2017 tax law limits business interest deductibility

The 1986 tax law created limitations on the deductibility of certain types of interest. This law forced tax practitioners to classify interest into categories. Personal interest became nondeductible. Business interest remained fully deductible.

The need to classify interest by category, and more importantly the differential tax result afforded these different categories, forced the Treasury Department to issue detailed regulations to “trace” interest by the use of the funds that generate that interest.

The 2017 Tax Cuts and Jobs Act now imposes limits on the deductibility of the most-favored classification — business interest. Beginning in 2018, a taxpayer may deduct business interest only to the sum of 30 percent of the adjusted taxable income of the taxpayer and any business interest income.

For tax years 2018 to 2021 adjusted taxable income is determined without depreciation, amortization, or depletion (allowing more business interest to be deducted). Any disallowed business interest will carry forward to future tax years and may then be claimed if the taxpayer’s adjusted taxable income is sufficient to allow it under the 30 percent test.

The good news: Most New Mexico businesses will be exempt from this provision. If the business has average annual gross receipts, determined over a three-year period, of $25 million or less, the new deduction limitation will not apply.

The computations can get tricky when the business is operated through a passthrough entity such as a partnership or an S corporation. There is a special limitation to prevent double counting of income and an additional deduction allowed to the partner or shareholder for excess business income of the entity.

The deduction limit is first applied at the passthrough entity level. The entity computes its adjusted taxable income and determines how much of its business interest may be deducted.

Let’s say a partnership with four equal owners has $1 million of income and business interest expense of $300,000. The deduction limit is $300,000 (30 percent of the income) and the partnership will be able to pass through the full amount of the interest to its owners.

When the owner receives the partnership information return (a schedule K-1), it will show $250,000 of income (25 percent of the total) and $75,000 of business interest expense.

Because the $250,000 increases the partner’s income, that income could then allow a second $75,000 business interest deduction at the partner’s level. To prevent this double counting, the partner computes adjusted taxable income without regard to the partnership income.

If this partner has an additional $20,000 of business interest but only $50,000 of non-partnership taxable income, the business interest deduction is limited to $15,000 (30 percent of $50,000). Note that the partner has already deducted the partnership’s business interest.

Now let’s assume that the partnership has $1.5 million of income but still has only $300,000 of business interest. This partnership is said to have excess taxable income.

The partnership has $500,000 of excess taxable income over what is needed to claim its own business interest. This excess is then allocated among the partners so they can claim more interest at their own level.

So, a 25 percent partner in this partnership has $125,000 of excess taxable income that would allow an additional $37,500 of business interest. This computation effectively allows the partner to use the full share of partnership income (25 percent of $1.5 million, or $375,000) to claim deductions as large as $112,500 (30 percent of $375,000).

Because the partnership has allocated only $75,000 of business interest to this 25 percent partner, he is then able to use the excess partnership income to fully deduct the $5,000 that was disallowed in the original example.

If this seems complicated, then realize that your business will probably be exempt under the $25 million average annual gross receipts test.

Whoever is tasked with preparing the partnership’s tax return may not be exempt from these rules and calculations. The partnership return preparer does not know if all partners will meet the gross receipts exemption. It is then likely that 2018 partnership returns will need to provide this information.

It is possible that, by regulation, a partnership may be exempt from reporting if it is known that all partners are also exempt. But this is one more burden for Treasury to sort out in the new law.