The bill generally limits the amount allowed as a deduction for business interest to the sum of the taxpayer’s business interest income and 30% of the taxpayer’s adjusted taxable income for the taxable year. In general, a taxpayer’s “adjusted taxable income” is its taxable income, determined by excluding (i) items not attributable to a trade or business, (ii) business interest income and business interest expenses, (iii) any net operating loss deduction, and (iv) deductions for depreciation, amortization or depletion.
In the case of partnerships, the limitation on the deductibility of business interest applies at the partnership level. That means that the deductibility of a partner’s share of a partnership’s business interest is determined by reference to the partnership’s adjusted taxable income, without regard to the amount of the partners’ adjusted taxable income. After application of the limitation, any partnership deduction for business interest will reduce the net business income allocated by the partnership to its partners.
- To prevent double counting, a partner’s adjusted taxable income will be determined without taking into account the partner’s share of the net business income of the partnership.
- If a partnership has excess capacity for business interest deductions, a partner is permitted to increase its limitation amount for its own business interest deductions. Specifically, the partner’s limitation amount will be increased by its share of the partnership’s “excess amount,” which is equal to the excess of (x) 30% the partnership’s adjusted taxable income over (y) the partnership’s net business interest expense (that is, the amount, if any, by which the partnership’s business interest expenses exceed its business interest income).
- If, instead, a partner has excess capacity for business interest deductions, but a portion of the partnership’s business interest expenses are disallowed, the partner is not permitted to take any portion of its share of the partnership’s disallowed business interest expense into account as a deduction. Rather, consistent with the application of the limitation at the partnership level, the partnership will carry forward its disallowed interest expense for purposes of determining its taxable income in subsequent years, but not past the fifth subsequent taxable year.
Because the excess amount rule applies only to the extent the partnership has unused capacity to deduct business interest, a single taxpayer’s total direct and indirect adjusted gross income and total direct and indirect business interest expense are not aggregated and, as demonstrated below, many situations could arise in which a taxpayer is left with an aggregate interest deduction limitation far more onerous than what the “30% of adjusted taxable income” concept contained in the statute implies.
Below, we provide examples of how the rule would operate in three common scenarios. All of the examples assume that neither the partner nor the partnership has any business interest income.
- Excess Capacity Above Partnership. Assume that, in a particular taxable year, a taxpayer’s adjusted taxable income (which, as discussed above, does not include the taxpayer’s share of the net business income of a partnership) is $100 and the taxpayer pays $20 of business interest. Assume also that the taxpayer is a 50% partner in a partnership and that, for the same taxable year, the partnership’s adjusted taxable income was $100 and the partnership paid $40 of business interest. In determining the taxable income that it will allocate to its partners, the partnership will treat only $30 of the $40 as a deductible interest expense. As a result, the taxpayer’s share of the partnership’s net income will be $35 (50% of $70). The taxpayer will thus have taxable income of $115 — $100, minus a business interest deduction of $20, plus his $35 share of the partnership’s taxable income, reflecting business interest deductions of $35 ($20 plus 50% of $30). If, by contrast, the limitation were determined at the partner level, the taxpayer would have adjusted taxable income of $150 and business interest expenses of $40, all of which would be allowed as a deduction. As a result, the taxpayer’s taxable income would be $110, reflecting business interest deductions of $40.
- Excess Capacity in Parallel Structure. A similar example illustrates how this rule could be seen as “shortchanging” a taxpayer with investments in two different partnerships. Assume a taxpayer with no other source of taxable income is a 50% partner in each of Partnership A and Partnership B and, in a particular taxable year, each partnership has $100 of adjusted taxable income. Assume further that Partnership A incurs $40 of business interest expense and Partnership B incurs $20 of business interest expense. Partnership A may claim an interest deduction of $30 and will have an interest expense carryforward of $10; Partnership B may claim an interest deduction of $20. Based on his 50% interest in each of the partnerships, the taxpayer’s share of the taxable income of the partnerships is $35 and $40, respectively, or $75. If, by contrast, the limitation were determined at the partner level, the taxpayer would have had $100 of adjusted taxable income and $30 of interest expense, with the result that his taxable income would have been $70. As a result of the application of the limitation at the partnership level, the taxpayer will instead have $75 of taxable income despite having economically borne $30 of interest expense on $100 of adjusted taxable income.
- Excess Capacity in Partnership. To illustrate what the excess amount rule does accomplish, assume a third example in which a taxpayer with $100 of adjusted taxable income has $40 of business interest expense and is a 50% partner in a partnership with $100 of adjusted taxable income that has $20 of business interest expense. The taxpayer will be entitled to deduct all $40 of his interest expense because the excess amount rule allows him to increase his limitation by an amount equal to $10 (i.e., 30% of the partnership’s $100 adjusted taxable income over the partnership’s $20 net interest expense).
Note that, in contrast to the disaggregated way in which the rule applies in the partnership context, the description of the provision provided by the Joint Committee on Taxation says that, in the case of a group of affiliated corporations that file a consolidated return, the limitation applies at the consolidated tax return filing level.