Excess taxable income significantly impacts your business, so understanding it is crucial for effective financial planning. At income-partners.net, we demystify complex financial concepts like excess taxable income to help you navigate the intricacies of business finance and optimize your earnings potential through strategic partnerships. By understanding how excess taxable income works, you can better manage your tax liabilities and make informed decisions to boost your bottom line; explore innovative partnership opportunities to amplify your revenue streams and achieve sustainable growth.
Table of Contents
- General Understanding of Excess Taxable Income
- Who Is Affected by the Section 163(j) Limitation?
- Understanding the Gross Receipts Test for Section 163(j) Limitation
- Scenario: Navigating Gross Receipts and Section 163(j) Limitation
- What Businesses Qualify as an Excepted Trade or Business?
- Electing for Excepted Trade or Business Status
- Consequences of Electing Excepted Trade or Business Status
- Defining Interest for Section 163(j) Purposes
- Understanding Business Interest Expense
- What Constitutes Business Interest Income?
- Calculating Adjusted Taxable Income (ATI) for the ATI Limitation
- Making the Election to Substitute Adjusted Taxable Income for the Last Taxable Year in 2019
- Understanding Floor Plan Financing Interest Expense
- Handling Business Interest Expense Disallowed in the Current Year
- Determining the Section 163(j) Limitation for Businesses Engaged in Both Excepted and Non-Excepted Trades or Businesses
- How the Section 163(j) Limitation Applies to Partnerships and S Corporations
- Accounting for Business Interest Expense in Computing the Section 704(d) Basis Loss Limitation
- Applying the Section 163(j) Limitation to a Consolidated Group of Corporations
- Does the Section 163(j) Limitation Apply to Foreign Corporations?
- Temporary Changes Under the CARES Act
- Temporary Changes Under the CARES Act for Partnerships and Its Partners
- Making an Election Under the CARES Act
- FAQ on Excess Taxable Income
1. General Understanding of Excess Taxable Income
Excess taxable income (ETI) refers to the amount of a partnership’s adjusted taxable income (ATI) that exceeds what is needed to deduct its business interest expense. In simpler terms, ETI is the extra income a business has after accounting for interest expenses, subject to certain limitations. Understanding how excess taxable income can impact your business is essential for making informed financial decisions, and income-partners.net is here to guide you through every step.
Unpacking the Section 163(j) Limitation
Generally, taxpayers can deduct interest expense paid or accrued in the taxable year. However, the section 163(j) limitation restricts the amount of deductible business interest expense in a taxable year. It cannot exceed the sum of:
- The taxpayer’s business interest income for the taxable year.
- 30% of the taxpayer’s adjusted taxable income (ATI) for the taxable year.
- The taxpayer’s floor plan financing interest expense for the taxable year.
According to the IRS, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) allowed a different percentage (50%) of ATI to be applied for taxable years beginning in 2019 and 2020. Revenue Procedure 2020-22 outlines ATI elections and special rules for partnerships during this period.
2. Who Is Affected by the Section 163(j) Limitation?
The section 163(j) limitation applies to all taxpayers with business interest expense for taxable years beginning after December 31, 2017, except for certain small businesses that meet the gross receipts test in section 448(c) (“exempt small business”), certain electing trades or businesses, and certain excepted trades or businesses. Therefore, most businesses, including corporations, partnerships, and S corporations, may be subject to this limitation.
3. Understanding the Gross Receipts Test for Section 163(j) Limitation
The gross receipts test of section 448(c) is met if the business is not a tax shelter (as defined in section 448(d)(3)) and has average annual gross receipts of $25 million or less in the previous three years. This amount is adjusted annually for inflation. For example, the inflation-adjusted gross receipts amount was $26 million for 2019 through 2021 and $27 million for 2022.
| Year | Gross Receipts Amount |
|---|---|
| 2019-2021 | $26 million |
| 2022 | $27 million |
4. Scenario: Navigating Gross Receipts and Section 163(j) Limitation
Let’s say your average annual gross receipts for 2018-2020 were more than $26 million, but your gross receipts in 2021 decreased enough to lower your average annual gross receipts for 2019-2021 to below $27 million. In this case, you would be subject to the section 163(j) limitation for the 2021 taxable year, but the limitation would not apply to you for the 2022 taxable year. Any business interest expense disallowed in 2021 due to the limitation is carried forward to 2022 and is no longer subject to the limitation in 2022.
5. What Businesses Qualify as an Excepted Trade or Business?
The following businesses qualify as excepted trades or businesses:
- The trade or business of providing services as an employee.
- Certain real property trades or businesses that elect to be excepted.
- Certain farming businesses that elect to be excepted.
- Certain regulated utility trades or businesses.
6. Electing for Excepted Trade or Business Status
To elect to be an excepted trade or business, an eligible real property trade or business or farming business must follow the procedures outlined in Treas. Reg. §1.163(j)-9, including attaching a statement to a timely filed federal income tax return (including any extensions) for the taxable year of election. Revenue Procedures 2018-59, 2020-22, and 2021-9 provide additional guidance.
| Required Information for Election Statement |
|---|
| Taxpayer’s name, address, and social security number or EIN |
| Description of the electing trade or business |
| Statement of election as a real property or farming business |
An exempt small business is also permitted to make this election, even if it is not already subject to the section 163(j) limitation. Once made, an election is generally irrevocable and binding on the trade or business for all succeeding years.
7. Consequences of Electing Excepted Trade or Business Status
Electing to be an excepted real property trade or business means that certain assets held in the electing trade or business must be depreciated using the alternative depreciation system (ADS) and are not eligible for a bonus depreciation deduction under section 168(k). These assets include nonresidential real property, residential rental property, and qualified improvement property.
Similarly, electing to be an electing farming business requires that any property with a recovery period of 10 years or more held in the electing farming business must be depreciated using ADS and is not eligible for a bonus depreciation deduction under section 168(k). Revenue Procedures 2019-08, 2020-22, 2020-25, and 2021-9 provide further details.
8. Defining Interest for Section 163(j) Purposes
Treas. Reg. §1.163(j)-1(b)(22) defines “interest” to determine interest expense and interest income for purposes of section 163(j). Interest is any amount paid, received, or accrued as compensation for the use or forbearance of money under the terms of an instrument or contractual arrangement treated as a debt instrument for purposes of section 1275(a) and Treas. Reg. §1.1275-1(d), or any amount treated as interest under other provisions of the Code or regulations.
This definition includes anti-avoidance rules and a list of other amounts treated as interest, such as certain amounts of bond premium, factoring income, and certain dividends from regulated investment companies.
9. Understanding Business Interest Expense
Business interest expense is any interest expense properly allocable to a trade or business that is not an excepted trade or business. Floor plan financing interest expense is also considered business interest expense. Understanding this distinction is critical for accurately calculating your section 163(j) limitation.
10. What Constitutes Business Interest Income?
Business interest income is interest income includable in gross income and properly allocable to a trade or business that is not an excepted trade or business. To accurately determine your section 163(j) limitation, it’s crucial to differentiate between interest income from excepted and non-excepted trades or businesses.
11. Calculating Adjusted Taxable Income (ATI) for the ATI Limitation
ATI is calculated by starting with taxable income for the taxable year (as if section 163(j) does not limit any interest deduction) and then adding and subtracting certain amounts.
| Additions to Taxable Income | Subtractions from Taxable Income |
|---|---|
| Business interest expense | Business interest income |
| Net operating loss deduction | Floor plan financing interest expense |
| Deduction for qualified business income under section 199A | Depreciation, amortization, or depletion of property sold (for taxable years beginning before 2022) |
| Depreciation, amortization, or depletion (for years before 2022) | Income or gain not properly allocable to a non-excepted trade or business |
| Capital loss carrybacks or carryovers | |
| Deduction or loss not allocable to a non-excepted trade |
For taxable years beginning after January 1, 2022, deductions for depreciation, amortization, or depletion are not added back to taxable income when calculating ATI.
12. Making the Election to Substitute Adjusted Taxable Income for the Last Taxable Year in 2019
The CARES Act allows taxpayers to elect to substitute their ATI for the last taxable year beginning in 2019 for their ATI in determining the section 163(j) limitation for any taxable year beginning in 2020, subject to modifications for short taxable years. If this election is made, complete line 22, adjusted taxable income, on Form 8990 and leave lines 6 through 21 blank. No formal statement is required to make this election.
Tax Forms
13. Understanding Floor Plan Financing Interest Expense
Floor plan financing interest expense is interest paid or accrued on floor plan financing indebtedness. This indebtedness is used to finance the acquisition of motor vehicles held for sale or lease and is secured by the acquired inventory. For example, interest paid on a loan secured by a dealership’s office equipment is not considered floor plan financing interest expense.
14. Handling Business Interest Expense Disallowed in the Current Year
Business interest expense disallowed as a deduction in the current year under section 163(j) is carried forward to the next taxable year as a “disallowed business interest expense carryforward.” This carryforward may be limited in the next taxable year if the section 163(j) limitation continues to apply. Special rules apply to partnerships and S corporations, as detailed below.
15. Determining the Section 163(j) Limitation for Businesses Engaged in Both Excepted and Non-Excepted Trades or Businesses
Interest expense properly allocable to an excepted trade or business is not subject to the section 163(j) limitation. Similarly, items of income, gain, deduction, or loss, including interest income properly allocable to an excepted trade or business, are excluded in determining the section 163(j) limitation. Tax items should be allocated between excepted and non-excepted trades or businesses to determine the section 163(j) limitation.
Treas. Reg. §1.163(j)-10 provides special rules for allocating various tax items. Generally, you must compare your basis in the assets used in your excepted trades or businesses and your basis in the assets used in your non-excepted trades or businesses to determine what portion of interest expense and interest income to allocate to your excepted trades or businesses. In limited cases, tracing of interest expense paid on certain nonrecourse debt may be available.
16. How the Section 163(j) Limitation Applies to Partnerships and S Corporations
The section 163(j) limitation is applied at the partnership level. The amount of deductible business interest expense in a taxable year cannot exceed the sum of the partnership’s business interest income, 30% of the partnership’s ATI, and the partnership’s floor plan financing interest expense.
Business interest expense deductible after applying the section 163(j) limitation is considered in determining the non-separately stated taxable income or loss of the partnership. Any business interest expense disallowed due to the section 163(j) limitation is allocated to each partner in the same manner as the non-separately stated taxable income or loss of the partnership. This is known as excess business interest expense (EBIE).
A partner carries forward their share of EBIE. In a succeeding taxable year, a partner may treat their EBIE as business interest expense paid or accrued by the partner to the extent the partner is allocated excess taxable income or excess business interest income from the same partnership. Excess taxable income is the amount of ATI of the partnership that was in excess of what it needed to deduct its business interest expense. Excess business interest income is the amount by which business interest income exceeded business interest expense at the partnership level.
S corporations apply the section 163(j) limitation at the S corporation level. Any business interest expense disallowed due to the section 163(j) limitation is not allocated to its shareholders but is instead carried over at the S corporation level to its succeeding taxable years. An S corporation allocates any excess taxable income and excess business interest income to its shareholders on a pro-rata basis.
Treas. Reg. §1.163(j)-6 provides special rules and defined terms relating to the application of section 163(j) to partnerships and S corporations. Treas. Reg. §1.163(j)-6(f)(2) specifically sets out the steps for allocating deductible business interest expense and the section 163(j) excess items for partnerships.
For taxable years beginning in 2020 only, a partner (unless they elect out) may treat 50% of their allocable share of a partnership’s EBIE for 2019 as an interest deduction for 2020 without limitation. The remaining 50% of the partnership’s EBIE for 2019 remains subject to the section 163(j) limitation applicable to the EBIE carried forward at the partner level.
17. Accounting for Business Interest Expense in Computing the Section 704(d) Basis Loss Limitation
Treas. Reg. §1.163(j)-6(h) provides for a separate section 704(d) loss class for business interest expense, comprised of:
- Deductible business interest expense and business interest expense of an exempt entity.
- Any excess business interest expense (EBIE) allocated to the partner in the current taxable year.
- Any EBIE from a prior taxable year that was suspended under section 704(d) (negative section 163(j) expense).
After the partner determines the amount of the limitation apportioned to this section 704(d) loss class, any deductible business interest expense is taken into account before any EBIE or negative section 163(j) expense. This provision is generally applicable for taxable years beginning on or after November 13, 2020.
18. Applying the Section 163(j) Limitation to a Consolidated Group of Corporations
The section 163(j) limitation applies at the consolidated return level, and a consolidated group has a single limitation. In calculating the limitation, a consolidated group’s business interest expense and business interest income are, respectively, the sum of its members’ business interest expense and business interest income. The consolidated group should calculate its ATI using the group’s taxable income as determined under Treas. Reg. §1.1502-11 without regard to any carryforwards or disallowances under section 163(j).
19. Does the Section 163(j) Limitation Apply to Foreign Corporations?
Yes, the section 163(j) limitation applies to any foreign corporation whose classification is relevant under Treas. Reg. §301.7701-3(d)(1) for a taxable year other than solely pursuant to section 881 or 882. As a result, section 163(j) applies to any foreign corporation that is a controlled foreign corporation (CFC). Generally, section 163(j) applies to a CFC in the same manner as it applies to a domestic C corporation. If a CFC is a partner in a partnership, the section 163(j) limitation applies to the partnership in the same manner as if the CFC were a domestic C corporation.
If a CFC group election is in effect, a single section 163(j) limitation is computed for the CFC group under rules provided in Treas. Reg. §1.163(j)-7(c). In addition, if a CFC or CFC group is eligible for a safe-harbor election, none of the CFC’s or CFC group members’ business interest expense is disallowed in a taxable year for which the election is made.
Section 163(j) also applies to any foreign corporation (or other foreign person) that is engaged in a U.S. trade or business. Prop. Reg. §1.163(j)-8 provides rules for determining the amount of ATI and calculating the limitation for the foreign corporation (or other foreign person). In the case of a foreign corporation engaged in a U.S. trade or business, the proposed regulations coordinate the application of section 163(j) with the rules for allocating interest expense to income effectively connected with a U.S. trade or business.
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20. Temporary Changes Under the CARES Act
The CARES Act amended section 163(j) to provide benefits to taxpayers. These amendments primarily affect the ATI percentage used in the limitation calculation and offer options for substituting ATI from previous years.
The CARES Act:
- Retroactively increases the ATI percentage for taxable years beginning in 2019 and 2020 to 50% (rather than 30%). A taxpayer can elect not to apply the 50% ATI limitation and use the 30% ATI limitation instead. The election is made by filing a return using the 30% ATI limitation instead of the 50% ATI limitation. No formal statement is required to be attached to the return.
- Allows a taxpayer to elect to substitute the taxpayer’s 2019 ATI for the 2020 ATI in determining the taxpayer’s section 163(j) limitation for taxable years beginning in 2020.
21. Temporary Changes Under the CARES Act for Partnerships and Its Partners
The CARES Act provides special rules for partnerships and partners:
- For taxable years beginning in 2019, a partner treats 50% of their allocable share of a partnership’s excess business interest expense (EBIE) for 2019 (2019 EBIE) as an interest deduction without limitation in the partner’s first taxable year beginning in 2020 (50% EBIE rule). A partner may elect out of the 50% EBIE rule. The remaining 50% of such EBIE remains subject to the section 163(j) limitation rules applicable to EBIE carried forward at the partner level.
- The 50% ATI limitation does not apply to partnerships for taxable years beginning in 2019.
- A partnership may elect to use the 30% ATI limitation instead of 50% for only taxable years beginning in 2020. No formal statement is required to be attached to the return.
- A partnership may elect to substitute the partnership’s 2019 ATI for the 2020 ATI in determining the partnership’s section 163(j) limitation for taxable years beginning in 2020. A partnership makes this election by timely filing Form 1065, including extensions, amended Form 1065 as appropriate or administrative adjustment request. No formal statement is required to be attached to the return.
22. Making an Election Under the CARES Act
Revenue Procedure 2020-22 provides more information on how to make an election under the CARES Act. These elections can significantly impact your tax liability, so understanding the procedures is crucial.
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23. FAQ on Excess Taxable Income
Q1: What Is Excess Taxable Income (ETI)?
ETI is the amount of a partnership’s adjusted taxable income (ATI) that exceeds what is needed to deduct its business interest expense.
Q2: Who is affected by the Section 163(j) limitation?
The limitation generally applies to all taxpayers with business interest expense, except for certain small businesses and those in excepted trades or businesses.
Q3: What are examples of excepted trades or businesses?
Examples include providing services as an employee, certain real property trades, farming businesses, and regulated utility trades.
Q4: How do I calculate adjusted taxable income (ATI)?
ATI is calculated by adjusting taxable income by adding back items like business interest expense and depreciation (for years before 2022) and subtracting items like business interest income.
Q5: What is business interest expense?
Business interest expense is any interest expense properly allocable to a trade or business that is not an excepted trade or business, including floor plan financing interest expense.
Q6: How does the Section 163(j) limitation apply to partnerships?
The limitation is applied at the partnership level, affecting how much business interest expense can be deducted.
Q7: What happens to business interest expense that I cannot deduct in the current year?
It is carried forward to the next taxable year as a “disallowed business interest expense carryforward.”
Q8: What temporary changes were made under the CARES Act?
The CARES Act increased the ATI percentage for taxable years beginning in 2019 and 2020 and allowed taxpayers to substitute 2019 ATI for 2020 ATI in certain cases.
Q9: How does a partner account for business interest expense when computing its Section 704(d) basis loss limitation?
A separate Section 704(d) loss class is created for business interest expense, which includes deductible business interest expense, EBIE, and negative Section 163(j) expense.
Q10: Does the Section 163(j) limitation apply to foreign corporations?
Yes, it applies to any foreign corporation whose classification is relevant under Treas. Reg. §301.7701-3(d)(1).
