8029 / Is business interest deductible when the business is a pass-through entity?

Under the CARES Act, partnerships could elect to apply modified rules. Under the CARES Act Section 163(j)(10)(A)(ii) amendments, a partner could elect to treat 50 percent of its allocable share of a partnership’s excess business interest expense (EBIE) for 2019 as an interest deduction in the partner’s first tax year beginning in 2020 without limit. The remaining 50 percent of EBIE remained subject to the Section 163(j) limitation applicable to EBIE carried forward at the partner level (discussed below). Partners could elect out of the rule. See heading below for details.³

Businesses that operate as pass-through entities (partnerships, S corporations, sole proprietorships) are permitted to deduct interest expenses incurred in operating the business. The 2017 Tax Act generally limits the interest expense deduction to the sum of (1) business interest income, (2) 30 percent of the business’ adjusted taxable income and (3) floor plan financing interest.⁴ Businesses with average annual gross receipts of $25 million ($31 million for 2025; $30 million in 2024) or less for the three-taxable year period that ends with the previous tax year are exempt from this new limitation (i.e., businesses that meet the gross receipts test of IRC Section 448(c)).⁵

These rules are applied at the partnership level, and the deduction for business interest must be taken into account in determining the non-separately stated taxable income or loss of the partnership.⁶ Under the 2017 tax reform legislation, the limit on the amount that is allowed as a deduction for business interest is increased by a partner’s distributive share of the partnership’s excess taxable income.⁷

“Excess taxable income” is the amount that bears the same ratio to the partnership’s adjusted taxable income as:

(x) the excess (if any) of (1) 30 percent of the adjusted taxable income of the partnership over (2) the amount (if any) by which the business interest of the partnership, reduced by floor plan financing interest, exceeds the business interest income of the partnership bears to

(y) 30 percent of the adjusted taxable income of the partnership.⁸

Excess taxable income must be allocated in the same manner as non-separately stated income and loss. A partner’s adjusted basis in his or her partnership interest must be reduced (not below zero) by the excess business interest that is allocated to the partner. The 2017 tax reform law provides that similar rules will apply to S corporations and their shareholders.⁹

As expressed in the Senate amendment to the 2017 tax reform legislation, the intent of this calculation was to allow a partner to deduct additional interest expense that the partner may have paid to the extent that the partnership could have deducted more business interest.

“Business interest” means interest paid on indebtedness that is properly allocated to a trade or business but excluding investment interest.¹⁰

“Business interest income” means the amount of interest income that is included in the entity’s income and properly allocated to a trade or business, excluding investment interest income.¹¹

“Trade or business” specifically excludes the trade or business of being an employee, any electing real property trades or businesses, electing farming businesses, furnishing or selling electrical, water or sewage disposal services, and gas or steam distribution and transportation.¹² Electing real estate businesses and farming businesses are permitted to elect out of the Section 163(j) limitation, but are then generally ineligible for increased bonus depreciation. Under the CARES Act, businesses that elected out of the Section 163(j) limit could revoke that election to take advantage of bonus depreciation, which may be valuable now that the so-called “retail glitch” was fixed by the CARES Act. The business revoked the election by filing an amended tax return or administrative adjustment request (AAR).¹³

“Adjusted taxable income” for purposes of these rules means taxable income computed without regard to non-business items of income, gain deduction and loss, business interest and business interest income, the net operating loss deduction under Section 172, the deduction for pass-through entities under IRC Section 199A and any deductions for depreciation, amortization or depletion.¹⁴

See Q for a discussion of the rules governing carryforwards of disallowed partnership business interest. See Q for a discussion of the general rules governing the corporate deduction for business interest.

CARES Act Elections

The IRS gave businesses substantial flexibility in making and revoking elections related to business interest expense deduction under the CARES Act. A taxpayer could simply elect under Section 163(j)(10)(A)(iii) not to apply the 50 percent ATI limitation for the 2019 or 2020 tax year (2020 only for partnerships).

An eligible taxpayer made the election not to apply the 50 percent ATI limitation by timely filing a federal income tax return or Form 1065 (or amendments) using the 30 percent ATI limitation. No formal statement was required. The taxpayer could then later revoke that election by filing an amended return or form using the 30 percent limit. Similarly, to use 2019 ATI for 2020, the taxpayer merely filed using 2019 ATI (and could then later revoke that election by filing a timely amended return or form).

The election was made at the partnership level.¹⁵