Determining If Subject to 163(j)

This article explains the applicability of Section 163(j), its calculation, exemptions, and the implications for businesses. It covers crucial criteria like gross receipts, business type, and interest expense, along with the calculation of limitations and carryforward rules.

Determining If Subject to 163(j)

Section 163(j) of the Internal Revenue Code (IRC) is a critical consideration for businesses when evaluating their tax liability. Introduced by the Tax Cuts and Jobs Act (TCJA) of 2017, this provision places limitations on the deductibility of business interest expenses, a factor that can significantly impact businesses relying on debt financing. Determining if Subject to 163(j) is essential for businesses to understand as it directly affects their tax planning strategies. The limitation is typically set at 30% of adjusted taxable income (ATI), with additions for business interest income and floor plan financing interest. However, navigating the complexities of Section 163(j) necessitates a thorough understanding of its various exceptions, special rules, and calculation methods. This article provides a guide to determine if your business falls under the purview of Section 163(j), outlines the calculation of the limitation, and explores potential exemptions that may apply.

Key Criteria for Section 163(j) Applicability

To ascertain whether Section 163(j) applies to your business, several factors must be assessed:

  1. Gross Receipts Test: The gross receipts test under IRC ยง448(c) offers a potential exemption for small businesses. If a business’s average annual gross receipts over the preceding three tax years do not surpass $27 million (adjusted for inflation, $30 million for 2024), it generally qualifies for exemption. Tax shelters, however, remain subject to Section 163(j) regardless of gross receipts.
  2. Type of Business: Certain business types are automatically exempt from Section 163(j):
    • Electing Real Property Trades or Businesses (RPTOB): Businesses engaged in real estate activities like development, rental, or leasing can elect out of Section 163(j), but this choice mandates using the alternative depreciation system (ADS) for specific property types.
    • Electing Farming Businesses: Similar to RPTOBs, farming businesses can also elect out, requiring the use of ADS for depreciation.
    • Utilities: Businesses providing utilities are excluded from the definition of trades or businesses under Section 163(j).
  3. Business Interest Expense: Section 163(j) specifically targets business interest expense, which encompasses any interest accrued or paid on indebtedness linked to a trade or business. This broad definition includes not just traditional interest payments but also payments that are essentially interest in nature. Determining what constitutes business interest expense is crucial in understanding the scope of Section 163(j).
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Calculating the Limitation

If your business is not eligible for an exemption, the deductible interest expense is determined through a specific calculation:

Business Interest Income + 30% * Adjusted Taxable Income (ATI) + Floor Plan Financing Interest

  • Adjusted Taxable Income (ATI): ATI is calculated without considering certain factors, including non-business income, business interest income or expense, net operating loss deductions, and, for tax years before January 1, 2022, depreciation or amortization.
  • Floor Plan Financing Interest: This pertains primarily to businesses dealing in vehicles or farm machinery, enabling them to deduct additional interest linked to financing their inventory. Understanding the nuances of ATI and floor plan financing interest is crucial for accurate calculation.

Carryforward Rules

In cases where a business’s interest expense surpasses the permissible deduction under Section 163(j), the excess can be carried forward indefinitely. This provision allows deduction in future years, subject to the same limitations, ensuring businesses can eventually deduct all interest expenses.

Exemptions and Special Elections

Certain businesses have the option to elect out of Section 163(j). However, these elections come with conditions:

  • Real Property Trade or Business Election: Electing RPTOBs are obligated to utilize ADS for property depreciation and forfeit bonus depreciation on specific assets. This election, once made, is irreversible.
  • Farming Business Election: Similarly, farming businesses opting out must use ADS for depreciation but are exempt from the interest deduction limitation.

Additional Planning Considerations

Beyond exemptions and calculations, several strategies can help mitigate the impact of Section 163(j):

  • Small Business Exception: The small business exception, detailed in Sec. 163(j)(3), provides relief for taxpayers meeting the gross receipts test of Sec. 448(c). This exception applies to taxpayers with average annual gross receipts not exceeding specified thresholds, subject to aggregation rules for related entities.
  • Real Property Trade or Business Election: Taxpayers engaged in real estate activities can elect to be treated as an RPTOB, exempting them from Sec. 163(j) limitations. However, this election necessitates using the alternative depreciation system for certain properties and forgoing bonus depreciation.
  • Self-Charged Interest: Regulations provide relief for self-charged lending transactions between partners and partnerships. If a lending partner incurs excess business interest expense from the borrowing partnership and receives interest income from the loan, they are deemed to receive an allocation of excess business interest income.
  • Capitalization Strategies: Capitalizing interest under Sec. 263A or Sec. 266 can offer tax benefits. Capitalized interest is not treated as business interest expense for Sec. 163(j) purposes, providing potential deductions as the property is depreciated or sold.
  • Buy vs. Lease Considerations: Choosing between buying and leasing assets can have varying tax implications under Sec. 163(j). Understanding the differences between capital leases and operating leases, and considering financial statement reporting implications, is crucial in decision-making.

Conclusion

Determining your business’s subjection to Section 163(j) involves a multifaceted analysis of gross receipts, business activities, and adjusted taxable income. While the limitation applies to many businesses, exemptions are available for small businesses and those in real estate or farming. Strategic decision-making regarding elections and planning considerations can significantly optimize a business’s tax position.

FAQs for Determining If Subject to 163(j)

FAQs

  • What is the purpose of Section 163(j)? To limit the amount of business interest expense that can be deducted in a given tax year.
  • What is adjusted taxable income (ATI)? Taxable income calculated without certain items, including non-business income and deductions.
  • Can businesses carry forward disallowed interest expense? Yes, indefinitely to future years, subject to the same limitations.
  • Are there exemptions for certain types of businesses? Yes, for certain small businesses, real estate businesses, and farming businesses.
  • What is floor plan financing interest? Interest on indebtedness related to financing inventory, primarily applicable to vehicle and farm machinery dealers.

Please note that this article provides a general overview of Section 163(j) and should not be considered as legal or tax advice. Consulting with a qualified tax professional is recommended for specific guidance tailored to your business circumstances.

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Internal Revenue Code Section 163(j)
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