The Tax Cuts and Jobs Act of 2017 (TCJA) installed a provision in the Internal Revenue Code commonly referred to as Section 163(j) which imposes a limitation on certain businesses to deduct interest expense. For construction businesses, this limitation typically applies when the average annual gross receipts for the three previous years exceeds $26 million ($27 million after the indexing for inflation for 2022). Keep in mind, there are complex rules which require entities to aggregate gross receipts with common ownership when determining average gross receipts. Additionally, if the company is highly leveraged and has significant interest expense, there is potential for some of the interest expense to be nondeductible and suspended to future years. Starting in 2022, the formula to compute this limitation becomes less favorable to businesses who are subject to this limitation.
Limitations for businesses that do not meet the small business exception
Here is a recap of the applicable rules and limitations for entities that do not meet the small business exception (i.e. businesses with average annual gross receipts for the three-tax-year period ending with the prior tax year in excess of $27 million):
- Business interest cannot exceed the sum of the business’ interest income and 30% of the taxpayer’s adjusted taxable income for the year.
- Adjusted taxable income is computed similarly to Earnings Before Interest, Taxes, Depreciation and Amortization Expense (EBITDA).
- For real estate trades or businesses, an election can be made to opt out of the interest expense limitation assuming certain conditions are met. However, the real estate fixed assets will then have to be depreciated under the Alternative Depreciation System (ADS) which may result in a reduced depreciation deduction.
For 2022, the adjusted taxable income calculation removes depreciation and amortization from being added back. As a result, adjusted taxable income will be lower. Many businesses that were not subject to the 163(j) limitation since 2018 may see some or all of their interest expense become nondeductible starting in 2022. Keep in mind, the deduction is not lost. It is merely suspended and carried forward to subsequent years.
Action Items for 2022
- Evaluate related party leases, especially if the construction business owners also own the real estate related to the business to determine if restructuring lease agreements makes sense.
- Evaluate whether to settle intercompany debts or restructure.
- For real estate trades or businesses, consider if making the election for real property trade or business makes sense.
All of this should be carefully analyzed to determine applicability and potential tax consequences. Please consult with your MarksNelson advisor if you have any questions.
