Section 163(j) Final Regulations Warrant Close Scrutiny for Self-Charged Interest Rules

On January 5, 2021, the U.S. Department of Treasury and the IRS issued new Final Regulations for IRC Section 163(j) (TD 9943) that apply limitations on the deductibility of business interest expense. Proposed Regulations had been issued in November 2018 and Final Regulations with new Proposed Regulations were issued in July 2020. The Proposed Regulations offered additional guidance and they were published in the Federal Register on September 14, 2020.

The Final Regulations adopted in January 2021 mirror the 2020 Proposed Regulations. They are in effect for taxable years beginning on or after the date 60 days after publication of the Final Regulations in the Federal Register. Entities may retroactively apply the 2021 Final Regulations to taxable years beginning after December 31, 2017, and before the 2021 Final Regulations are otherwise consistently applied.

Limitations on the Business Interest Expense Deduction

The deductibility of business interest expense (BIE) was limited by the Tax Cuts and Jobs Act (TCJA) which significantly altered Section 163(j) for tax years beginning after December 31, 2017. The taxpayer’s business interest expense deduction limit is the sum of 30% of adjusted taxable income (ATI) for that year, its business interest income (BII), and its floor plan financing interest. The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) increased the 30% limitation to 50% for tax years 2018 through 2020.

The intent of IRC Section 163(j) is to limit a taxpayer’s deduction for business interest expense in any tax year. The deduction is calculated as the sum of:

1. The taxpayer’s BII for the tax year that includes interest paid or accrued appropriately allocable to a trade or business. Business interest expense does not include investment interest.
2. The taxpayer’s floor plan financing interest for the tax year.
3. A maximum of 30% of the taxpayer’s ATI for the tax year (but not less than zero). However, under the CARES Act, the 30% limit changed to 50% for 2019 and 2020 except in the case of a partnership. A partnership must use 30% for 2019 and 50% for 2020. Any business may choose to apply the 30% limitation instead of 50% for a given year. In 2020, a taxpayer may choose to use its 2019 ATI and if 2020 is a short period, it can prorate its 2019 ATI.

For partnerships, the business interest deduction limitation is applied at the partnership level and each partner’s ATI is increased by the partner’s share of excess taxable income (ETI) and excess business interest income (EBII). The amount of partnership BIE exceeding the Section 163(j) limitation is carried forward at the partner level as excess business interest expense (EBIE).

Clarifying Self-Charged Interest Rules for Partnerships

The Final Regulations provide guidance on the treatment of interest expense on self-charged lending transactions for partnerships. In cases where certain partners have made loans to their partnership, they are allowed to deduct their share of partnership interest expense with respect to the loan even if the interest expense deduction was disallowed to the partnership under Section 163(j). The deduction does not apply to loans made by a partnership to a partner, or loans made by a partner in an upper-tier partnership to a lower-tier partnership in which the upper tier partnership owns an interest.

This change means that pass-through entities and their related owners should consider whether the limited nature of the Final Regulations for self-charged interest relief will affect their current and future financing. Under Reg. 1.469-7, the scenarios that cause interest expense to be classified as self-charged and thus limit its deductibility are outlined and include situations where:

• A loan is made between two pass-through entities where each of the entities’ owners has the same proportionate ownership interests in each entity.
• A taxpayer makes a loan to a pass-through entity (a partnership or S corporation) in which it owns a direct or indirect interest at any time during the entity’s tax year.
• The pass-through entity makes a loan to a person or persons who own direct or indirect interests in the pass-through entity.

In most cases, a self-charged lending transaction in which the interest charged on a loan between a pass-through entity and its owner may lead to limitations on the deductibility of interest expense. Interest expense deductions may be disallowed, while the lender is taxed on the interest income. Thus, a pass-through entity owner in a self-charged interest situation may end up reporting interest income generated by the loan, while the interest expense is nondeductible.

Two examples illustrate the potential problems of self-charged interest:

• A partner who is not engaged in a lending business makes a loan to their partnership. The partnership uses the funds to make expenditures in connection with a passive activity in which the partner owns an interest. As a result, the lending partner has portfolio interest income (as the lender) and a distributive share of the partnership’s passive interest deductions.
• A similar result can occur if a partnership not engaged in lending business loans money to a partner who uses the money to make passive activity expenditures. The borrowing partner receives a distributive share of the partnership’s portfolio interest income and has passive interest deductions resulting from their use of the debt proceeds.

In either case, the regulations do not allow the partner to deduct the passive interest deductions from the portfolio interest income because the partner has essentially loaned the money to himself.

Recharacterization of Self-Charged Interest

An exception under this regulation provides for “recharacterization” of a portion of the taxpayer’s distributive share of self-charged interest income as passive activity gross income and recharacterization of certain deductions for self-charged interest expense that are properly allocable to the self-charged interest income as passive activity deductions. This exception allows for the “netting” of income and deductions that otherwise would be placed into separate categories of income and deductions and not offset one another. The pass-through entity irrevocably elects out of the recharacterization option.

Considerations for Business Interest Expense

The 2020 Proposed Regulations provided that in a transaction between a lending partner and a borrowing partnership in which the lending partner owns a direct interest in any BIE of the borrowing partnership attributable to the self-charged lending transaction, that self-charged interest is considered BIE for purposes of determining the partnership’s IRC Section 163(j) limitation. The intent of the Proposed Regulations was to avoid subjecting BIE associated with a partner loan to the limitations of Section 163(j), to the extent this BIE would be allocated to the lending partner.

Under the Final Regulations, if a partner lends money to a partnership and is allocated EBIE from the partnership (interest that is not currently deductible), the lending partner may treat the interest income attributable to it as receiving an allocation of EBII from the borrowing partnership in the same taxable year. This frees up the EBIE equal to the interest income generated by the partner from the lending transaction.

In the case of a lending partner (other than a C corporation) who has interest income on the self-charged lending transaction greater than the lending partner’s allocation of EBIE from the borrowing partnership and for which the interest income would be considered portfolio investment income in the hands of the lending partner for that year under Section 163(j), the excess amount of interest income would continue to be treated as investment income for that year.

Summary

Although the Final Regulations provide greater clarity on Section 163(j), the rules are very complex and some provisions have not yet been finalized. Taxpayers, and particularly partnerships, should consult their tax advisors for assistance in tax planning and compliance.

If you have any questions on this topic, please contact your ALL tax advisor or call us at 617-738-5200.