8533 / 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 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

“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 new 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 The final regulations released in 2020 specifically exclude commitment fees and debt issuance costs from the definition of interest. While partnership guaranteed payments and hedging gains or losses are not specifically included in the definition of business interest, examples in the regulations provide guidance on when such payments may be included. The final regulations retain substitute interest payments in the definition of interest because the payments generally are economically equivalent to interest. However, the final regulations provide that a substitute interest payment is treated as interest expense to the payor only if the payment relates to a sale-repurchase or securities lending transaction that is not entered into by the payor in the payor’s ordinary course of business. Further, the rules provide that a substitute interest payment is treated as interest income to the recipient only if the payment relates to a sale-repurchase or securities lending transaction that is not entered into by the recipient in the recipient’s ordinary course of business.

“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

“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.¹³

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

A taxpayer permitted to make the election could elect 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 to make the election. 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 filed using 2019 ATI (and could later revoke that election by filing a timely amended return or form).

Partnerships could elect out of the 50 percent EBIE rule by not applying the CARES Act rule on their return, but could later revoke that election on an amended return or form.¹⁴