Section 163(j) Limitation Impacts Deduction of Small Business Interest Expense

What small businesses need to know regarding Section 163(j) limitation

Since the passage of the Tax Cuts and Jobs Act (TCJA), many companies have been limited in how much business interest they could deduct thanks to code section 163(j). The corresponding small business exception for taxpayers with less than $25 million (2019) or $26 million (2020) in average annual gross receipts was originally intended to cause these limitations to apply only to larger businesses. However, the incorporation of the “tax shelter” definition into the disqualification for that small business exception caused numerous entities that generated losses and had 35 percent or more of its ownership held by passive investors to get tagged by the limitations on interest as well.

No material change to ‘tax shelter’ definition

The American Institute of Certified Public Accountants (AICPA) and other lobbyists have been pushing Treasury to eliminate, or at least clarify, the tax shelter aspect of these limitations so that small businesses would not be subject to the interest limitations just because they have passive investors. Unfortunately, Treasury has now issued regulations that uphold the original definition of a tax shelter and the limitation on using the small-business exception to get out of the business interest expense limitations.

New regulation provides potential tax benefit

The new regulations provided one change that may be a potential benefit to taxpayers. Taxpayers can now look to how the taxable income or loss of the immediately preceding tax year was allocated to determine whether 35 percent or more was allocated to passive investors. In some cases, this could provide a one-year delay in the application of these limitations. For example, when ownership changes cause an entity to exceed the 35 percent passive ownership threshold in the next year.

In other cases, this new rule puts more focus on partnership allocations. The language in the regulations focuses on how activity is actually allocated, not percentage of ownership. You could have a partnership that has more than 35 percent of its units held by passive investors, but because of operating agreement provisions or basis limitations, less than 35 percent of the losses are actually allocated to passive members. In this scenario, the entity would not be subject to the business interest limitations for that year because more than 65 percent of the losses were actually allocated to non-passive members. Businesses can then layer on the one-year look back allowance to cause the next year to avoid the limitations as well.

In conclusion, many businesses will still be snagged by the business interest limitations because Treasury did not agree to change the definition or application of a “tax shelter” in this context. However, the Treasury did provide one more option to help your small business avoid these limitations, if the stars align.

Each business owner’s tax situation is unique and you should speak with your tax advisor before making any decisions. If you have questions about tax planning for your business, please contact your Opportunity Advisor or Email | Call: 804.747.0000. We are here to listen and provide sound advice.