EBIE Tax Rules: How Business Interest Deductions Are Impacted

Businesses that borrow money often rely on interest deductions to lower their taxable income. However, tax laws limit how much interest can be deducted, particularly under the rules governing Excess Business Interest Expense (EBIE). These restrictions impact cash flow and financial planning, making it essential for businesses to understand when and how they apply.

The way EBIE is calculated and carried forward affects different types of businesses. Understanding these rules helps companies optimize deductions while complying with tax regulations.

Criteria for Deducting Certain Types of Interest

The ability to deduct business interest depends on factors such as the type of loan, its purpose, and the entity’s financial position. The Internal Revenue Code (IRC) 163(j) limits interest deductions for businesses with high debt levels, generally capping them at 30% of adjusted taxable income (ATI). Exceptions exist for small businesses with average annual gross receipts under a certain threshold (currently $29 million for 2023) and for industries like real estate and farming.

For interest to be deductible, it must be both ordinary and necessary—meaning it directly relates to business operations. Interest on loans used to acquire assets, fund operations, or refinance debt typically qualifies. However, personal loans, capitalized interest, and certain related-party transactions may not be deductible. The IRS closely examines loans between related entities to prevent tax avoidance, requiring that interest rates reflect market conditions.

Some businesses, such as those in real estate and farming, can opt out of the 163(j) limitation, but this comes with trade-offs. Real estate businesses making this election must use the Alternative Depreciation System (ADS), which extends the depreciation period for certain assets, reducing annual deductions. This decision affects long-term tax liabilities and cash flow.

Calculation of Disallowed Amount

The limitation under IRC 163(j) compares total business interest expense to the allowable deduction threshold—30% of ATI, plus any business interest income and floor plan financing interest, if applicable. Any interest expense exceeding this limit is disallowed and must be carried forward.

For example, a company with $5 million in ATI and $2 million in total business interest expense can deduct up to 30% of ATI, or $1.5 million. The remaining $500,000 is disallowed for the current year and classified as EBIE, which may be carried forward under specific rules.

The treatment of disallowed interest depends on the business structure. In partnerships, the excess amount is passed down to individual partners, who must track and apply their share of EBIE separately in future tax years. In contrast, S corporations retain the disallowed amount within the entity, applying it when the business generates sufficient taxable income.

Applying Disallowed Amount in Future Tax Years

When business interest expense exceeds the deductible limit, the unused portion is carried forward indefinitely under IRC 163(j). Businesses can apply it in later years when they generate enough taxable income.

Tracking disallowed interest requires detailed record-keeping. Businesses must maintain schedules documenting the amount carried forward, the year it originated, and how much has been applied in each subsequent year. This is particularly important for companies with fluctuating earnings, as periods of high profitability provide opportunities to utilize previously disallowed amounts.

Strategic planning helps businesses maximize carryforwards. Companies anticipating growth may delay certain deductions to align with future periods of higher taxable income. Mergers and acquisitions introduce additional considerations, as acquiring a business with significant disallowed interest carryforwards may provide tax advantages. However, limitations under IRC 382 could restrict usage if ownership changes significantly.

Effects on Pass-Through Entities

Pass-through entities, such as partnerships and S corporations, face unique challenges with EBIE due to how tax attributes flow through to owners. Unlike C corporations, which handle disallowed interest at the entity level, pass-through entities must allocate EBIE to individual partners or shareholders.

For partnerships, EBIE is assigned to each partner based on their distributive share. However, partners cannot deduct their allocated portion unless the partnership generates sufficient excess taxable income (ETI) in later years. S corporations handle disallowed interest differently, keeping it at the corporate level until the business generates enough taxable income to absorb the deferred deduction, preventing direct allocation to shareholders.

Adjusted Taxable Income Considerations

Adjusted taxable income (ATI) plays a key role in determining the business interest deduction limit under IRC 163(j). Since the deduction cap is based on a percentage of ATI, understanding what is included or excluded from this figure is necessary for businesses managing interest expense.

Before 2022, businesses could add back depreciation, amortization, and depletion when calculating ATI, increasing the deduction limit. However, starting in 2022, these adjustments were removed, reducing ATI and lowering the amount of deductible interest. This change has significantly impacted capital-intensive industries like manufacturing and real estate, where depreciation expenses are substantial. Businesses in these sectors now face tighter restrictions on interest deductions, requiring them to reassess financing strategies, such as shifting towards equity financing or restructuring debt to minimize non-deductible interest.