While the U.S. federal tax overhaul passed at the end of 2017 lowers corporate tax rates, it also limits the extent to which businesses can claim interest deductions. Now is the time to plan for how these new caps will impact your future tax bills.
Additionally, the change represents an opportunity to rethink how you use debt to finance capital spending and growth projects.
Before plunging into planning, though, assess whether you will in fact face changes to your interest deductions. Businesses whose average gross receipts for the preceding three years were less than $25 million are not subject to the new interest limitations. That’s a plus for truly small businesses, who will be spared the administrative burden, and possibly the lost deductions, involved in implementing the new rules.
The new tax code also allows farm and real estate businesses to opt out of the limits, regardless of their size. However, keep in mind that doing so will force you to forego the ability to use certain faster methods for depreciation. As with most areas of the new tax code affected taxpayers will need to weigh the pros and cons of their options.
If you are subject to the new rules, here are some key features of them that you should know:
There’s a 30% Cap on Tax-Basis EBITDA on Interest Deductions Through 2021
Through 2021, the tax code caps interest deductions at 30 percent of tax-basis Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). For the businesses to which the limit applies, lost tax deductions could result in higher taxes.
Calculating the impact of the limit is straightforward. For example, assume a business has $1 million of tax-basis earnings after $9 million in depreciation and amortization and $5 million of interest payments. For 2018, this business can deduct only $4.5 million of business interest. The limit base is $15 million, which is the $1 million of earnings plus $9 million of depreciation, plus $5 million of interest payments. Thirty percent of $15 million is $4.5 million.
Capping the interest deduction at $4.5 million for 2018 would mean the business could pay tax on $500,000 more in income than it did in 2017, when there was no cap on business interest.
The limit applies similarly for each type of legal entity. However, for pass-through structures such as partnerships and S-corps, there are complexities in how the rules flow to the owner level.
The Limit Base Changes in 2022
Beginning with the 2022 tax year, the limit calculation changes to remove the effects of depreciation and amortization. This change means the limit and the amount of interest that’s deductible will be lower starting in 2022, all other facts being equal. With the same facts as the example above, in 2022, with depreciation factored in, the limit base would be $6 million instead of $15 million as at present. As a result, only $1.8 million of interest would be deductible, rather than the $4.5 million that was allowable under the old rules.
For businesses with significant leverage, the change in limit base to include depreciation warrants planning, because it can trigger a meaningful change in cash flow.
That the limit through 2021 uses tax-basis earnings before depreciation is key, in part because of changes to another part of the tax act, governing bonus depreciation rules. Through 2022, these new rules allow businesses to charge-off 100% of the cost of eligible assets when they are placed in service. Another change is that the 2017 tax act permits bonus depreciation for used property, not just new assets.
Almost All Interest is Subject to the Limit
The new rules carve out only one type of debt that isn’t subject to the limit. The tax code now makes a specific exclusion for the arrangements motor vehicle dealerships use to finance their inventories.
Otherwise, interest subject to the limit is inclusive, and the tax code does not favor one type of debt over another, whether by seniority or security. Congress also did not change the rules that define interest for tax purposes by, for example, expanding the definition of taxable interest to include tools such as merchant cash advances, which are not loans.
Overall, the stability and inclusivity in the changes to taxation of interest will be a positive for many businesses, because it will reduce a potential administrative burden and allow the flexibility to use any type of debt without worry about its tax implications compared with alternative types.
Interest Above the Cap Carries Forward Without Expiration
Under the new code, if your business maxes out on its interest deduction for the year, any excess deductions can be carried forward to the next year, and then carried forward again if you hit the maximum then as well. This indefinite carry-forward feature is a potential benefit for growing businesses who make investments that serve to exceed their deductions, because they can apply those to a future year in which they have earnings sufficient to absorb the excess.
In the example above where the interest deduction maxed out at $4.5 million in 2018, and the total interest was $5 million, $500,000 in interest would carry forward to the next year. In each tax year, however, the cap on total interest applies, whether incurred currently or brought forward from a previous year, based on that year’s adjusted taxable income. There are complexities in how the rules treat carryforward amounts in pass-through entities such as partnerships and S-corps.
The Top Corporate Rate Will Be Lower
Through the gross-receipts exemption, and by setting the cap at 30% of tax-basis EBITDA through 2021, Congress narrowed the pool of affected small businesses. For businesses that are more leveraged, and so may face new limits on the interest deductions they claim, there is another consideration: By reducing the top corporate tax rate from 35 percent to 21 percent, the impact of the new limits are mitigated. That’s because the lost benefit will be less valuable than when tax rates were higher.
Even without the tax shield, debt is a less expensive source of capital than equity. In the end, then, small businesses are as likely as ever to look to the debt section of their balance sheet to finance capital spending and growth projects.
Maxime Rieman is Product Manager at ValuePenguin. Educating and assisting shoppers about financial products has been Rieman's focus, which led her to joining ValuePenguin, a consumer research and advice company based in New York. Previously, she was product marketing director at CoverWallet and launched the personal insurance team at NerdWallet.
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