As the Fed tries to ease inflation by increasing interest rates, there’s a rather nasty tax issue lurking in the shadows. For businesses that issued floating-rate debt, the interest rate is about to increase significantly at the next reset date because the Fed recently increased its benchmark interest rate by 75 basis points for the second straight month. In addition to the increased out-of-pocket cost, there is also added cost because of the dreaded “163(j) Limitation.”
For those not too familiar with section 163(j) of the Internal Revenue Code, this section came about as part of the Trump-era Tax Cuts and Jobs Act (TCJA) that was passed in 2017. It was one of the revenue raisers that allowed Congress to use the budget reconciliation process to pass about $1.47 trillion of tax cuts. Section 163(j) was introduced under the guise of forcing American companies to be less reliant on debt to finance growth. The crux of section 163(j), without getting too far into the weeds, is that it requires businesses with average gross receipts of more than $27 million (adjusted annually) to cap their deductible interest expense to the sum of (i) the amount of their business interest income and (ii) 30% of their adjusted taxable income (ATI).
Before 2022, the rules were more favorable because businesses could add back to ATI depreciation, amortization, and depletion expenses. Starting in 2022, these items can no longer be added back to ATI, which can dramatically increase taxable income. Here is a simple example:
| 2021 | 2022 | |
| Taxable Income | 100,000 | 100,000 |
| Interest expense | 50,000 | 50,000 |
| Depreciation expense | 25,000 | — |
| Amortization expense | 10,000 | — |
| _________ | _________ | |
| Adjustable Taxable Income | 185,000 | 150,000 |
| 30% Limitation | 55,500 | 45,000 |
| Deductible interest | 50,000 | 45,000 |
| Non-deductible interest | — | 5,000 |
A $5,000 limitation on interest expense doesn’t seem too bad at first blush, especially when you factor in that you could get that deduction in a future year when you have “excess ATI” (that’s a topic for another article). What happens though if your business was to break even in 2022, holding all other factors constant? Let’s take a look:
| 2021 | 2022 | |
| Taxable Income | 100,000 | |
| Interest expense | 50,000 | 50,000 |
| Depreciation expense | 25,000 | — |
| Amortization expense | 10,000 | — |
| _________ | _________ | |
| Adjustable Taxable Income | 185,000 | 50,000 |
| 30% Limitation | 55,500 | 15,000 |
| Deductible interest | 50,000 | 15,000 |
| Non-deductible interest | — | 35,000 |
The example shows that the interest deduction limitation becomes much more costly in 2022 because it denies a deduction for interest expenses paid in cash. And this doesn’t even consider any increased interest expense that may occur because of rising interest rates.
There are numerous factors affecting your business right now. With increases to interest rates being used to curb spending and force inflation back down to more “reasonable” levels, you already know there is going to be some negative impact to your top line, and most probably your bottom line. The impacts of section 163(j) are lurking in the shadows, and unless something changes, there may not be any relief in sight.
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For more information on this topic, please contact a member of Withum’s Assurance and Accounting Services Team.
