The Tax Cuts and Jobs Act (TCJA) repeals the so-called “earnings-stripping” rules and replaces them with a new limit on the deduction of business interest expense by corporate and noncorporate taxpayers. This change could, in turn, affect the feasibility of your company’s capital investment decisions. But the calculations can be confusing.

The Basics

Under the TCJA, starting in 2018, the deduction for business interest will generally be limited to 30% of the taxpayer’s adjusted taxable income (ATI) for the tax year. The limit does not apply to businesses with average annual gross receipts of $25 million or less for the three preceding tax years. It also doesn’t apply to certain regulated utilities.

In addition, investment interest and interest on floor plans (debt incurred to finance a dealer’s purchase of motor vehicle inventory for sale or lease) are exempt from this limitation.

Real estate and farming businesses can elect to exempt themselves, but, in exchange, they must use the Alternative Depreciation System (ADS) for certain depreciable assets. Useful lives under the ADS are longer than under the Modified Accelerated Cost Recovery System (MACRS). Plus, under the ADS, companies that make this election also must forgo generous first-year bonus depreciation and Section 179 deductions.

Any interest that isn’t deducted because of the limit generally may be carried forward indefinitely.

Close-Up on ATI

ATI refers to taxable income adjusted for the following items:

• Nonbusiness income and losses, such as gains and losses from sales of assets held for investment,
• Business interest expense or business interest income,
• Net operating losses (NOLs), and
• The 20% deduction for qualified business income (QBI).

In addition, through 2021, ATI is computed without regard to deductions for depreciation, amortization or depletion. Beginning in 2022, ATI will be decreased by those items, further limiting the interest expense deduction for companies with significant depreciation deductions.

Crunching the Numbers

For example, for 2018, ABC Company (an S corporation with approximately $30 million in average annual revenue) has $920,000 of earnings before interest, taxes, depreciation and amortization (EBITDA).

For 2018, the company’s EBITDA includes a $100,000 QBI deduction and $20,000 of business interest income. But it already excludes $120,000 of business interest expense. ABC is a manufacturer that doesn’t use floor plan financing — or qualify to elect out of the interest expense limitation.

To arrive at ATI, ABC must adjust EBITDA for:

• Business interest income (subtract $20,000), and
• The 20% QBI deduction (add $100,000).

So, ABC has $1,000,000 of ATI for 2018 ($920,000 – $20,000 + $100,000). Therefore, the company can deduct all of its business interest expense ($120,000), because it’s less than $300,000 (30% × $1,000,000).

In 2019, ABC reports only $214,000 of EBITDA, including a $20,000 QBI deduction and $14,000 of business interest income. The company’s EBITDA already excludes $120,000 of business interest expense.

So, for 2019, ATI is $220,000 ($214,000 – $14,000 + $20,000). Therefore, ABC’s deduction for business interest expense would be limited to $66,000 (30% × $220,000). The $54,000 of disallowed interest expense can be carried forward indefinitely.

Under the same scenario for 2022, ABC’s interest expense deduction would be further limited, because depreciation, amortization and depletion expenses would be subtracted when computing ATI.

Need Help?

Our tax professionals can help you understand the full impact of the new tax law on your capital spending plans and minimize surprises when you file federal tax returns for 2018 and beyond. Contact us for more information.

The TCJA…So Many Changes, So Many Questions…we can help you navigate this huge tax overhaul! Need help with your tax planning? Contact any member of our Tax Services Team.