Benefits to affect tax years beginning in 2019 and 2020
Introduction
The Senate passed the CARES Act (the Coronavirus Aid, Relief and Economic Security Act) on March 25, 2020. The CARES Act includes tax and non-tax provisions, and is generally summarized in our Alert. The CARES Act may be enacted as soon as Friday, March 27, 2020. This Alert describes effects it will have, if enacted, on the interest deduction limitation of section 163(j). The CARES Act amendments to section 163(j) will allow many taxpayers increased interest deductions in tax years beginning in 2019 and 2020.
Section 163(j) in general
Section 163(j) limits business interest expense deductions. Section 163(j) generally may apply to any taxpayer.1 It generally limits a taxpayer’s business interest deductions for a taxable year to the sum of: (1) 30% of the taxpayer’s adjusted taxable income (ATI) for that year, (2) its business interest income and (3) floor plan financing interest.2
For taxpayers conducting a business that does not involve lending or selling vehicles from inventory, the section 163(j) limitation generally is equal to 30% of ATI. For additional background, our prior Tax Alerts on section 163(j) are available (Proposed interest deduction disallowance regulations issued, Broad new limitation on business interest deductions, IRS notice on section 163(j) business interest deduction limitation, Evaluation of the realizability of a section 163(j) carryforward, New election may provide enhanced interest deduction for multinationals, and Correction narrows eligibility for 163(j) exception.
CARES Act amendments to section 163(j)
There are three ways that the CARES Act amends section 163(j): (1) increasing the limitation to 50% of ATI, (2) providing a special rule for a partnership’s 2019 section 163(j)-disallowed interest expense and (3) allowing an election to apply 2019 ATI to the 2020 section 163(j) computation.
Increasing the limitation to 50% of ATI
The CARES Act increases the section 163(j) limitation by including 50% of ATI in the limitation amount instead of only 30% of ATI. However, this increase to the limitation only applies to certain taxable years.
For partnerships, the increase to 50% of ATI applies to all taxable years beginning in 2020 only, and the special partnership rule discussed below applies to years beginning in 2019. For other taxpayers, such as corporations (including S corporations) and individuals, the increase to 50% of ATI applies to all taxable years beginning in 2019 or 2020.
A taxpayer may elect not to have the 50% of ATI rule apply. A partnership electing not to apply this increase to its interest deduction limitation can make the election for years beginning in 2020 only. The partnership, rather than its partners, can make the election. Other taxpayers, such as corporations (including S corporations) and individuals, can make the election with respect to years beginning in 2019, in 2020, or both.
Special rule for a partnership’s 2019 section 163(j) disallowed interest expense
While partnerships do not benefit from the 50% of ATI rule for taxable years beginning in 2019, the CARES Act provides partners a different benefit instead. Each partner’s allocable share of the partnership’s excess business interest (i.e., interest of the partnership disallowed under section 163(j) and carried forward by the partner) for a taxable year beginning in 2019 (the Partner’s 2019 Share) will be treated as follows:
First, the CARES Act provides a new beneficial rule under which 50% of the Partner’s 2019 Share will be treated as business interest that is not subject to any section 163(j) limitation paid or accrued by the partner in the partner’s first taxable year beginning in 2020.
Second, the remaining 50% of the Partner’s 2019 Share will be subject to the same section 163(j) rules that previously were in place. Those rules generally do not permit any deduction for the partner’s allocable share of the partnership’s excess business interest (i.e., the interest of the partnership disallowed under section 163(j) and carried forward by the partner). Instead, the partner’s section 163(j) carryforward from the partnership is put in a ‘silo’ and has very limited permitted uses. The carryforward may exit the ‘silo’ and be deducted as interest expense under these rules only to the extent (if any) that the same partnership allocates to the partner in a later taxable year excess taxable income or excess business interest income (i.e., partnership taxable income or interest income not applied by the partnership to free its own interest expense from section 163(j)). Otherwise, the partner’s section 163(j) excess business expense carryforward from the partnership would never be deducted as interest expense, and instead be added to the partner’s basis in its partnership interest immediately before the partner disposes of all (or substantially all) of its interest in that same partnership. Because these section 163(j) ‘silo’ rules applicable to partners are so strict, freeing 50% of the Partner’s 2019 Share from these rules may provide a significant benefit.
Election to apply 2019 ATI to the 2020 section 163(j) computation
To provide a benefit to taxpayers whose 2020 income will decrease from its 2019 level, the CARES Act allows an election to apply their 2019 ATI, rather than their 2020 ATI, to their 2020 section 163(j) computation.
Taxpayers making this election will compute their section 163(j) limitation for a taxable year beginning in 2020 based on their ATI for their last taxable year beginning in 2019. For partnerships, this election is available at the partnership level, not the partner level.
For a short taxable year beginning in 2020, the CARES Act reduces the elective ATI amount proportionally to the length of the short year. However, no comparable rule is provided to proportionally increase the ATI in circumstances where the last taxable year beginning in 2019 is a short taxable year.
Conclusion
The CARES Act amends section 163(j) in three ways that will provide significant tax savings to many taxpayers. First, the section 163(j) limitation is temporarily based on 50% of ATI (rather than 30% of ATI). Second, a special beneficial rule applies to 50% of a partner’s share of a partnership’s 2019 section 163(j)-disallowed interest expense. Third, taxpayers are allowed to electively apply 2019 ATI to their 2020 section 163(j) computations. When considering the results of these tax law changes, taxpayers should consult with their tax advisers.
1Section 163(j) may apply, for example, to corporations, partnerships or individuals. However, there is a small business exemption from section 163(j) for business whose gross receipts, together with gross receipts of certain related parties, does not exceed a threshold on a three-year average basis (the threshold is $26 million for 2019 and is indexed for inflation). Certain farming and real estate business are excepted from section 163(j) on an elective basis. In addition, certain public utility business are excepted from section 163(j) on a mandatory (non-elective) basis. 2Floor plan financing interest generally is interest expense on certain debt funding vehicle inventory purchases.
