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Beginning in 2018 the federal income tax deduction of business interest can be limited. The law provides a “small business” exception to this limitation.  However, businesses conducted in multiple related entities must be combined when determining if the small business exception applies.

The limitation on business interest expense was originally enacted to target “earnings stripping,” that is, paying interest to a related party who paid no U.S. income tax on the interest received while the U.S. taxpayer took a deduction for the interest paid. Such interest was disqualified and not deductible by the corporation if the corporation’s debt-to-equity ratio exceeded 1.5 to 1. Generally, all other interest expense was deductible. Interest expense WAS deductible until the Tax Cuts and Jobs Act of 2017 (the “TCJA”) repealed these rules and replaced them with a general limitation on business interest expense applying to all taxpayers, and not just related party arrangements.

The business interest expense limitation in I.R.C. Section^[1] 163(j) provides that a taxpayer’s business interest deduction for a tax year cannot exceed: (1) the taxpayer’s business interest income for the tax year; (2) plus thirty percent (30%) of the taxpayer’s adjusted taxable income[2] for the tax year which cannot be less than zero; and (3) plus the taxpayer’s floor plan financing interest[3] for the tax year. While this new business interest expense limitation applies to taxpayers at the taxpayer level, and applies to partnerships at the partnership level, maybe it might not apply to your client’s business. The revised rules exempt certain small businesses. Specifically, if the taxpayer meets the $25 million gross receipts test,[4] as amended by the TCJA, and the taxpayer is not a tax shelter, then the taxpayer will not be subject to the business interest expense limitation.

I am sure that by now you are familiar with the new I.R.C. Section 163(j) business interest expense limitation rules and the small business exception discussed above. What probably is not as clear is how to determine whether your client meets the small business exception. Many family owned businesses and their related entities may not exceed the $25 million gross receipts threshold when viewed individually; however, when aggregated, their combined gross receipts may push them over the threshold.

So how do we determine what businesses get aggregated?

Businesses with common control must be aggregated to determine whether the small business exception is met.[5]

What then is common control?

Unfortunately, we have to look beyond I.R.C. Section 163(j) to determine common control. The road map leading to the answer starts with I.R.C. Section 448(c)(2), which provides that persons treated as a single employer are aggregated in determining whether the $25 million gross receipts test is satisfied. To determine whether there is a single employer, the next stop on our travels is I.R.C. Section 52(a) and (b); however, this is just a temporary rest stop as the final destination is Treas. Reg. Section 1.52-1. Here, we finally find the definition of common control. Trades or businesses are under common control if either the parent-subsidiary group is under common control or the brother-sister group is under common control.

A parent-subsidiary group is under common control if the parent directly or indirectly owns a controlling interest in the organization. A parent’s controlling interest means: (1) owning over fifty percent (50%) of the total combined voting power of all classes of stock entitled to vote or over fifty percent (50%) of the total value of all classes of stock in a corporation; (2) owning over fifty percent (50%) actuarial interest in a trust or estate; (3) owning over fifty percent (50%) profit interest or capital interest in a partnership; or (4) owning the sole proprietorship.

Effective control for the brother-sister group is identical to the parent’s controlling interest definition above. A brother-sister group is under common control if the same five or fewer persons (i.e., individuals, trusts or estates) own a controlling interest in each organization and, considering the ownership of each person only to the extent that person’s ownership is identical with respect to each organization, then such persons are in effective control of each organization. Here controlling interest means: (1) owning at least eighty percent (80%) of the total combined voting power of all classes of stock entitled to vote or at least eighty percent (80%) of the total value of all classes of stock in a corporation; (2) owning at least eighty percent (80%) actuarial interest in a trust or estate; (3) owning at least eighty percent (80%) profit interest or capital interest in a partnership; or (4) owning the sole proprietorship.

Now that we know the tests for common control, how do we determine whether the small business exception applies? Imagine our client owns a partnership, Company A, with two friends. Our same client owns a second partnership, Company B, with three friends (two of the friends are his partners in Company A). For the last three years, both Company A and Company B have had gross receipts of $15 million. The following is the ownership structure of Company A and Company B:

	Company A	Company B
Owner 1	30%	30%
Owner 2	40%	40%
Owner 3	30%	15%
Owner 4	0%	15%

 

Since Owner 1, 2, and 3 own at least eighty percent (80%) of the profit interest or capital interest of both Company A and Company B, the companies are under common control. Aggregate the gross receipts for Company A and Company B to determine if the $25 million gross receipts test is satisfied. Since Company A and Company B have each had gross receipts of $15 million over the last three years, when aggregated they have gross receipts of $30 million. Company A and Company B do not meet the small business exception and are both subject to the business interest expense limitation. We aggregate Company A and Company B ONLY to determine whether the small business exception applies. We DO NOT aggregate Company A and Company B when calculating the business interest expense limitation. Instead, since Company A and Company B are partnerships, we calculate a business interest expense limitation for Company A and a business interest expense limitation for Company B.

If instead Company A and Company B each had $10 million of gross receipts for the last three years, then in the aggregated the companies would have gross receipts of $20 million. Here, the small business exception is met and the business interest expense limitation does not apply to Company A and Company B

What if the ownership of Company A and Company B was instead:

	Company A	Company B
Owner 1	30%	10%
Owner 2	40%	20%
Owner 3	30%	10%
Owner 4	0%	60%

 

Now, Owner 1, 2, and 3 own at least eighty percent (80%) of the profit interest or capital interest of Company A, but fall short in their ownership of Company B. Company A and Company B are not under common control, and therefore are not aggregated for the small business exception.

The reason for the aggregation rules is to prevent companies from splitting up their income among multiple companies to shield themselves from the business interest expense limitation. If your client operates multiple business entities, while it may seem like your client is not subject to the business interest expense limitation, consider whether the aggregation rules apply. Smaller businesses need to make sure they are not overlooking these aggregation rules.

 

[1]              Unless otherwise indicated, all references to “section” or “§” are to the Internal Revenue Code of 1986, as amended, and all references to “Treas. Reg. §,” “Temp. Treas. Reg. §,” and “Prop. Treas. Reg. §,” are to the final, temporary, and proposed regulations, respectively, promulgated thereunder (the “Regulations”), as in effect as of the date of this Article. All “Service” or “IRS” references are to the Internal Revenue Service.

[2]              A taxpayer’s adjusted taxable income is computed without regard to deductions allowable for depreciation, amortization, depletion or business interest expense (similar to EBITDA). For tax years beginning after December 31, 2021, adjusted taxable income will include deductions for depreciation and amortization, but not business interest expense (similar to EBIT).

[3]              Generally, most taxpayers will not have floor plan financing unless the taxpayer is in the automobile industry.

[4]              The gross receipts test is met if the average gross receipts of the taxpayer for the three taxable year period does not exceed $25 million; see I.R.C. Section 448(c)(1).

[5]              See I.R.C. Section 448(c)(2).