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Tax Deduction for Business Interest Expenses

The IRS has released new rules for business interest expenses that may require you to file Form 8990. The form’s Part II deals with partnerships and Part III, S-corporations.

The recent changes in tax law have made it more difficult for businesses to deduct their interest expenses. These factors were altered with the passage of the Tax Cuts and Jobs Act and then again through CARES Act adjustments.

The CARES Act significantly changes how taxes are calculated for individual taxpayers. The IRS has certain limitations that prevent you from fully deducting business interest payments if it exceeds 30% of your adjusted taxable income. The 30% limitation on the amount of unused ARP that can be carried forward and applied against future taxable income will increase to 50 percent for 2019 and 2020. Taxpayers may choose whether they would like this more restrictive limit or stay at the current amount (30%).

The new rules will increase the Alternative Innovation Credit (ATI) tax to 50%. This applies only to partnerships that begin in 2020 or afterward, but it does not affect corporations at all.

Exemptions and More

The average taxpayer gets some relief from this limitation, asking if their gross receipts have been more than $25 million in the prior three years. As adjusted for inflation, this number goes up by one million dollars in 2019 and 2020.

The IRS has created an anti-avoidance rule which prevents you from using lower-tier partnerships to skirt your obligation. The limitations on this tax exemption don’t apply to “tax shelters,” generally defined as anything other than C corporations if more than 35% of losses are allocable to limited partners or entrepreneurs who do not actively manage their businesses.

The new law extends the depreciation rules for farmers and real estate businesses. It also relieves certain limitations on these deductions, such as an election that brings in lesser expenses due to higher interest rates during this year’s cycle.

These new regulations will limit the amount you can expense for interest payments. This is because for tax years beginning after 2017 and before 2022, your “adjusted taxable income” focuses on what’s not being taxed – like deductions of depreciation or depletion. From 2021 onwards, this changes as these credits are no longer considered.

Although a partnership or S corporation may have “excess taxable income” that can flow through to help the partner, there are limits on how much of this money is available. Individuals with higher adjusted gross income (AGI) will be able to use their extra tax burden as computing credit against future taxation.

If an S Corporation has disallowed business interest expense, the amount will carry over and be treated as an additional interest in that year. If you are in an S Corporation, your basis is not affected by this disallowed interest expense. A separate line for adjusting tax attributes will appear on 2020 form 1120-S K1.

The business interest expense is limited to the amount that can be offset by credits, which are accumulated and distributed among partners in proportion to their shareholdings. The deduction for this type of spending at both entity level and partner level means it isn’t subject to too much scrutiny or analysis on behalf of the individuals involved with these companies.

For partnerships, any disallowed interest expense is treated as if it were earned by the partner in that next succeeding year. The excess passes through to them and does not carry over into other years.

The partner can include the excess business interest reported on behalf of a partnership for tax purposes in their gross income. The amount will be passed through to them and reduce what they have paid out, making it eligible as a deductible expense.

If you have excess taxable income or business interest expenses, it’s essential to calculate how much of these will be allocated per partner. This can be quickly done on Form 8980 by following 11 steps.

Interest expense can be tricky to manage when multiple businesses in the same entity, only some of which face Section 163(j) limitations.

The changes in these new rules may be very substantial for some people, but the impact on taxpayers is not proportional. One practical consideration that must be considered when implementing them will involve telling clients about any additional fees they’ll owe due to the complexity of their taxes and how complicated it has become since last year’s law change.