Treasury and the IRS have finalized additional regulations regarding the business interest expense limitation of section 163(j)1 (the 2021 Final Regulations). These regulations were originally released on July 28, 2020 and issued on Sept. 14, 2020 in proposed form (the 2020 Proposed Regulations), concurrent with the issuance of the previous set of final 163(j) regulations (see prior coverage: Final business interest expense limitation regulations issued). The 2021 Final Regulations clarify the application of section 163(j) to partnerships and partners, including further guidance on changes to section 163(j) made by the CARES Act. While Treasury and the IRS declined to finalize many of the regulations proposed in July 2020 (the 2020 Proposed Regulations), they emphasized that the 2020 Proposed Regulations are retained in their current proposed form and may still be relied upon by taxpayers.
Self-charged lending transactions
The 2021 Final Regulations--in a provision adopted without change from the proposed regulations--provide relief from section 163(j) for certain self-charged lending transactions when a partner, who owns a direct interest in a partnership, lends money to that partnership thereby creating interest income for the partner and a corresponding potential business interest expense deduction to the borrowing partnership.
If, in a given tax year, a borrowing partnership allocates excess business interest expense to a lending partner that is attributable to the self-charged lending transaction, the final regulations allow the lending partner to re-characterize the interest from that transaction as excess business interest income from that same partnership. This has the effect of generally allowing an equal amount of deductible interest expense from that partnership. The lending partner may only include the re-characterized interest once when calculating the lending partner's section 163(j) limitation so as not to double count business interest income, for example, if the interest income would otherwise be business interest income to the partner, without regard to the self-charged lending transaction partner.
Treasury and the IRS declined to adopt applying this rule to indirect loans through tiered partnerships, due to concerns regarding complexity. Additionally, the regulations declined to apply this rule to S Corporations. Treasury and the IRS stated in the new final regulations’ preamble that they view the pro rata income and loss allocation requirements applicable to S Corporations would make adopting similar rules for self-charged lending transaction difficult to apply and might potentially impact S Corporation eligibility criteria. Partnerships, S corporations and their owners should consider the 2021 Final Regulations when addressing their financing arrangements and plans, since the 2021 Final Regulations’ self-charged interest relief has a limited scope that leaves many pass-through financing arrangements exposed to potentially unfavorable results under section 163(j).
The 2020 Proposed Regulations contained provisions governing so-called trading partnerships—partnerships engaged in a business of actively trading securities, commodities or similar items. Generally, a partner who does not materially participate in a trading activity is subject to the investment interest expense limitation of section 163(d) with respect to that activity. The proposed regulations provide that a trading partnership must bifurcate all of its items of income, deduction and credit (including items affecting the section 163(j) calculation) between items allocable to partners that do materially participate and to those that do not, applying section 163(j) only with respect to items allocable to the materially participating partners. The 2020 Proposed Regulations also provided that a partner may not group a trading activity with any other activity for material participation determination purposes.
Numerous commentators suggested revisions to these provisions, particularly the limitations on trading activity grouping. Ultimately, Treasury declined to adopt any of these comments, finalizing this portion of the regulations without change. Trading partnerships accordingly face potentially significant tax compliance burdens relating to the bifurcation of their activities and the partner material participation determinations called for under the 2021 Final Regulations.
The 2021 Final Regulations are effective for tax years beginning 60 days after publication in the Federal Register. For calendar year taxpayers, this generally means that tax year 2022 will be the first year for which the Final Regulations will be binding. However, the regulations do allow taxpayers to apply the rule to a taxable year beginning after Dec. 31, 2017 and all subsequent taxable years, provided that the taxpayer and all related parties consistently apply the regulations.
As stated above, Treasury and the IRS declined to finalize many provision of the 2020 Proposed Regulations. Items not finalized include rules addressing:
- Partner basis adjustments upon liquidating distributions
- Partnership basis adjustments upon partner dispositions
- Tiered partnership
- Debt-financed distributions and debt-financed acquisitions of partnership interests
- Partnership (or S Corporation) deductions capitalized by a partner (or an S Corporation shareholder) under section 59(e) (elective capitalization and amortization of certain expenditures that would otherwise be deductible)
However, as mentioned above, the 2020 Proposed Regulations were not withdrawn, and taxpayers may still rely on them subject to certain conditions. Please consult with your tax advisor when considering the impact of section 163(j) on your taxable income and deductions.
1Section 163(j) limits business interest expense deductions. It generally limits a taxpayer’s business interest deductions for a taxable year to the sum of: (1) 30% (50% for some years) of the taxpayer’s adjusted taxable income (ATI) for that year, (2) its business interest income and (3) floor plan financing interest. To the extent a taxpayer’s business interest expense exceeds the Limitation, the excess cannot be deducted by the taxpayer. Instead, the taxpayer may carry this ‘excess business interest expense’ forward indefinitely, testing its deductibility each year under section 163(j). These rules apply broadly to all taxpayers, with limited exceptions for businesses in specific industries and an exemption for small businesses that meet a gross receipts test.