We are hearing this question more and more now that the CARES Act has passed—are there other tax planning items to examine to minimize the amount of paperwork?
Section 163(j) received a major overhaul with the 2017 Tax Cuts and Jobs Act (TCJA). Before 2018, this tax provision typically applied to foreign-owned U.S. businesses, the so-called “inbound businesses.” Beginning in 2018, for a calendar year corporate taxpayer, it applies to taxpayers that are inbound but also US corporations with US ownership.
Limit on tax-deductible interest deductions
Section 163(j) is quite technical but big picture; it limits tax-deductible interest deductions to 30% of EBITDA from calendar year 2018-2021. From calendar year 2022 thereafter, the 30% limitation is applied to a company’s EBIT. In the tax code, they call this adjusted taxable income (ATI); however, conceptually, it is extremely close to EBITDA/EBIT. The concern Congress addressed was that companies were taking on too much debt. Reducing the amount of interest that could be deducted was therefore thought of as a way to reduce the incentive for companies to over-leverage their businesses. The 30% figure was determined in a Congressional committee.
Reduced phantom income
The CARES Act gave a generous gift to corporate taxpayers. When an expense is disallowed for tax purposes but is a real expense that your business pays, this phantom income can result in real cash taxes that your business must pay. The CARES Act can reduce your phantom income in a specific way. For calendar taxpayers, tax years 2019 and 2020 only, corporations can use a 50% figure rather than a 30% figure. In practical terms, this means for 2019, a C corporation (C-Corp) has $100,000 in ATI, $100,000 in interest expenses that are otherwise deductible, under the TCJA rules, that corporation would be limited to a $30,000 deduction for interest. However, under the CARES Act, that corporation can deduct $50,000 in interest expense. In this small example, that is $4,200 of reduced taxes.
In some cases, this additional deduction can create a net operating loss. As discussed in a previous article, net operating losses can be carried back five tax years when the tax rate was 35%. Further, the CARES Act was forward-thinking. For 2020, a C-Corp can choose to use the 2019 or 2020 ATI to figure the interest expense limitation. That means, if a business suffers higher expenses in 2020, that business can at least use 2019 ATI to figure the allowable interest expense under section 163(j). Recall that 2020 net operating losses may also be carried back five years.
The benefit of the amended section 163(j) limitations is not just for C-Corps or calendar year taxpayers. Partners of partnerships are also impacted but the benefits generally begin in calendar year 2020. Fiscal-year filers will also have benefits under these new rules. Calvetti Ferguson has taxation experts who can help guide your business optimally through these rules.
Your CPA is likely hard at work on your 2019 taxes right now. The sooner your business can submit the required data, the sooner the benefits under the CARES Act can be maximized for your business. If you have filed already and have relatively large interest expenses, it is worth a second look at that return. We are ready and able guide your business through changes to Section 163(j), as well as impacts on other tax provisions to reduce your cash taxes and improve cash flow.
It can be difficult to make sense of all the new legislation passed in the wake of COVID-19. Contact us to learn more about these exciting tax benefits and how this can apply to your business. Check out our COVID-19 Resources page for more information.