Is Your 163(j) Arrangement an Abusive Tax Shelter?

Section 163(j) of the tax code limits the amount of business interest expense a company can deduct each year. Recently, the Internal Revenue Service (IRS) has increased its scrutiny of transactions designed to improperly avoid this limitation. The IRS considers these arrangements to be abusive tax shelters, and businesses involved can face significant penalties. Understanding the rules of Section 163(j) and the features of these targeted transactions is necessary for compliance.

What is Section 163(j)?

Section 163(j) was significantly expanded by the Tax Cuts and Jobs Act of 2017. The rule limits a taxpayer’s deduction for net business interest expense for the year. The deduction is capped at the sum of the taxpayer’s business interest income, floor plan financing interest, and a percentage of its adjusted taxable income (ATI). For most businesses, the limitation is primarily based on 30% of their ATI.

Any business interest expense that cannot be deducted in the current year due to this limitation can generally be carried forward to future tax years indefinitely. The purpose of this rule is to discourage businesses from taking on excessive debt to finance their operations and reduce their taxable income through large interest deductions.

The IRS’s Focus on Abusive 163(j) Arrangements

The IRS has identified that some taxpayers are engaging in structured arrangements to circumvent the Section 163(j) limitation. These transactions are designed to create significant interest deductions without the business having a genuine economic reason for the underlying debt. In response, the IRS issued Notice 2023-80, which designates certain 163(j) arrangements as “listed transactions.”

A listed transaction is a type of reportable transaction that the IRS has determined to be a tax avoidance scheme. This designation imposes specific disclosure requirements on taxpayers who participate in them and on advisors who promote them. The notice signals the IRS’s intent to challenge the purported tax benefits of these arrangements and to impose penalties on those involved.

What Constitutes an Abusive Tax Shelter?

An abusive tax shelter is a transaction or series of transactions designed to generate tax benefits that are inconsistent with the intent of the law. These arrangements often lack economic substance, meaning they do not have a legitimate business purpose apart from tax avoidance. They may involve a series of predictable steps that result in a tax outcome the law was not intended to allow.

The IRS looks for transactions that use formal compliance with a tax rule to achieve results that are contrary to the rule’s purpose. In the context of Section 163(j), this involves creating artificial interest expense or inflating ATI to increase the interest deduction limit.

Identifying a Potentially Abusive 163(j) Arrangement

The IRS has identified several red flags that may indicate an abusive 163(j) arrangement. These transactions often involve related parties and lack a genuine business purpose beyond creating a tax benefit. The arrangement may also use circular financing, where funds are loaned and then quickly returned to the lender or a related entity. The IRS also scrutinizes transactions that generate a large interest deduction for a U.S. business without the lender paying U.S. tax on the corresponding interest income.

Other common indicators of a potentially abusive arrangement include:

• A U.S. borrower is closely related to a foreign lender who is not subject to significant U.S. tax on the interest income.
• A special purpose entity (SPE) is created specifically to facilitate the interest deduction.
• The debt involved is issued with an artificially high interest rate.
• The debt is treated as equity for some purposes but as debt for generating interest deductions.

The Role of Related Parties and Special Purpose Entities (SPEs)

Many of the targeted arrangements involve transactions between related domestic and foreign parties. A common structure involves a foreign parent company or affiliate, which is not subject to significant U.S. tax, lending money to its U.S. subsidiary. The goal is for the U.S. subsidiary to claim a large interest deduction, while the foreign entity recognizes interest income in a low-tax or no-tax jurisdiction.

Special purpose entities are frequently used to facilitate these transactions. An SPE might be inserted between the lender and the borrower to obscure the related-party nature of the loan or to create an instrument that appears to be debt for tax purposes but has features of equity. These entities often have no employees and conduct no business activities other than those required to enable the tax shelter.

Reportable Transactions and Disclosure Requirements

Because the IRS has designated these arrangements as listed transactions, taxpayers who have participated in them have strict disclosure obligations. Participation requires filing Form 8886, Reportable Transaction Disclosure Statement, with their tax return for each year of participation. This form alerts the IRS that the taxpayer has engaged in a transaction that the agency has identified as potentially abusive.

Material advisors, such as accountants or lawyers who provide assistance or advice regarding these transactions, also have disclosure requirements. Failure to comply with these disclosure rules carries its own set of significant penalties, separate from any penalties related to the underpayment of tax.

Penalties for Non-Compliance

Taxpayers who are found to have participated in an abusive 163(j) arrangement face multiple penalties. The primary consequence is the disallowance of the improper interest expense deduction, which results in a higher tax liability plus interest on the underpayment.

Additionally, substantial financial penalties can be imposed. A penalty under Internal Revenue Code Section 6662A may apply to any understatement of tax attributable to a listed transaction. For failure to disclose a listed transaction on Form 8886, penalties under Internal Revenue Code Section 6707A can be severe, reaching up to $200,000 for a corporation. These penalties are strict and difficult to have abated.

How to Protect Your Business

Businesses should review their financing structures, especially those involving related parties or foreign entities. If a transaction seems designed primarily to create a tax deduction, it warrants a closer look. Ensure that all debt arrangements have a clear business purpose and that the terms, such as the interest rate, are commercially reasonable.

Maintaining thorough documentation that supports the business purpose and economic substance of all financing transactions is a defense against an IRS challenge. This includes loan agreements, board meeting minutes, and evidence of how the borrowed funds were used in the business. Consulting with a qualified tax professional who is independent of the transaction’s promoter can provide an objective assessment of the potential risks.