The Tax Cuts and Jobs Act (“TCJA”) was the most sweeping overhaul of the Internal Revenue Code since President Reagan’s Tax Reform Act of 1986. Given the fact that there were no hearings on TCJA and little advance legislative planning, many of the law’s provisions required regulatory clarification. However, the new provisions limiting deductibility of business interest expense and expanding the small business exemption stand apart as provisions which required significant clarification.
Tax practitioners and taxpayers struggling to understand the legislative intent behind these rules were helped by proposed interest deduction regulations released around the first anniversary of the bill. This guidance, however, raised as many questions as it answered. New guidance released this week answers some, but not all, of those questions. The discussion below draws from the final and proposed regulations, as well as a notice of a proposed revenue procedure.
What is included in Interest Expense?
The definition of “interest” in the original proposed regulations was quite expansive and included loan costs not normally considered interest. In response to comments, and subject to certain anti-abuse rules, the final regulations have eliminated the following from the definition of interest:
- Commitment fees (although the Service indicated that the treatment of commitment fees and other fees paid in connection with lending transactions will be addressed in future guidance)
- Debt issuance costs
- Guaranteed payments for the use of capital under the partnership rules
- Hedging transactions
What depreciation is added back in computing Adjusted Taxable Income?
Under the original proposed regulations, the amount of any depreciation, amortization or depletion that is capitalized into inventory during a taxable year beginning before January 1, 2022 was not to be added back to taxable income when calculating Adjusted Taxable Income for that taxable year. Under the final regulations, such amounts are added back to tentative taxable income, regardless of the period in which the capitalized amount is recovered through cost of goods sold.
How is Excess Business Interest Expense treated in tiered partnerships?
The 2018 proposed regulations reserved guidance on how tiered partnerships should handle a number of issues relating to the application of the interest expense limitation. One key area of uncertainty was what happens to excess business interest expense allocated from a lower-tier partnership to an upper-tier partnership. Most practitioners assumed that this interest expense stayed trapped at the upper-tier and was not allocated to its partners. This conclusion is confirmed in the new proposed regulations.
How is self-charged interest treated?
Of significant concern, and unaddressed in the 2018 proposed regulations, was the possibility that self-charged interest in a partnership might be income to the lender but not deductible by the borrower partnership. To avoid this outcome, these proposed regulations treat the lending partner’s interest income from the loan as Excess Business Interest Income (EBII) from the partnership, but only to the extent of the partner’s share of any Excess Business Interest Expense (“EBIE”) from the partnership for the taxable year. This allows the interest income from the loan to be offset by the EBIE. The business interest expense ("BIE") of the partnership attributable to the lending transaction will thus be treated as BIE of the partnership for purposes of applying the business interest expense limitation at the partnership level.
How are debt-financed distributions affected by the limitation?
Prior to the new business interest expense limitation, the law required the application of a tracing rule based on how a pass-through entity owner uses the proceeds of a debt-financed distribution. This did not mesh well with the new rules requiring the application of the interest expense imitation at the pass-through entity level. To solve this problem, the proposed regulations adopt and modify previous guidance creating, in essence, a three layer cake of interest expense for each partner. The allocation rules are complex and beyond the scope of this Tax Alert but, while they seem fair to taxpayers, they will make tax compliance significantly more complicated.
Have the partnership allocation rules been simplified?
No, the final regulations retain the 11-step process for allocating business interest expense and related items among members of a partnership. This too makes compliance with the regulations more complex and time consuming.
Are residential living facilities real property businesses?
The 2018 proposed regulations were silent on whether residential living facilities that include the provision of supplemental assistive, nursing or routine medical services qualified as electing real property trades or businesses. The IRS said they plan to issue a Revenue Procedure that such businesses will qualify as real property trades or businesses eligible for the election exempting them from the interest limitation rules.
What is a syndicate or tax shelter?
A definition that affects not just the interest deduction rules but also the small business exemption for other accounting methods, the tax shelter rules came as a surprise to many businesses that never thought the term applied to them. And, while the new guidance doesn’t eliminate the adverse effect of the tax shelter designation – ineligibility for any small business exemption – it does make it easier to determine whether or not it applies.
The new guidance specifies that an otherwise eligible entity is a tax shelter if 35% of its losses are allocated to non-working members. Previous guidance was less clear as the wording was losses allocable and taxpayers were uncertain how to interpret that. Also, to simplify matters, the proposed regulations allow an election to determine if more than 35% of the losses of a venture are allocated to limited partners or limited entrepreneurs. Instead of using the current taxable year’s allocation of losses, qualifying entities may elect to use the allocations made in the immediately preceding taxable year.
Can a taxpayer that meets the small business exemption make the real property trade or business election?
Under the 2018 proposed regulations, it was unclear if taxpayers who met the small business exemption (met the gross receipts test and weren’t tax shelters) were eligible for the real property trade or business election. The final regulations allow those taxpayers to make a protective real property trade or business election. Additionally, under the 2018 proposed regulations, it was unclear whether taxpayers who were unsure if their activity constituted a trade or business could make an election. The final regulations clarify that a taxpayer who is unsure whether its activity constitutes a trade or business under section 162 is eligible to make an election.
Have the aggregation rules been simplified?
Unfortunately, no. The IRS did release a series of Frequently Asked Questions (“FAQs”) in an effort to explain the aggregation rules that apply for purposes of the gross receipts test in determining if a taxpayer meets the small business exemption. However, the rules themselves have not changed.
What guidance is still missing?
There are still many unanswered questions, leaving taxpayers and their advisors to fend for themselves. Among them are:
- In a tiered partnership structure, can an upper-tier entity that invests in a real property trade or business make the election to be exempt from the interest deduction limitation? Does it matter whether the lower-tier entity made the election?
- What is the effect of debt cancellation income on the interest deduction limitation?
- --And, is carried over interest expense a tax attribute that can be used to offset cancellation of indebtedness income?
- Just how far do the anti-avoidance rules extend to include certain hedging transactions and guarantee fees in the definition of interest expense?
- Can a multi-generational family business be exempted from the tax shelter rules since the older generation may have been involved in the business but is no longer?
There is still more to be unpacked in the over 900 pages of guidance released this week. In the coming weeks, we will provide additional commentary, including explanations of the international provisions with particular respect to those relating to shareholders of controlled foreign corporations. In the meantime, feel free to contact your Friedman LLP tax professional to discuss how this new guidance affects you and your business.