The Tax Cuts and Jobs Act (the Act) introduced a limitation on the amount of interest expense a business can deduct on its tax return. Overall, the Act is viewed as ‘good for business’, but the limitation does have the ability to impact a business’ profitability and cash flow.
It was created to help offset the costs of other tax cuts made in the Act – the 21% corporate tax rate and 20% deduction on qualified business income. How will this limitation on business interest expenses impact you?
About the new deduction
A business’ deduction of business interest expense¹ is limited to the sum of: (1) the business interest income; (2) 30% of adjusted taxable income; and (3) floor plan financing interest. The maximum amount of interest expense you can deduct is your deductibility threshold.
Adjusted taxable income doesn’t include nonbusiness income, business interest expense or business interest income, net operating loss deductions, the 20% qualified business income deduction, depreciation, amortization, or depletion.
If you have any interest that isn’t deductible because of the limitation, you can carry it forward forever, until it’s absorbed. Any excess limitation – which is your deductibility threshold subtracted by the amount you claim – can’t be carried forward. This rule is in place now and applies to all tax years beginning after Dec. 31, 2017.
Are there exceptions to the rule?
Yes. This limitation only applies to businesses with average annual gross receipts of $25 million or more in the prior three years. If your gross receipts are less than this amount, you’re exempt from this limit.
If you’re a regulated public utilities company or electric cooperative, you’re also exempt. But, if you’re a farming business or in the real property industry, and elect to use the alternative depreciation system (ADS), you can elect exemption from this limitation.
Pay attention to your adjusted taxable income
The definition of adjusted taxable income will change in 2022 which could make the limitation less beneficial and more restrictive.
Why? In 2022, depreciation and amortization expenses will be excluded from adjusted taxable income. The limitation will be calculated as 30% of earnings before interest and taxes, effectively reducing your deductibility threshold.
This is a significant change. Businesses that have large depreciation and amortization expenses – who probably rely on debt to finance capital expenditures – will see a dramatic decrease in their deductibility thresholds.
How could this limitation impact you?
You could pay a higher corporate tax rate if your business faces any deductibility challenges.
If you’re subject to this limitation, your effective tax rate could vary each period and each year as interest expense becomes nondeductible. Your tax rate could be more than 100% of your business’ net income after the interest expense deduction.
So, your business could owe federal income taxes even if it’s not profitable after interest is paid. This could be especially troublesome for businesses that carry a lot of debt.
The changing tax rate also makes it difficult to accurately project future earnings. And, it can impact your company’s profitability and free cash flows.
How? Under the previous rule, if your company was profitable, you could deduct the full interest expense from taxable income.
Now, companies have to pay tax on the interest without being profitable. They lose the cash flow benefit. Therefore, future earnings may be more impacted by effective income tax rates, capital structure, capital expenses, and depreciation and amortization ratios as they relate to revenue and net income.
Who will this affect most?
This limitation will most likely impact companies that are heavily indebted and businesses that face deductibility issues. Companies with high levels of depreciation and amortization expenses as a proportion of net income could also be at risk once those expenses are removed from the limitation calculation.
The impact this rule has on your business will partly be determined by free cash flows and how you can reduce debt and any associated interest expenses.
What should you do?
Know the impact of this limitation on your business – short-term and long-term. Effective tax rates and future earnings may not be easy to predict, but it’s smart to analyze your current state and calculate your deduction limitation. Analyze your exposure to this change as much as possible.
1. Estimate your 2018 tax liability and business interest limitation. This example shows you how.
Gross receipts: 1,000
Interest income: 50
Cost of goods sold: -700
Interest expense: -150
Taxable income before interest limitation: 100
Taxable income before interest limitation: 100
Add back the net interest expense: +100 (interest expense – interest income)
Add back depreciation: +100
Adjusted taxable income: 300
Multiply by 30%: x .3
Business interest deduction limitation: 90
2. If you’re a real estate or farming business, analyze the costs and benefits of electing to be exempt from the limitation. What’s the benefit of the interest expense deduction vs. the cost of longer depreciation lives under ADS and being ineligible for the 100% bonus depreciation?
3. Consider the effect this limitation could have on your capital structure since it will increase the after-tax cost of debt financing.
¹Business interest expense is the cost of interest that’s charged on business loans.
Have questions about this new limitation on the interest expense deduction? Let’s talk!