How the 163(j) Limitation Affects Business Interest Deductions

The IRS Section 163(j) limitation restricts the amount of business interest expense certain taxpayers can deduct, potentially increasing taxable income. Introduced as part of the Tax Cuts and Jobs Act (TCJA) and later modified by the CARES Act, this rule is a key factor for businesses with significant financing costs.

Understanding its application is essential for tax planning and compliance.

Eligible Entities

Section 163(j) applies to corporations, partnerships, and sole proprietorships, requiring them to assess whether their interest expense deductions are capped. However, small businesses that meet the gross receipts test may be exempt.

For tax years beginning in 2024, a business qualifies as small if its average annual gross receipts for the prior three years do not exceed $29 million. This threshold is adjusted annually for inflation. Businesses under common control must apply aggregation rules, which could push total receipts above the exemption limit.

Real property and farming businesses can elect out of the limitation but must use the Alternative Depreciation System (ADS) for certain assets. ADS extends depreciation periods, affecting cash flow and long-term tax planning. Businesses must weigh the benefit of full interest expense deductions against slower asset depreciation.

Calculating the Limitation

The Section 163(j) limitation caps deductible business interest expense at 30% of adjusted taxable income (ATI), plus business interest income and floor plan financing interest. ATI is a modified version of taxable income that, before 2022, excluded depreciation, amortization, and depletion. Starting in 2022, these items are no longer added back, reducing the ATI base and potentially limiting deductions further.

For businesses with fluctuating earnings, the impact varies. A company with high ATI in one year may deduct more interest expense, while a decline in profitability the following year could restrict deductions. This is particularly relevant for industries like manufacturing and retail, where earnings can be volatile. Businesses with significant debt financing may need to reassess their capital structure to mitigate the effects of a lower deduction cap.

Disallowed interest carries forward indefinitely and can be deducted in future years, subject to the same 30% ATI cap. Businesses must maintain detailed records to track these carryforwards and ensure proper utilization.

Potential Exemptions

Certain businesses can avoid the Section 163(j) limitation by qualifying for specific exemptions.

Real Property and Farming Businesses
Real estate businesses, including development, construction, rental, leasing, and property management, can elect out of the limitation if they use ADS for certain assets. This allows full deduction of interest expense but extends depreciation periods, potentially increasing taxable income over time.

Farming businesses can also elect out in exchange for using ADS on farm buildings and equipment. This slows depreciation, which may lead to higher taxable income in the short term. However, for farms with stable financing needs, deducting all interest expense can provide long-term tax benefits.

Floor Plan Financing
Businesses engaged in floor plan financing, such as automobile dealerships, can deduct all interest expense related to financing motor vehicles, boats, or farm machinery held for sale. However, using this exemption prevents claiming bonus depreciation, which may impact overall tax strategy.

Allocations in Partnerships

Partnerships face unique challenges under Section 163(j) because interest expense is allocated among partners. The limitation applies at the partnership level first, and any disallowed interest is passed to partners as excess business interest expense (EBIE).

Partners cannot immediately deduct EBIE. Instead, it carries forward at the individual level and can only be deducted in future years when the partnership generates excess taxable income (ETI) or excess business interest income (EBII). Timing mismatches can occur, where a partner accumulates EBIE but lacks sufficient ETI in later years to deduct it.

If a partner exits the partnership before utilizing their EBIE, they generally forfeit the deduction. This is a concern for investors in private equity or real estate funds where ownership changes frequently.

Carryforward Implications

When business interest expense exceeds the allowable deduction, the disallowed portion carries forward indefinitely. The timing of when these deductions can be used depends on fluctuations in earnings, making long-term tax planning more complex.

For corporations, carried-forward interest expense remains at the entity level and is subject to the same 30% ATI limitation in future years. Partnerships allocate excess business interest expense (EBIE) to individual partners, who must track it separately. If a partner leaves the partnership before using their EBIE, they typically lose the deduction.

Businesses must carefully manage financing strategies to ensure they can eventually benefit from carried-forward deductions.

Recordkeeping Requirements

Accurate documentation is necessary to comply with Section 163(j) and track disallowed interest expense for future use. Businesses must maintain records of ATI calculations, interest expense deductions, and carryforward amounts. Errors in recordkeeping can lead to lost deductions or compliance issues during an IRS audit.

For partnerships, each partner must track their allocated EBIE separately. This requires coordination between the partnership and its partners to ensure proper reporting in individual tax filings. Taxpayers should also retain documentation supporting any elections made to opt out of the limitation.

Filing Adjustments

Businesses subject to Section 163(j) must adjust their tax filings to reflect the limitation’s impact. This includes modifying taxable income calculations, adjusting interest expense deductions, and properly reporting carryforward amounts in future years. Given the complexity of these adjustments, tax software and professional guidance are often necessary.

For partnerships, Schedule K-1 must accurately reflect each partner’s share of excess business interest expense. If a partnership generates excess taxable income in a later year, it must properly allocate this income to partners so they can deduct previously disallowed interest. Corporations must ensure that carryforward interest is correctly incorporated into their financial statements, particularly for public companies subject to SEC reporting requirements.