The new Tax Cuts and Jobs Act limits the ability of many businesses to deduct interest payments. Under prior law, any interest expense was generally deductible. Now, many businesses are prohibited from deducting any interest expense that exceeds 30 percent of adjusted taxable income.
Before January 1, 2022, the formula for calculating net taxable income generally approximates EBITDA. Beginning in 2022, the formula will generally approximate EBIT. The EBIT formula will make the limitation even more restrictive for capital intensive businesses that finance equipment acquisitions with debt because they will be prohibited from adding back depreciation and amortization expenses to earnings for purposes of calculating the 30 percent limitation. When the EBIT formula becomes effective, it will apply to all debt regardless of whether incurred before or after 2022.
Several key points concerning the new limitation include:
- The limitation does not apply to businesses with less than $25 million in average gross receipts for a trailing three-year period.
- The gross receipts of related businesses are combined for purposes of the $25 million test. If the combined receipts exceed $25 million, the 30 percent limitation applies to each business.
- Real property businesses (including development, construction, rental, management, leasing and brokerage businesses) are allowed to make an irrevocable election out of the business interest deduction limitation, but if so electing must use the alternative depreciation system for their nonresidential real property, residential rental property, and qualified improvement property.
- Disallowed interest expenses may be carried forward indefinitely.
Family businesses subject to the new limitation should reassess their current debt profile. Beginning in 2022, family businesses in capital intensive industries may have little or no ability to deduct interest payments. In addition, family businesses that are looking to make a debt-financed acquisition, or that are considering a sale of their business, may be negatively impacted by the new limitation. It is generally anticipated that the limitation will raise the cost of debt-financed acquisitions.