For business owners, interest expense is often a significant financial factor and a critical component of tax planning. However, due to evolving tax laws, the process of deducting business interest has become increasingly complex.

The Tax Cuts and Jobs Act (TCJA) introduced substantial changes to interest deduction rules under §163(j). These changes became more restrictive in 2022, and with some TCJA provisions set to expire after 2025, a proactive approach to planning is essential.

So, how can you make the most of your business interest deductions while staying compliant? Let’s break down the workings of §163(j), the businesses it affects, and strategies to optimize your interest expense deductions.

Understanding the Changes to Business Interest Deduction
Before the TCJA, most businesses could fully deduct interest expense in the year it was paid or accrued, with minimal restrictions. The earlier version of §163(j) primarily impacted highly leveraged corporations, particularly those paying interest to related parties on tax-exempt debt. For the majority of businesses, interest deductions were rarely a concern.

That changed drastically in 2018, when the TCJA expanded §163(j) to impose limitations on business interest deductions. The law capped deductible business interest at 30% of adjusted taxable income (ATI). Initially, ATI included add-backs for depreciation, amortization, and depletion, which closely resembled earnings before interest, taxes, depreciation, and amortization (EBITDA). This allowed for a higher deduction limit.

However, as of 2022, the law no longer allows depreciation and amortization to be added back, effectively shifting ATI to an EBIT-based calculation. This change significantly reduces the deductions available to businesses with substantial depreciation or amortization expenses, even if their overall financial performance remains unchanged.

Who is Affected by §163(j)?
Most businesses with interest expense are subject to §163(j) unless they qualify for specific exceptions. Let’s explore the main exemptions:

1. Small Business Exception
If your business meets the three-year average gross receipts test under §448(c), you may qualify for the small business exemption. For 2024, the gross receipts threshold is approximately $30 million, adjusted annually for inflation.

Key considerations:

• The test uses a rolling three-year average of gross receipts.
• Related entities, such as commonly controlled LLCs, must combine their gross receipts under aggregation rules.
• Qualification is reviewed annually, so your status could change from one year to the next.

2. Other Exceptions
Real property trades or businesses can opt out of §163(j) by using the Alternative Depreciation System (ADS) for certain assets. This trade-off eliminates the interest deduction cap but requires longer depreciation periods.
Farming businesses can also elect out, with similar ADS requirements.
Public utilities are automatically excluded from §163(j).
The landscape could shift further after 2025. If §163(j) reverts to its pre-TCJA form, the expanded limitation may narrow again, potentially rendering some exemptions unnecessary.

What Qualifies as Business Interest?
Under §163(j), business interest expense refers to interest paid on loans used for operational or income-generating activities. However, if a portion of the loan is used for personal or investment purposes, the related interest is excluded from the business deduction. Additionally, interest income earned in connection with your business activities can help offset the limitation. Businesses with significant interest income may use this to reduce the amount of disallowed interest expense under the 30% ATI cap.

Special Case: Floor Plan Financing Interest
Certain industries, such as auto dealerships, rely heavily on floor plan financing to purchase inventory. Interest on these loans is not subject to the §163(j) limitation and qualifies for a separate deduction. However, businesses using this provision may be required to forgo bonus depreciation on other eligible assets.

Strategies to Maximize Business Interest Deductions
1. Real Property Trade or Business Election
Real estate businesses can elect out of §163(j) to avoid the interest deduction cap. However, this requires switching to ADS depreciation, which extends asset recovery periods and eliminates bonus depreciation. For businesses heavily reliant on financing, accepting slower depreciation in favor of an unlimited interest deduction can often result in a better overall tax outcome.

It’s important to note that this election is irrevocable, so careful modeling is necessary to evaluate its long-term impact.

2. Capitalize Interest
Instead of expensing interest immediately, businesses may consider capitalizing it under §263A or §266. Capitalized interest is added to the cost of an asset, increasing its basis and spreading the deduction over time through depreciation or upon asset sale.

This strategy is particularly beneficial for businesses facing §163(j) limitations, as it removes interest from the 30% ATI cap. However, it also delays the deduction, making it less favorable for businesses needing immediate tax relief.

3. Evaluate Financing Structures
If interest expense is being partially disallowed under §163(j), you might reconsider your financing approach:

Debt vs. Equity Financing: Raising capital through equity can eliminate interest expenses. However, it may affect ownership and control.
Lease vs. Purchase Decisions: Operating leases may provide a more favorable tax profile than financing purchases when interest deductions are limited.

4. Optimize Partnerships and S Corporations
For partnerships and S corporations, §163(j) applies at the entity level. If interest expenses exceed the allowable limit, the excess business interest expense (EBIE) is carried forward by partners or shareholders.

Special rules, such as self-charged interest, may allow partners lending directly to the business to partially recharacterize the interest for more favorable tax treatment.

Compliance and Reporting
Businesses subject to §163(j) must file IRS Form 8990 to report interest limitations. Additional statements may also be required for elections under §266 or for opting out as a real property trade or business. Proper documentation and thorough recordkeeping are essential to avoid errors or disputes.

Planning for 2025 and Beyond
With TCJA provisions expiring in 2025, now is the time to revisit financing arrangements, partnership structures, and annual elections. Consider working with a CPA or tax advisor to navigate these complexities and identify the best strategies for your business.

For personalized advice on optimizing your tax position, contact our office today.