On January 5, 2021, the Treasury and IRS released a second set of final business interest expense deduction regulations (the 2021 Final Regulations) that provide additional rules to reflect changes made to the IRS Revenue Code section 163 (j) made by the TCJA and CARES Act.
These final rules implement specific characters of the proposed regulations published in September 2020. The final 2020 regulations largely adopted the proposed 2018 regulations, with revisions to some controversial rules. The new final regulations for 2021 similarly follow the proposed regulations for 2020, with some important changes.
Section 163 (j) commonly limits the amount of Business Interest expenses that can be deducted in the current fiscal year. The amount allowed as a deduction for the business interest expenses or the limitation in Section 163(j) is limited to the amount of the taxpayer's business interest income for the year, 30% of the taxpayer's taxable income for the year, and the taxpayer's floor plan that finances the year's interest expense.
The CARES Act increases the deduction under Section 163(j) from 30% of the adjustable taxable income to 50% for taxpayers other than partnerships for the fiscal years beginning in 2019 and 2020 (although the taxpayer can choose to continue using the 30% adjustable taxable income). For partnerships, the 50% adjustable taxable income rule only applies for fiscal years from 2020. For fiscal periods starting in 2019, 50% of the EBIE partnership transferred to a partner may be treated as interest expense deductible in the member's first fiscal year beginning in 2020. Additionally, partnerships may choose to use 2019 adjustable taxable income instead of 2020's adjustable taxable income to calculate the partnership's level Section 163(j) limit value.
The adjustable taxable income is the taxable income of the taxpayer calculated without taking into account elements that cannot be correctly attributed to commercial or entrepreneurial activity; business interest expenses and business interest income; net operating loss; deductions for qualifying business income under section 199A; depreciation deduction, amortization, and depreciation with respect to taxable years beginning after December 31, 2017, and before January 1, 2022, and some other less common adjustments provided by the IRS.
The limitation rules in Section 163 (j) only apply to interest attributable to a transaction or business, whether it is an asset or a liability, but does not apply not to investment income or expenses, personal interest, or mortgage interest. The expression "trade or business" is generally defined by reference to section 162 but does not include, for section 163 (j), including the business or trade of performing service as an employee, business or an electing farming business, an electing real property trade or business, or certain utilities. Taxpayers (excluding tax shelters) who meet the small business exempt amount, defined as taxpayers whose average gross annual income is $26 million or less in the past three years (as adjusted for inflation).
The 2021 final regulation covers several rules that apply to all taxpayers, including the small business taxpayer exemption and the adjustable taxable income calculation. The 2021 final regulations also addressed some specific provisions for foreign-controlled businesses and companies. This notification summarizes the important rules that apply to all taxpayers. The BDO has issued separate notifications to address the demand for new foreign companies and branches.
Small business tax exemption
As mentioned above, Section 163 (j) exemption for small businesses does not apply to a taxpayer considered as a tax shelter. A tax shelter includes, among other entities, any union defined in the Code. There has always been uncertainty about how an entity is considered a syndicate.
The 2021 final regulations adopted the proposed 2020 regulation, which defines a trade union as any partnership or other entity (other than a non-S corporation) if more than 35% of that entity's losses during the year are allocated to shareholders or limited liability companies. In other words, an entity whose losses are attributable to limited partnerships or limited liability companies would only be considered a syndicate if that entity attributes more than 35% of the losses to limited partners and limited liability companies in a given year.
Calculation of the Adjustable Taxable Income
One of the changes to adjustable taxable income "lesser of" test states that, to the extent that the taxpayer did not benefit from the add-back of depreciation deductions to adjustable taxable income (ATI) during the earnings before interest, taxes, depreciation, and amortization (EBITDA) period, the taxpayer will not be required to deduct this part of the deductions when the properties are disposed of.
Consider this example: In a tax year of the EBITDA period, ABC had an ATI of $150, including a total of $50 of depreciation. If the addback was not applied, ABC would have had ATI of $100. In the same tax year, ABC did not have business income expenses and therefore did not benefit from the $50 increase in the ATI due to the addback. As such, ABC is not required to deduct $50 from ATI in the year the properties are sold.
The final 2021 regulation also clarifies that to calculate the ATI, the amount of profit that a consolidated group takes into account in a "sale or other disposition" includes the "net profit" that the group would take into account, including as a result of intercompany transactions.
For example, suppose A (a member of the Q group) recognizes a profit of $100 from selling a property to a non-member. However, instead of selling the property directly to a non-member, A could sell the property to member Z and see a profit of $60. Z could then sell the property to the non-member and see an additional profit of $40. Either way, the group would recognize a net gain of $ 100 per property. According to the final regulation of 2021, this net gain of $100 is taken into account in determining the value of any subtractions to ATI.
The "lesser of" standard does not replace the rules for deconsolidation operations (i.e., when the holding of a consolidated subsidiary falls below 80% of the votes and value threshold for consolidation), which could trigger excess loss accounts and deferred revenue accounts between companies. A deemed disposition of affiliate member shares may include certain unrecognized transactions (e.g., tax-free transfers of shares) and would also be subject to the "lesser of" rule. However, there is an exception for transactions under Section 381 (tax-free business reorganizations).
Regulated investment companies
The 2021 regulation adopted the proposed 2020 regulation for certain rules on regulated investment companies (RICs). Suppose a RIC has certain elements of income or profit. In that case, the RIC may pay dividends that a shareholder of RIC could claim in the same (or similar manner) as the shareholder would treat the basic income or profit element if the shareholder realized it directly.
The 2021 Final Rules also provide rules according to which a RIC earning business interest income can pay interest dividends per Section 163(j). The total amount of interest dividends under Section 163 (j) of a business income expenses for a financial year is limited to the excess RIC's business interest income for the taxable year over the sum of the RIC's business income expenses for the taxable year and the RIC's other deductions for the year fiscal year can be correctly allocable to the RIC's business interest income.
The 2021 final regulations provide that a RIC shareholder that receives an interest dividend under section 163 (j) may treat the dividend as interest income within the meaning of section 163 (j), subject to the investment period and other limitations.
Effective Date
The 2021 final regulation applies to taxable years that begin within 60 days of the regulation's publication in the Federal Register. Taxpayers and their related parties can apply the 2021 final regulations retroactively to a fiscal year beginning after December 31, 2017, and before the 2021 final regulation is applied if the 2020 final regulation applies.
FOR MORE INFORMATION OR TO MAKE AN APPOINTMENT TO SEE HOW FLYNN FINANCIAL GROUP, INC. CAN BEST HELP YOU WITH YOUR TAX FILING NEEDS, PLEASE CLICK THE BLUE TAB ON THIS PAGE.
THANKS FOR VISITING.
Flynn Financial Group Inc