Tax planning as interest rates climb and interest expense deductions decrease

Executive summary

A perfect storm of inflation, rising interest costs, and an unfavorable change in tax rules governing deductions of interest expense is reducing the deductibility of interest for businesses. In fact, some businesses that do not realize the interest limitation rule changed have been surprised when doing tax cash flow planning.

Specifically, the tax code section 163(j) limitation on deductible interest expense that previously applied to an EBITDA-like base shifted in 2022 to a smaller, EBIT-like base. The resulting inability to increase the base through add-backs of items such as depreciation may affect many capital-intensive businesses, including private equity-backed companies.

However, taxpayers might find relief through planning opportunities and by modeling to manage cash flows.

Inflation and rising interest costs

Businesses are facing increasing costs of all kinds during 2022, as the United States experiences its highest inflation rate in 40 years and interest rates rise.

For example, the secured overnight financing rate increased from 0.05% to 0.70% from March 15 to June 15. SOFR is a widely used interest rate index, replacing the London interbank offered rate, or LIBOR, in many variable rate debt instruments, such as syndicated bank debt. As a result, many businesses are seeing increased interest costs during 2022.

Declining tax deductions for interest expense

Meanwhile, the broad limitation on business interest expense, or BIE, deductions, also known as the section 163(j) limitation, has become more stringent. The add-back for depreciation, depletion and amortization previously allowed in the section 163(j) computation no longer applies for tax years beginning after Dec. 31, 2021, due to an automatic change to the tax code that Congress scheduled back in 2017.

As a result, businesses are experiencing a reduced ability to deduct BIE. Their ability to plan around this stringent rule depends on factors such as what industry the business operates in and the taxpayer’s preferred financing methods.

Section 163(j) business interest limitation

Section 163(j) generally limits a taxpayer’s BIE deductions to the sum of the following:

• 30% (50% for some years) of the taxpayer’s adjusted taxable income, or ATI
• Its business interest income
• Floor plan financing interest, which generally is interest expense on certain debt funding vehicle inventory purchases.

A taxpayer cannot deduct the portion of its BIE that exceeds the limitation for a given year. Instead, the taxpayer may carry this so-called excess BIE forward indefinitely, testing its deductibility each year under section 163(j). If the taxpayer is a partnership, however, it does not carry the excess BIE forward. Instead, the excess BIE is allocated to the partners of the partnership, and the partners may carry it forward indefinitely.

These rules apply broadly to all taxpayers, with limited exceptions for businesses in specific industries. For example, certain farming and real estate businesses are excepted from section 163(j) on an elective basis. In addition, certain public utility businesses are exempted from section 163(j) on a mandatory (non-elective) basis.

There also is a small-business exemption from section 163(j) for a business whose gross receipts, together with gross receipts of certain related parties, do not exceed a threshold on a three-year-average basis (the threshold is $27 million for 2022 and is indexed for inflation).

Section 163(j) ATI computations now similar to EBIT instead of EBITDA

As noted above, a taxpayer’s limitation generally is based on 30% of its ATI. In common business parlance, ATI approximated earnings before interest, income tax, depreciation and amortization—EBITDA—for tax years beginning prior to Jan. 1, 2022; however, it changed to an approximation of earnings before only interest and income tax—EBIT—for tax years beginning after Dec. 31, 2021. (Note that ATI is computed under federal income tax rules, while EBITDA and EBIT are not.)

In other words, the so-called add-back of depreciation, depletion and amortization in computing ATI no longer applies for the 2022 calendar year (or other tax years beginning after December 2021). Applying the EBIT-like ATI computation results in lower ATI, a lower limitation, and lesser allowed tax deductions for interest expense for many businesses.

Planning strategies to counteract a loss of tax deductions

Businesses have a number of ways to improve their tax position in the face of more stringent interest limitation deductions. Which strategies are available to a given business will depend on factors such as the industry the business operates in and the business’s preferred financing methods. Strategies that may be worth considering include:

1. Employing preferred equity financing rather than debt financing

Because investors’ preferences are a major factor in choosing financing methods, businesses’ ability to switch to preferred equity financing varies widely.

2. Sale-leaseback structures

A sale-leaseback often can be treated as a sale for tax purposes, even if it’s treated as financing (i.e., as debt) under generally accepted accounting principles. A detailed examination of the facts and circumstances is necessary to determine whether the transaction is treated for tax purposes as a sale and lease, or as secured financing. If the transaction is treated as a sale and leaseback for tax purposes, payments under the lease generally would be characterized as tax-deductible rent, which is not subject to limitation under section 163(j).

3. Beware of certain related party loans

Certain loans between related parties, particularly so-called brother-sister companies, may result in taxable interest income for the lender and section 163(j)-disallowed interest for the borrower. Although documenting a loan is relatively simple, taking the simple approach may yield a tax problem.

4. Acquire partnership interests rather than directly acquiring business assets

Increased interest expense deductions may be allowable after an acquisition structured as a purchase of a partnership interest when compared to one structured as a purchase of business assets. In lieu of amortization or depreciation expense for the partnership, this structure typically produces adjustments based on amortization or depreciation at the partner level.

This structure would produce an increased interest deduction for the partnership in many cases, but also could have a downside in some cases.

A good practice is to look before you leap. We recommend analyzing whether amortization and/or depreciation would be more beneficial at the partnership level or at the partner level, based on the facts of the particular transaction and the various tax rules that apply to it.

5. Elections for real property and farming businesses

Congress provided elective exceptions from the section 163(j) limitation for a real property trade or business and for a farming trade or business. Taxpayers conducting an eligible business of one of these types may elect to except it from the section 163(j) interest deduction limitation; the election does not apply to any business ineligible for the exception. The election generally is irrevocable.

Many businesses eligible to make this type of election have already done so. A taxpayer conducting a business of one of these types with no election in place may find making the election advantageous.

6. Depreciation method elections

Accelerated depreciation methods for property used in a business can be very beneficial. However, removal of the section 163(j) add-back for depreciation, depletion and amortization provides a downside to accelerated depreciation. Decisions regarding depreciation methods should take the taxpayer’s section 163(j) interest deduction limitation into account.

The takeaway

Many businesses are seeing a rise in interest expense in 2022 due to inflation and increased interest rates. At the same time, many are seeing a decrease in their tax deductions for interest expense due to section 163(j). Tax planning may provide some relief from the increased stringency of the interest tax deduction rules. RSM recommends taxpayers model out the impact of these rules to properly plan for and manage cash flows, and discuss their options with their tax advisors.