How to Make the Section 163j Election

Internal Revenue Code Section 163(j) establishes a rule that can restrict the amount of business interest expense a company is permitted to deduct on its annual tax return. This provision was broadened by the Tax Cuts and Jobs Act of 2017, impacting a wide range of businesses. Some businesses may be automatically exempt, while others in specific industries can formally elect out of the limitation, though not without consequences. This article focuses on the elections taxpayers can make to manage or bypass this interest deduction limitation.

Understanding the Business Interest Limitation

The business interest limitation under Section 163(j) caps the deductibility of business interest expenses. A taxpayer’s deduction for business interest expense is limited to the sum of its business interest income, 30% of its adjusted taxable income (ATI), and its floor plan financing interest. The rule applies to most taxpayers, including corporations, partnerships, and individuals who have business interest expenses.

Business interest expense is any interest paid or accrued on debt that is allocable to a trade or business, including any amount treated as interest for tax purposes. Business interest income includes all interest income that is includible in a taxpayer’s gross income for the year and is allocable to a trade or business.

Adjusted Taxable Income (ATI) is a central element of the formula, calculated by making specific adjustments to a business’s tentative taxable income. For tax years beginning after January 1, 2022, ATI is computed without regard to any business interest income or expense, net operating loss deductions, and deductions for qualified business income. Previously, deductions for depreciation, amortization, and depletion were also added back, resulting in a higher ATI. This change makes the limitation more restrictive for many businesses.

Any business interest expense that is not deductible in a given year is not permanently lost but is carried forward to the following tax year. This carryforward is treated as business interest expense paid or accrued in that succeeding year, subject to that year’s limitation. This allows businesses to potentially deduct the interest in future years when they have sufficient ATI or business interest income.

The Small Business Exemption

A primary exception to the Section 163(j) limitation is an automatic exemption for small businesses that meet a gross receipts test. This exemption is not an election and is not available to tax shelters, which can include partnerships or S corporations that allocate over 35% of losses to limited partners.

The gross receipts test is met if a taxpayer’s average annual gross receipts for the three-prior-tax-year period do not exceed an inflation-adjusted threshold. For tax year 2024, the threshold is $30 million, and it is projected to be $31 million for 2025.

For businesses that are part of a controlled or affiliated group, the gross receipts of all related entities are combined to apply the test. These aggregation rules prevent businesses from splitting into multiple smaller entities to circumvent the limitation.

Qualification is determined annually based on the gross receipts test. A business could be subject to the limitation in one year but exempt in the next if its average gross receipts fall below the threshold.

Electing Out as a Real Property or Farming Business

An “electing real property trade or business” and an “electing farming business” can make an irrevocable election to be exempt from the Section 163(j) limitation. Making this election allows the business to deduct 100% of its business interest expense, which can be advantageous for capital-intensive businesses that rely on debt financing.

A real property trade or business is any trade or business involved in real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage. A farming business includes operations such as cultivating land, raising or harvesting agricultural or horticultural commodities, and operating a nursery or sod farm.

The trade-off for making this election is that the business becomes ineligible for bonus depreciation on certain assets and must use the Alternative Depreciation System (ADS). ADS requires longer recovery periods for assets compared to the standard Modified Accelerated Cost Recovery System (MACRS), resulting in smaller annual depreciation deductions.

For an electing real property trade or business, this ADS treatment applies to nonresidential real property, residential rental property, and qualified improvement property. For an electing farming business, ADS must be used for any property with a MACRS recovery period of 10 years or more. The benefit of full interest deductibility must be weighed against the impact of reduced depreciation deductions.

Required Information and Statement for Making an Election

Before making an election, a business must analyze financial data and projections to model the long-term consequences. This data should include projected business interest expense and forecasts of adjusted taxable income to determine if the business is likely to be constrained by the 30% ATI limitation.

The analysis must also compare depreciation deductions under both the standard MACRS and mandatory ADS rules. This comparison will quantify the annual reduction in depreciation deductions that would result from making the election, allowing the business to calculate the net effect on taxable income.

Once the decision to elect out is made, the taxpayer must prepare a formal election statement. According to IRS regulations, this statement must include:

• The taxpayer’s name, address, and taxpayer identification number (TIN).
• A description of the trade or business sufficient to show it qualifies for the election.
• A declaration that the taxpayer is making an election to be exempt from the interest limitation.

How to File the Election

The formal election statement must be attached to the taxpayer’s timely filed federal income tax return for the first tax year in which the election is to be effective. The election is made on an entity-by-entity basis.

Submitting the tax return with the attached statement finalizes the election, and no separate form is required. The election becomes part of the official tax record for that year. For example, a business electing for the 2025 tax year would attach the statement to its 2025 tax return filed in 2026.

Once made, the election is irrevocable and binding for all subsequent tax years, with no provision for revoking it if circumstances change. The business will be permanently classified as an electing real property or farming business.

The business interest limitation was enacted as part of the Tax Cuts and Jobs Act of 2017, and its provisions are scheduled to expire at the end of 2025. Unless Congress acts to extend it, the rules for interest deductibility may change for tax years after 2025. This adds another layer of complexity to the decision-making process.