The new limitation on deducting business interest expenses creates unique challenges for partnerships, but government officials indicated they are aware of the concerns and are working to address them.
Amendments made to section 163(j) by the Tax Cuts and Jobs Act (P.L. 115-97) pose challenges for partnerships because the income from those entities flows out to the partners, said Paul McLaughlin, Joint Committee on Taxation legislation counsel. The changes to section 163(j) include partnership-specific rules, McLaughlin noted January 25 at a District of Columbia Bar Community of Taxation event hosted by Jones Day in Washington.
“These rules will affect the way that you structure your debt financing and it is going to require folks to think more about where the debt sits,” McLaughlin said.
The interest limitation provision in section 163(j) targets businesses that rely on debt financing by limiting the business interest expense deduction to 30 percent of adjusted taxable income. The provision may have limited impact because 85 percent of businesses have no debt and over 99.5 percent of businesses are below the $25 million gross receipts threshold for the limitation to apply.
Section 163(j)(4) provides rules specific to partnerships and includes a provision that prevents the deduction from being unintentionally expanded, McLaughlin said. Illustrating the dilemma, he explained that a partnership with $100 of adjusted taxable income would be permitted to deduct $30 in interest expense and the remaining $70 would flow out to the partners. “Without any additional rules, that $70 of income could potentially create another $21 of interest capacity” at the partner level, he said.
Robert J. Crnkovich of EY said the rules in section 163(j) for applying excess capacity or excess interest expense will present a guidance challenge for the government. A partnership with $100 in adjusted taxable income and $30 in interest expense can deduct the entire $30, he said, but he added that the partnership needed the entire $100 of income to be entitled to the $30 deduction.
The excess capacity rules require partnerships to look at how much of the adjusted taxable income supported the deduction in order for excess capacity to be used by the partners, Crnkovich said. Only $50 of the $100 adjusted taxable income would be needed to support a $15 interest expense, which would allow the partners to use the remaining $50 in excess capacity to deduct their own interest, he said.
There are also rules that prevent partners from using excess capacity from one partnership to offset excess interest from another partnership, Crnkovich said, adding that this may encourage taxpayers to review partnership structures so that interest expense and excess capacity don’t flow out from separate partnerships.
McLaughlin said another concern unique to partnerships is how excess interest limitation deductions are carried forward. Those deductions are carried forward indefinitely until a taxpayer has the capacity to use them, he said, adding that Congress had to determine whether the excess interest limitation deduction should sit with the partnership or the partners. “We decided the wiser approach was for it to sit at the partner level to get it away from the partnership,” which required rules for how that works and to track the carryforward, he said.
The carryforward rule is another area that will require guidance, Crnkovich said, adding that it includes a basis adjustment requirement that the government will have to decide how to apply to tiered partnerships. Section 163(j)(4)(B)(iii) provides a special basis adjustment rule for carryforwards that requires an adjustment to a partner’s basis in the partnership interest by the amount of excess business interest deduction allocated to the partner.
That rule raises the question whether corresponding basis reductions are required up through the tiers in a tiered partnership, Crnkovich said. “My initial reaction is you would [require it]. Otherwise somewhere up the chain you’re creating inside/outside basis disparities” that create planning opportunities, he said.
Speaking on a later panel, Bryan Rimmke, attorney-adviser, Treasury Office of Tax Policy, said that Treasury has been receiving many questions on how the carryforward rule applies. “We’re definitely discussing that, and we will be coming up with answers to those questions, although we don’t have them quite yet,” he said.