IRS releases final regulations on deductibility of interest

The “Tax Cuts and Jobs Act” (the “TCJA”) enacted into law in December 2017 significantly revised the rules regarding the deductibility of interest attributable to a trade or business.[1] The Internal Revenue Service (“IRS”) has issued several sets of both proposed and final regulations interpreting many parts of the law, but also left many questions unanswered. In January 2021 the IRS issued additional final regulations (“2021 Final Regulations”) that address subjects covered in the proposed regulations issued in July 2020 but do not address several issues around the more complex partnership and international items.

The 2021 Final Regulations will be effective 60 days after the date they are published in the Federal Register and are generally applicable to taxable years beginning on or after such date.  However, taxpayers may apply the Final Regulations retroactively, subject to certain requirements.   It should be noted than the Biden administration may review and modify these regulations before they are published.

General rule

The deductibility of interest incurred in the operation of a trade or business is limited by the provisions of Code Section 163(j) (the “163(j) limitation”).  Deduction is limited to the sum of (i) the business interest income of the taxpayer; (ii) 30% (50% for 2019 and 2020 taxable years) of its “adjusted taxable income;”[2] and (iii) the taxpayer’s floor financing interest expense.

The 163(j) limitation applies to all interest expenses of all taxpayers, however only corporate taxpayers may elect to increase the amount of the limitation to 50% for 2019.  Taxpayers may elect to use 2019 adjusted taxable income (“ATI”), in lieu of their 2020 ATI, for the 2020 calculations. Such an election may be made on a partnership-by-partnership basis

Any excess business interest expense (i.e., not deductible due to this limitation) may be carried forward indefinitely. This limitation applies, as well, to interest deductions that were suspended under prior law and carried forward to years beginning on or after January 1, 2018.

ATI is computed without including interest income or deductions for interest expense, net operating losses (“NOLs”), the special 20% deduction for pass-through entities, and depreciation and amortization.  The amount of any depreciation, amortization or depletion that is capitalized into inventory under section 263A during taxable years beginning before January 2022 is added back to when calculating ATI for that taxable year.  For taxable years beginning in 2022 and after, ATI is also reduced by depreciation and amortization.

Final regulations

On the sale or disposition of a property, the 2021 Final Regulations make clear that the “lesser of” standard may be used in determining “negative” adjustments when computing ATI. For example, ATI may be reduced (thereby reducing the amount of interest that can be deducted) by the lesser of gain on sale of an asset or the depreciation claimed with respect to the asset.   On the other hand, any “unused” benefit of a positive adjustment that did not result in an increase in the amount of deducible interest may be added back to ATI, thereby increasing the amount of deductible interest.

Consolidated C Corporations – The 2021 Final Regulations clarify that gain on a sale or other disposition taken into account by a consolidated group of corporations includes any gain attributable to an intercompany transaction.  The 2021 Final Regulations also clarify that a non-taxable transfer of a partnership interest between members of a consolidated group that does not result in a termination of the partnership will be treated as a “disposition” for purposes of the gain element in the “lesser of” standard.

Partnerships – The Final Regulations adopt the rule of the proposed regulations that partnerships bifurcate interest income and expense (and all other items of income and deduction), allocable to activities that are per se non-passive between partners that materially participate and partners that are passive investors.  The partnership’s 163(j) limitation would be based solely on items attributable to partners that materially participate, and all items properly allocable to passive investors would be treated as items from investment activity and subject to those partners’ investment interest limitations.  The 2021 Final Regulations contain a transition rule that permits partners to rely on a statement in the preamble to proposed regulations issued in 2018.

The 2021 Final Regulations also adopt the rules for “self-charged” lending transactions between a partner and partnership contained in proposed regulations.  If a lending partner is allocated excess business interest expense from the borrowing partnership and also has interest income attributable to the self-charged loan, the lending partner treats such interest income as an allocation of excess business interest income to the extent of the lending partner’s allocation of excess business interest expense from the borrowing partnership in the same taxable year.  The IRS is continuing to study situations in which corporate partners are members of the same consolidated corporate group as the lender, and also where the lender is subject to the unrelated business income tax rules.

S Corporations – The proposed regulations had asked for comments on whether a rule requiring bifurcation of interest income and expense (along with all other items of income and expense) between shareholders that materially participate and shareholders that are passive investors (much like the partnership rule discussed above) would violate the prohibition on a second class of stock.  Having received no comments, the IRS did not include any such rule in the 2021 Final Regulations.

Issues that the IRS has not yet addressed include:

  • Treatment of interest expense from debt-financed distributions from partnerships
  • Partnership and partner basis adjustments upon partner dispositions
  • Treatment of excess business interest expense in tiered partnership structures
  • Treatment of a US shareholder’s ATI when a CFC group election has been made
  • Treatment of foreign persons with effectively connected income

Mazars’ Insight 

The 2021 Final Regulations provide welcome guidance in addressing outstanding issues regarding the deductibility of interest under Section 163(j).  Clarification that the “lesser of” standard may be elected by taxpayers in computing ATI is particularly helpful, as is the adoption of the self-charged rules for partner-to-partnership lending transactions.  

Please contact your Mazars USA LLP professional for additional information.

[1] This is separate and apart from limitations on deductibility that apply to investment interest and qualified residence interest.

[1] The 50% increased limitation is contained in the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”), enacted in March 2020.

Published on January 22, 2021

The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.