What Is the Business Interest Expense Limitation and How Does It Work?
Learn how the business interest expense limitation affects deductions, which entities qualify, and how disallowed amounts can be carried forward.
Businesses that take on debt often deduct interest expenses to reduce taxable income. However, tax laws limit these deductions to prevent excessive borrowing for tax benefits. These restrictions primarily affect larger businesses with significant interest costs.
Qualifying Entities and Thresholds
The business interest expense limitation applies to many entities, but not all. A key factor is the gross receipts threshold. Under Internal Revenue Code Section 163(j), businesses with average annual gross receipts of $29 million or less (for tax years beginning in 2024, adjusted annually for inflation) are generally exempt. This exemption allows smaller businesses to deduct interest expenses without restriction.
For businesses above this threshold, the limitation applies to corporations, partnerships, and sole proprietorships, though certain industries are excluded. Real property trades or businesses, such as real estate development, construction, and rental property operations, can opt out if they use the Alternative Depreciation System (ADS) for real property assets. Farming businesses can also elect out by applying ADS to farming-related property. These elections are irrevocable, requiring businesses to consider long-term tax implications.
Calculating Adjusted Taxable Income
The deductible amount of business interest expense is based on Adjusted Taxable Income (ATI), which modifies taxable income by excluding certain items. Before 2022, ATI resembled EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), but under current rules, depreciation, amortization, and depletion are no longer added back. This change makes ATI more restrictive, resembling EBIT (Earnings Before Interest and Taxes), which reduces the deductible interest expense.
For example, a company with $10 million in taxable income, $2 million in interest expense, $3 million in depreciation, and $1 million in amortization had an ATI of $16 million under pre-2022 rules ($10M + $3M + $1M + $2M). Under current rules, ATI is $13 million ($10M + $2M), lowering the deductible interest expense cap. Since the limitation restricts deductions to 30% of ATI, the allowable deduction drops from $4.8 million (30% of $16M) to $3.9 million (30% of $13M). Businesses with high depreciation costs, such as manufacturers, are particularly affected.
Carryforward of Disallowed Deductions
If a business’s interest expense exceeds the allowable deduction, the excess carries forward indefinitely. This allows companies to apply it in future years when taxable income increases or financing costs decrease.
For corporations, disallowed interest expense remains at the entity level until it can be deducted. Partnerships handle it differently—any disallowed interest is passed to partners, who must track their individual carryforwards. Partners can only use their share of the carryforward when the partnership generates sufficient excess taxable income in future years, adding complexity to tax planning.
Mergers and acquisitions also impact carryforwards. If a company with substantial carried-forward interest expense is acquired, Section 382 may limit the acquiring entity’s ability to use those deductions. Businesses involved in M&A must assess how these tax attributes transfer and whether they remain usable post-transaction.
Exemptions for Certain Small Businesses
The gross receipts test exempts many small businesses from the limitation, but additional carve-outs exist based on industry and structure. Certain service-based businesses, such as professional service firms, may avoid the limitation if they operate as pass-through entities without significant financing costs. These businesses generate income primarily through labor rather than capital-intensive operations, making them less affected by interest expense restrictions.
S corporations also navigate these rules differently. Unlike C corporations, which retain disallowed interest deductions at the entity level, S corporations allocate excess interest to shareholders, who then apply the limitation individually. This structure provides planning opportunities for business owners managing multiple income streams, allowing them to optimize deductions across different tax filings.