Highlights of the 163(j) Business Interest Guidance Issued by Treasury and the IRS on July 28, 2020 – Part 2
On July 28, 2020, the US Treasury and IRS released final regulations (the Final Regulations) and new proposed regulations (the 2020 Proposed Regulations) on the business interest expense (BIE) deduction limitation under §163(j) (§163(j) limitation) of the Internal Revenue Code (Code). Both the Final Regulations and the 2020 Proposed Regulations were published in the Federal Register on September 14, 2020.
§163(j) was modified by the 2017 US tax reform legislation, referred to as the Tax Cuts and Jobs Act (TCJA) (Pub. L. No. 115-97 enacted December 22, 2017). §163(j) was further modified by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) in 2020. The original set of proposed regulations were released on December 28, 2018 (the 2018 Proposed Regulations).
The IRS also issued two additional pieces of guidance along with the Final and Proposed Regulations: Notice 2020-59 and a set of 11 Frequently Asked Questions (FAQs). Notice 2020-59 proposes a revenue procedure that would create a safe harbor to allow taxpayers in the business of managing or operating qualified residential living facilities to qualify as an electing real property trade or business. The FAQs are related to the aggregation rules and the gross receipts test that determine whether a taxpayer is a small business that may claim an exemption from the §163(j) limitation.
In this True Insight, Part 2 of 2 of our analysis of the new §163(j) guidance, we highlight issues related to partnerships, S corporations, foreign corporations with effectively connected income (ECI), and the FAQs related to the small business exemption. In Part 1 of our analysis of the new §163(j) guidance, we highlighted the key issues addressed by the Final and 2020 Proposed Regulations with respect to the definition of interest and adjusted taxable income (ATI), rules for C corporations and controlled foreign corporations (CFCs), and effective dates of the new guidance.
- 163(j) is applied to partnership business indebtedness and computed at the partnership level. Partnership’s BIE is deductible in the current year in an amount up to its §163(j) limitation and is allocated to its partners as part of the partnership’s non-separately stated taxable income.
- To the extent that a partnership’s BIE is less than its §163(j) limitation, that partnership should have either excess taxable income (ETI) or excess business interest income (excess BII).
- If a partnership’s business interest deduction is limited under §163(j), the amount of BIE that is disallowed because it exceeds the §163(j) limitation (excess BIE) must be allocated to and carried forward by each partner, and it reduces the partner’s basis in its partnership interest.
- In subsequent years, BIE carryforwards are treated as paid or accrued by a partner and are only deductible in a tax year when, and to the extent that, the partner receives an allocation of ETI or excess BII from the same partnership.
- The Final Regulations generally follow the rules in the 2018 Proposed Regulations, but two significant changes are included related to guaranteed payments for the use of capital (GPUCs) and basis adjustments.
- The Final Regulations retain the 11-step method for allocating deductible BIE and excess items, including excess BIE, excess BII, and ETI, to partners.
- The 2020 Proposed Regulations include specific rules on: (1) debt-financed distributions; (2) trading partnerships; (3) tiered partnerships; (4) self-charged lending transactions; (5) publicly traded partnerships; (6) exempt partnerships; and (7) changes from the CARES Act.
- 163(j) is generally applied to S corporation business indebtedness at the S corporation level. However, unlike the rules for partnerships, an S corporation’s excess BIE is carried forward at the S corporation level and potentially deductible by the S corporation in future tax years.
- Special rules apply to S corporations with regard to self-charged lending transactions, debt-financed distributions, short years, and exempt S corporations.
- The 2018 Proposed Regulations included rules for applying §163(j) to certain foreign persons with ECI, but the Final Regulations reserved on this issue and instead included these rules in the new 2020 Proposed Regulations. The 2020 Proposed Regulations have similar rules as the 2018 Proposed Regulations: ATI, BIE, and BII only include items that are effectively connected with a US Trade or Business (ECI), and there are coordination rules for the branch profits tax.
- Taxpayers who meet the §448(c) gross receipts test (gross receipts test) may qualify for the “small business exemption” to be excluded from the §163(j) limitation if the taxpayer is not a tax shelter (as defined in §448(d)(3)).
- The IRS issued a set of 11 FAQs that provide an overview of how to apply the aggregation rules that combine the gross receipts of certain related parties to determine whether they qualify for the small business exemption.
As amended by the TCJA and the CARES Act, for tax years beginning after December 31, 2017, the §163(j) limitation imposes a cap on a taxpayer’s annual BIE deduction equal to the sum of: (i) BII, (ii) 30% of ATI (50% in 2019 and 2020), and (iii) floor plan financing income. Taxpayers may also elect to use their 2019 ATI to compute the limitation in tax year 2020, which is beneficial for taxpayers whose profits declined in 2020.
To the extent that a taxpayer’s current year BIE exceeds its §163(j) limitation, the taxpayer has excess BIE that may be carried forward and treated as BIE in the next taxable year. Alternatively, if the taxpayer’s §163(j) limitation exceeds its current year BIE, the taxpayer likely has ETI or excess BII, neither of which may be carried forward.
The Final Regulations provide guidance on how to calculate the §163(j) limitation; describe what constitutes interest for purposes of §163(j); address which taxpayers and trade or businesses are subject to §163(j); and describe how §163(j) applies to consolidated groups, partnerships, and certain international companies.
Along with the Final Regulations, the IRS also issued the 2020 Proposed Regulations that provide additional guidance on various issues including the application of §163(j) to partnerships (and their partners), S corporations, CFCs and their US shareholders, and foreign persons with ECI.
Taxpayers exempt from § 163(j)
Certain small businesses may be exempt from the §163(j) limitation in taxable years when their average annual gross receipts for the three prior tax years is less than a threshold amount that is adjusted annually for inflation. For taxable years beginning in 2019 and 2020, the inflation adjusted threshold amount is $26 million. The IRS issued a set of 11 FAQs on the aggregation rules under §448(c)(2) which require that certain related parties must combine their gross receipts in order to determine whether they qualify for the small business exemption.
Qualifying taxpayers who elect to be treated as a real property trade or business, or a farming business, may also be excluded from §163(j). However, taxpayers making these elections cannot claim the additional first-year depreciation deductions that are otherwise allowed for certain types of property purchased by the electing trade or business.
The Final Regulations generally apply to tax years beginning on or after November 13, 2020, although taxpayers (and their related parties) may apply the Final Regulations in their entirety to tax years beginning after December 31, 2017. The Final Regulations also allow taxpayers and their related parties to apply the 2018 Proposed Regulations before the Final Regulations become effective.
The 2020 Proposed Regulations will apply 60 days after they are published as final regulations in the Federal Register, but taxpayers and their related parties may apply them in any tax year beginning after December 31, 2017 and before they are published as final regulations as long as all of the related parties apply those regulations in each applicable tax year.
TPC Observation: Although the Final Regulations generally apply to tax year 2021 for calendar-year taxpayers, some provisions have unique effective date rules. For example, taxpayers who otherwise choose to apply the 2018 Proposed Regulations may still apply the rule from the Final Regulations that allows for an addback depreciation and amortization (D&A) that are included in cost of goods sold (COGS) when computing ATI for all tax years beginning after December 31, 2017. See Part 1 of our analysis of the new §163(j) guidance for details about the treatment of COGS D&A.
TPC Observation: When initially released, the Final Regulation’s applicability date language implied that taxpayers could not apply certain taxpayer-friendly rules, such as the addback for COGS D&A, to any tax years before they adopted the Final Regulations, unless they and their related parties apply that rule for all tax years beginning after December 31, 2017. This interpretation would have created an administrative burden by requiring taxpayers to amend previously filed tax returns on which a different rule was applied in order to apply those rules on future tax returns to be filed before 2021. Therefore, the IRS revised the language before publishing the Final Regulations in the Federal Register in order to clarify that taxpayers may make an annual decision to apply any of the applicable regulations to any tax year before 2021 – the only requirement is that taxpayers and their related parties each must apply the same set of regulations in each tax year.
- 163(j) is applied to partnership business indebtedness at the partnership level. A partnership accounts for basis adjustments to its property under §734(b) when determining the partnership’s ATI, but the partnership does not account for partner-level adjustments (e.g. under §743(b)). Instead, such partner-level basis adjustments are taken into account at the partner level as items derived directly by the partner in determining its own §163(j) limitation.
To the extent a partnership’s BIE is limited under §163(j), the excess BIE must be allocated to and carried forward by the partners. The Final Regulations further provide that allocations of excess BIE should reduce the partner’s basis in its partnership interest in the current year.
To the extent a partnership’s BIE is less than its §163(j) limitation, that BIE is 100% deductible and the partnership has ETI or excess BII. In such cases, the partnership allocates the ETI to the partners in the same manner as it allocates its non-separately stated taxable income or loss which includes the partner’s allocation of deductible BIE.
By including deductible BIE in the partner’s allocation of taxable income, that BIE loses its tax character for purposes of §163(j) and is not subject to a second limitation under §163(j) at the partner level. However, partners must also exclude their allocation of the partnership’s taxable income when computing ATI at the partner level.
Alternatively, a partner’s allocation of excess BIE retains its tax character. The excess BIE is carried forward and treated as if paid or accrued in subsequent tax years, but may only be deducted to the extent that the partner is allocated either ETI or excess BII from the same partnership in that tax year.
The 2018 Proposed Regulations addressed some partnership-related issues, but they also reserved on certain issues. The Final Regulations generally follow the rules in the 2018 Proposed Regulations, and some of the reserved issues are addressed in the 2020 Proposed Regulations.
Two significant changes are, however, included in the Final Regulations related to guaranteed payments for the use of capital (GPUCs) and basis adjustments.
Guaranteed Payments for the Use of Capital
Under §707(c), GPUCs are amounts that a partnership pays to a partner for the use of capital when the amount is determined without regard to the partnership’s income. The 2018 Proposed Regulations included GPUCs in the definition of BIE subject to §163(j). The Final Regulations remove GPUCs from the list of items automatically treated as BIE, but add a principal purpose test to the interest anti-avoidance rule. The Final Regulations include an example of a GPUC treated as BIE under the anti-avoidance rule.
TPC Observation: The 2018 Proposed Regulations’ inclusion of GPUCs in the definition of BIE that is subject to §163(j) was unexpected and could have led to unfavorable outcomes for many private equity firms whose allocations of preferred returns include GPUCs. The removal of that automatic reclassification in the Final Regulations is a welcome taxpayer-friendly change, however, the inclusion of GPUCs in the anti-abuse rule could be a signal that the IRS may focus on these allocation structures in future years under the new partnership audit regime.
TPC Observation: The line between preferred returns that are and are not considered GPUCs was already blurry, and it was not clarified in these Final Regulations. Furthermore, the relevant example in the Final Regulations raises questions about how to determine whether a GPUC has the purpose of reducing BIE and is thus subject to reclassification as BIE. For these reasons, taxpayers are advised to reconsider whether their allocations may be viewed as GPUCs under the new guidance as well as the potential impact if their future payments are reclassified as BIE.
- 163(j)(4)(B)(iii)(II) provides that if a partner disposes of a partnership interest, the adjusted basis of the partnership interest is increased immediately before the disposition by the entire amount of the partner’s remaining excess BIE (“Basis Addback Rule”). Under the 2018 Proposed Regulations, the Basis Addback Rule would have applied only if a partner disposes of all, or substantially all, of the partner’s partnership interest. If a partner disposed of less than substantially all of the partner’s interest in a partnership, the partner would not have been able to increase its basis by any portion of the remaining excess BIE.
The Final Regulations modify this rule to provide that a partial disposition of a partnership interest triggers a proportionate basis addback with respect to the disposed partnership interest, and a corresponding decrease to such partner’s excess BIE.
Allocating Deductible Business Interest Expense and Excess Items – 11 Step Method
The Final Regulations retain the 11-step method for allocating deductible BIE and excess items, including excess BIE, excess BII, and ETI, to partners. Despite taxpayer comments that the 11-step process was complex, the government did not decide to provide any alternative allocation methods, although they do include one special rule: partnerships that allocate all items of income and expense on a pro rata basis may similarly allocate the partnership’s §163(j) items on a pro rata basis.
TPC Observation: This exception should have little practical effect in most cases because pro rata allocations should yield the same result as the 11-step process.
2020 Proposed Regulations: Partnerships
Debt-Financed Distributions: Treas. Reg. §1.163-8T contains rules for allocating interest expense for the purpose of applying the various interest expense limitations, including limits on passive activity losses and investment interest expense. The new guidance includes rules for tracing debt proceeds, including debt-financed distributions, to specific expenditures of a partnership. The rules follow the approach taken in Notice 89-35, 1989-1 C.B., with some modifications.
TPC Observation: Taxpayers should reconsider their capital structure and usage of debt proceeds in order to avoid any unexpected limitation on their interest deductions that could arise from the new debt-financed distribution rules.
Trading partnerships: The 2018 Proposed Regulations stated that interest expense of a partnership engaged in per se non-passive activities under §469, such as trading activities, is subject to §163(j) at the partnership level, even if the interest expense may also be subject to limitation under §163(d) as investment interest expense at the partner level for certain passive investors. The 2020 Proposed Regulations change this rule by requiring a partnership to bifurcate its items between partners that materially participate and passive investors.
Tiered partnerships: The Preamble to the 2018 Proposed Regulations requested comments on whether excess BIE should be allocated by an upper-tier partnership (“UTP”) to its partners, as well as how and when the basis of a UTP should be adjusted when a lower-tier partnership (“LTP”) has BIE that is limited under §163(j). The 2020 Proposed Regulations take an “entity approach” to tiered partnerships by providing that if a LTP allocates excess BIE to an UTP, the excess BIE is carried forward by the UTP (rather than that UTP’s partners), and basis reduction occurs only in the UTP’s basis in the LTP (and not in the basis of the partners in the UTP). Special rules address §704(b) capital account adjustments for UTPs and their partners.
TPC Observation: These proposed rules may result in added complexity for tracking excess BIE of tiered partnerships and partner’s §704(b) capital, particularly if negative §743(b) or §734(b) adjustments are involved, or if a different approach is used before adopting the 2020 Proposed Regulations and the UTP was not tracking excess BIE.
Self-charged lending transactions: A lending partner may offset its share of the partnership’s excess BIE against its interest income from the partnership. The 2020 Proposed Regulations provide that in the case of a lending transaction between a partner and a partnership in which the partner holds a direct interest, if the lending partner is allocated excess BIE from the borrowing partnership, the lending partner is deemed to receive an allocation of excess BII equal to the lesser of (1) its excess BIE from the borrowing partnership for the tax year, or (2) the interest income on the loan for the tax year. Double counting rules would apply to prevent BII from being used more than once in calculating the partner’s §163(j) limitation.
Publicly Traded Partnerships: In order to be readily tradeable, each unit of a publicly traded partnership (PTP) must have identical tax characteristics so that such PTP units are fungible. The 2020 Proposed Regulations provide a method for applying §163(j) in a manner that is intended to allow PTP units to retain their fungibility.
Exempt Partnerships or S corporations: Under the 2018 Proposed Regulations, a partnership or S corporation that qualifies as an exempt entity would not be subject to §163(j), but the exempt partnership’s or S corporation’s BIE would have been subject to §163(j) at the partner level. The Final Regulations reverse this and provide that an exempt partnership’s or S corporation’s BIE does not retain its character as BIE and is therefore not subject to §163(j) at the partner or shareholder level.
CARES Act application to partnerships: In the case of excess BIE of a partnership that is allocated to a partner for any tax year beginning in 2019, 50% of such excess BIE is treated as BIE paid or accrued by the partner in 2020 and is not subject to the §163(j) limitation at the partner level. The 2020 Proposed Regulations provide that if a partner disposes of a partnership interest in the partnership’s 2019 or 2020 tax year, the 50% deduction provided for by the CARES Act is deductible by the partner and does not result in a basis increase immediately before the disposition.
Like partnerships, §163(j) is generally applied at the S corporation level. However, unlike partnerships, S corporations carry forward their excess BIE which becomes deductible by the S corporation in future tax years, rather than allocating excess BIE to its shareholders.
Self-charged lending transactions: The proposed self-charged interest rule described above would not apply to S corporations because excess BIE is carried forward by the S corporation instead of its shareholders.
Debt Financed Distributions: S corporations are covered by the same rules that apply to partnerships.
Short years: Guidance is provided for calculating the §163(j) limitation for an S corporation in short tax years. The Final Regulations modify Treas. Reg. §§ 1.1362-3(c), 1.1368-1(g)(2), and 1.1377-1(b)(3) to provide that a separate §163(j) limitation will apply when an S corporation has either an actual short tax year, or in the limited circumstances where the S corporation elects to treat its tax year as two separate tax years.
Exempt S corporations: S corporations are covered by the same rules that apply to partnerships.
Foreign Corporations/Effectively Connected Income (ECI)
The 2018 Proposed Regulations included rules related to the application of §163(j) for certain foreign persons with ECI, but the Final Regulations reserved on these rules and instead included this issue in the new 2020 Proposed Regulations (Treas. Reg. §1.163(j)-8), because the IRS needed more time to consider these issues. The 2020 Proposed Regulations are similar to the rules in the 2018 Proposed Regulations.
Under the 2020 Proposed Regulations, the §163(j) limitation will be applied to foreign persons with ECI. The definitions of ATI, BIE, and BII are modified to take into account only ECI items. There are specific rules applicable to partnerships with ECI, foreign corporations with ECI, and coordination rules for the branch profits tax.
The 2020 Proposed Regulations further provide that after determining whether BIE is attributable to ECI or non-ECI, if such BIE is disallowed in a particular year, the BIE retains its ECI or non-ECI character in later years. There are also ordering rules to determine the amount of excess BIE that is treated as paid or accrued in a subsequent year.
US Branch: The 2020 Proposed Regulations clarify that a US branch of a foreign person must first determine its interest expense under Treas. Reg. §1.882-5 interest allocation rules before applying §163(j) and the 2020 Proposed Regulations.
Partnerships: The 2020 Proposed Regulations provide rules for how a foreign partner determines how much of the partnership’s deductible BIE as well as the foreign partner’s allocations of ETI and excess BIE are considered to be attributable to ECI.
Foreign Corporations: For foreign corporations that have ECI, the 2020 Proposed Regulations provide specific rules for determining the portion of deductible and excess BIE.
Small Business Exemption
Taxpayers who qualify for the small business exemption are not subject to the §163(j) limitation. A taxpayer qualifies for the small business exemption if the taxpayer is not a tax shelter (as defined in §448(d)(3)) and meets the gross receipts test under §448(c).
Taxpayers meet the gross receipts test by having average annual gross receipts for the past three taxable years of $25 million or less, which is adjusted annually for inflation. For taxable years beginning in 2019 and 2020, the inflation adjusted average annual gross receipts amount is $26 million.
The IRS issued a set of 11 FAQs that provide additional clarification about how taxpayers should apply the aggregation rules in order to determine whether they meet the gross receipts test. Generally, taxpayers must include the gross receipts of certain related parties who would be treated as a single employer under the controlled group rules of §§52(a) or 52(b), the affiliated service group rules of §414(m), or under the rules of §414(o). These rules are designed to prevent taxpayers from circumventing the gross receipts test by subdividing into multiple related entities that each have gross receipts below the statutory limit.
For purposes of the small business exemption, all taxpayers are subject to the gross receipts test as if they were a corporation or a partnership, but should treat themselves as the type of entity that they actually are when applying §§52(a), 52(b), 414(m), and 414(o) of the Code.
The FAQs are divided into three parts and provide a general overview of the aggregation rules that apply under (i) §52(a) to corporations; (ii) §52(b) to partnerships, trusts, estates, corporations, or sole proprietorships; and (iii) §414(m) to organizations (defined in § 414(m)(6)(A) as a corporation, partnership, or other organization).
The 11 FAQS include the following questions:
- What aggregation rules apply when all entities considered for aggregation are corporations?
- What is a parent-subsidiary controlled group?
- What is a brother-sister controlled group?
- What is a combined group of corporations?
- How is ownership determined for purposes of a parent-subsidiary or brother-sister controlled group?
- What are the aggregation rules that apply to partnerships, trusts, estates, corporations, or sole proprietorships?
- How are the parent-subsidiary group rules different for partnerships, trusts, estates, corporations, or sole proprietorships?
- How are the brother-sister group rules different for trades or businesses that are partnerships, trusts, estates, corporations, or sole proprietorships?
- Are the rules that apply to a combined group under common control under §52(b) the same as the aggregation rules that apply to corporations under §52(a)?
- How is ownership determined for purposes of a parent-subsidiary or brother-sister group under common control?
- What are the aggregation rules that apply to affiliated service groups?
TPC will continue to monitor for additional §163(j) guidance and will provide additional insights as it is released. Meanwhile, please contact a member of your TPC engagement team if you have any questions or to learn more about how TPC can help.