a position with no express support in the statute and significant implications for C corporations holding investment assets. It announces that the disallowed interest carryforward under § 163(j)(2) will be treated as an item allocable to the activity that produced the interest for consolidated return purposes. It reserves on how tiered partnerships pass excess business interest up a chain. It reserves on how the small-business exemption interacts with partnerships that control, or are controlled by, larger entities through § 448(c) aggregation. And it reserves on whether the syndicate rule in § 448(a)(3) is measured before or after the allocation that triggers it, which is the chicken-and-egg problem at the heart of § 163(j)(3) for real estate and private-equity funds.

The practical upshot for a founder or small-business owner in May 2018: if your gross receipts are well under $25 million, if your business is not a syndicate, and if your entity is not aggregated up to something larger, you are probably outside § 163(j) for the year you are in. You should still document the test. If your partnership crosses the syndicate line, you are subject to the 30 percent cap for that year with no cure. If you are a real estate operator weighing the § 163(j)(7)(B) election, the cost is a 30 or 40 year MACRS tail, and the decision is not reversible.

The broader point, which our January outline of TCJA § 199A and our follow-up on open § 199A questions have already flagged in another corner of the new Code: TCJA wrote a set of rules that do not run off the statute alone. Section 163(j) is one of those rules. The small-business exemption is a genuine off-ramp for most of the people who will ever read it, and a tripwire for the subset that will not.

Sources

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