What Is Excess Business Interest Expense and How Does It Affect Taxes?
Understand how excess business interest expense impacts tax liabilities and learn about calculation, allocation, and reporting procedures.
Understanding excess business interest expense is crucial for businesses managing their tax liability. This concept became significant under the Tax Cuts and Jobs Act (TCJA), which introduced limits on the deductibility of business interest expenses. These restrictions can influence taxable income, requiring businesses to navigate the rules carefully.
Efficient management of excess business interest expense can lead to tax savings. Understanding its implications helps businesses plan strategically and remain compliant with tax regulations.
Circumstances That Create Excess Business Interest Expense
Excess business interest expense arises when a company’s interest expenses surpass the deduction limit established by tax laws. Under the TCJA, this deduction is generally capped at 30% of the business’s adjusted taxable income (ATI). Businesses with high leverage or those in capital-intensive industries, such as real estate or manufacturing, are particularly susceptible as they often rely heavily on debt financing.
ATI is a critical factor in determining whether a business will face excess interest expenses. It is calculated by adding back certain deductions, such as depreciation, amortization, and interest expenses, to taxable income. However, starting in 2022, the calculation of ATI excludes depreciation and amortization, further restricting the deductible amount. This change has increased the likelihood of excess interest expenses for businesses with significant depreciation and amortization deductions.
Businesses in cyclical industries or those with fluctuating earnings may also encounter excess interest expenses during downturns. When earnings decline, the 30% cap becomes more restrictive, potentially resulting in higher disallowed interest. Strategic financial planning is essential to anticipate periods of reduced earnings and adjust debt levels accordingly.
Calculating the Disallowed Amount
To calculate the disallowed business interest expense, a company must first determine its total interest expense for the fiscal year. Next, it calculates the allowable deduction, typically 30% of ATI. ATI includes specific add-backs and exclusions as defined by the tax code.
The disallowed amount is the difference between the total interest expense and the allowable deduction. For example, if ATI permits $200,000 in deductible interest, but the total interest expense is $250,000, the $50,000 difference is disallowed. This disallowed amount can be carried forward to future tax years, where it may be deductible if the company’s financial circumstances allow for a higher deduction.
Allocation in Pass-Through Entities
Pass-through entities, such as partnerships and S corporations, face unique challenges when dealing with excess business interest expense. The Internal Revenue Code requires that disallowed interest expense be allocated at the entity level before being passed to individual owners. This allocation affects the tax liabilities of partners or shareholders, as they must include their share of disallowed interest on their personal tax returns.
The allocation is typically based on ownership percentages or profit-sharing agreements outlined in the entity’s operating agreement. For instance, if a partnership has $100,000 in disallowed interest and a partner owns 25%, they would report $25,000 of disallowed interest on their tax return. A clear and well-structured operating agreement is vital to ensure fairness and transparency in this process. Additionally, any allocated disallowed interest is carried forward at the individual level, not the entity level, adding complexity to compliance.
Carryforward Procedure
The carryforward mechanism allows businesses to apply disallowed interest expenses in future tax years. This flexibility can be advantageous for companies expecting growth, as higher future earnings may permit the deduction of previously disallowed amounts.
Proper documentation and reporting are critical to the carryforward process. Businesses must maintain detailed records to substantiate carryforward claims, as required by the IRS. Changes in ownership or structure, such as those governed by IRC Section 382, can impact carryforward eligibility, making careful planning essential. Companies should consult tax professionals to navigate these rules effectively.
Reporting on Tax Returns
Reporting excess business interest expense on tax returns requires precision. Corporations typically use Form 8990, “Limitation on Business Interest Expense Under Section 163(j),” to report both allowable and disallowed interest expenses.
Pass-through entities follow a different process, reporting on both the entity’s return and the individual owners’ returns. Partnerships use Form 1065, while S corporations file Form 1120-S. These entities also issue Schedule K-1s to partners or shareholders, detailing each individual’s share of the disallowed interest. Accurate reporting ensures compliance and minimizes the risk of penalties or audits. Maintaining detailed records and seeking professional advice can help businesses meet these reporting requirements efficiently.