8533 / Is business interest deductible when the business is a pass-through entity?

Editor’s Note: The CARES Act modified the rules for calculating the business interest deduction in 2019 and 2020. For 2020, the 30 percent limit increased to 50 percent (the 30 percent limit continued to apply to partnerships in 2019).¹ All entities (corporations and pass-throughs) were permitted to use 2019 ATI instead of 2020 ATI in determining the 2020 business interest expense deduction, which often increased the business interest deduction for businesses who experienced reduced income levels in 2020.²

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 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 reform legislation 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 $31 million for 2025 ($30 million in 2024, $29 million in 2023, $27 million in 2022, $26 million in 2019-2021) 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 See Q for more information on the small business exemption.

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