What Is the 30 Percent Rule for Business Interest?

The 30 percent rule, formally known as the business interest expense limitation under Internal Revenue Code Section 163(j), significantly affects how businesses deduct interest on their debt. Introduced by the Tax Cuts and Jobs Act of 2017, this rule generally restricts the amount of business interest expense a taxpayer can deduct in a given tax year. It was implemented to broaden the tax base and discourage excessive debt financing among businesses. The limitation aims to ensure that highly leveraged businesses do not disproportionately reduce their taxable income through interest deductions.

Understanding the Business Interest Expense Limitation

The core of the 30 percent rule involves defining “business interest expense” (BIE) and “adjusted taxable income” (ATI). Business interest expense refers to any interest paid or accrued on indebtedness properly allocable to a trade or business. This includes interest on debt used to fund operations, acquire equipment, purchase inventory, or finance expansions. However, it specifically excludes investment interest and personal interest, focusing solely on interest related to business activities.

Business interest income, which can offset BIE, is interest includible in gross income properly allocable to a non-excepted trade or business. Another component that can increase the deduction limit is floor plan financing interest, which is interest on debt used to finance the acquisition of motor vehicles held for sale or lease. The total deductible amount of business interest expense is limited to the sum of business interest income, floor plan financing interest, and 30 percent of the taxpayer’s adjusted taxable income (ATI).

Adjusted taxable income (ATI) serves as the base for calculating this 30 percent limit. ATI is generally derived from a taxpayer’s tentative taxable income, which is taxable income before considering the Section 163(j) limit itself. Specific adjustments are made to this tentative taxable income to arrive at ATI. These adjustments include adding back non-business income or deductions, business interest expense (excluding carryforwards), net operating loss (NOL) deductions, and the qualified business income (QBI) deduction.

A notable change impacting ATI calculation occurred for tax years beginning after December 31, 2021. For these years, deductions for depreciation, amortization, and depletion are no longer added back when computing ATI. This change can result in a lower ATI, potentially making the business interest limitation more restrictive for many businesses.

Identifying Applicable Taxpayers

The business interest expense limitation broadly applies to all taxpayers, encompassing various legal structures such as C corporations, S corporations, partnerships, and sole proprietorships. However, a significant “small business exemption” exists, which exempts many smaller entities from this limitation. A taxpayer qualifies for this exemption if their average annual gross receipts for the three prior tax years do not exceed a specific threshold. For tax years beginning in 2023, this threshold was $29 million, increasing to $30 million for 2024, and $31 million for 2025.

To determine if a business meets this gross receipts test, the average is calculated based on the three preceding tax years. Aggregation rules apply, meaning the gross receipts of certain related entities must be combined to prevent businesses from artificially separating to qualify for the exemption. This small business exemption is generally not available to tax shelters or syndicates.

Beyond the small business exemption, certain types of businesses or activities are specifically exempt from the Section 163(j) limitation. These include certain regulated public utilities and specific real property trades or businesses. Farming businesses also have an option to elect out of the limitation. Businesses that elect out, such as electing real property trades or businesses and farming businesses, must use the Alternative Depreciation System (ADS) for certain depreciable property, which generally results in longer recovery periods and slower depreciation deductions.

Computation of the Deduction Limit

Calculating the deductible amount of business interest expense involves a series of steps. The first step requires determining the total business interest expense (BIE) for the current tax year, which includes all interest paid or accrued on debt properly allocable to the business. This amount is identified before applying any limitations.

The second step involves calculating the adjusted taxable income (ATI). This calculation begins with the taxpayer’s tentative taxable income, which is essentially taxable income before considering the interest limitation itself. To this amount, specific adjustments are made: business interest income, floor plan financing interest, net operating loss (NOL) deductions, and the qualified business income (QBI) deduction are added back.

Once ATI is determined, the third step is to apply the 30% limit. This is done by multiplying the calculated ATI by 30%. This result establishes the primary component of the maximum deductible amount. The fourth step compares the actual Business Interest Expense (from Step 1) to the calculated limit (from Step 3), along with any business interest income and floor plan financing interest.

The final step determines the deductible and disallowed amounts. The deductible business interest expense for the year is the sum of business interest income, floor plan financing interest, and the lesser of the actual BIE or 30% of ATI. Any amount of business interest expense that exceeds this calculated limit is the disallowed amount.

For example, consider a company with $100,000 in business interest expense, $10,000 in business interest income, and $0 in floor plan financing interest. If its ATI is $200,000, the 30% ATI limit is $60,000 ($200,000 x 30%). The maximum deductible interest would be $10,000 (business interest income) + $0 (floor plan interest) + $60,000 (30% of ATI) = $70,000. Since the actual business interest expense is $100,000, only $70,000 is deductible in the current year, and the remaining $30,000 is disallowed.

Managing Disallowed Business Interest Expense

When business interest expense is disallowed due to the 30 percent limitation, it is not permanently lost. Instead, the disallowed amount can generally be carried forward indefinitely to future tax years. This means that a business can potentially deduct these amounts in subsequent years, subject to the limitation in those future years.

For C corporations, disallowed business interest expense carryforwards are treated as business interest expense paid or accrued in the succeeding tax year. These carried-forward amounts are then subject to the 30% ATI limitation in that carryforward year, along with any current-year business interest expense. Special rules apply to corporate acquisitions, where disallowed interest expense carryforwards may be subject to limitations under Sections 381 and 382.

Pass-through entities, such as partnerships and S corporations, have specific rules for managing disallowed business interest. For partnerships, the limitation is applied at the entity level. Any business interest expense disallowed at the partnership level is not carried forward by the partnership itself. Instead, it is allocated to each partner as “excess business interest expense” (EBIE). Partners carry forward their share of EBIE. A partner can then deduct their share of EBIE in future years to the extent they are allocated “excess taxable income” or “excess business interest income” from the same partnership.

For S corporations, the Section 163(j) limitation is also applied at the entity level. However, unlike partnerships, any disallowed business interest expense of an S corporation is carried over at the S corporation level to succeeding tax years. It is not allocated to the shareholders. The S corporation then applies the carried-over amount against its own future ATI capacity.