The Tax Cuts and Jobs Act (TCJA) of 2017 significantly restricted the deduction of business-related interest expense under Section 163(j), limiting the deduction to 30% of adjusted taxable income (ATI) plus business interest income and floor plan financing interest. Initially, ATI was calculated like EBITDA, but since 2022, the add-back of depreciation and amortization has expired, increasing tax liabilities for higher-leveraged taxpayers.

To mitigate or eliminate the limitations, several strategies are available:

Small Business Exception

Businesses with average annual gross receipts of less than $30 million in 2024 may qualify for an exception under Sec. 163(j)(3), although aggregation rules may apply for related businesses.

Real Property Trade or Business (RPTOB) Election

Real property businesses, such as those involved in development, construction, or leasing, may elect to opt out of the interest deduction limitation, though they must switch to an alternative depreciation system and forgo bonus depreciation.

Self-Charged Interest

For partner loans to partnerships, the final 2021 regulations offer some relief by allowing certain interest expense allocations back to the lending partner.

Capitalization Strategies

Taxpayers can capitalize interest on certain properties including inventories, reducing their business interest expense. This applies after any required interest capitalization under Sec. 263A.  This allows for elective capitalization of certain costs, like interest, improving timing for deductions.

Buy vs. Lease Considerations

Taxpayers must weigh the benefits of leasing versus buying assets, considering both tax and financial reporting. With changes to depreciation and interest deduction limits, capital leases (now finance leases under GAAP) might be less attractive than before, as operating leases may allow for more flexible deductions.

Overall, the Sec. 163(j) limitation presents challenges but also opportunities for strategic tax planning, particularly in choosing between exceptions, capitalization, or restructuring to optimize deductions.

IRS Practice Units, developed by the IRS’s Large Business and International (LB&I) division, serve as training and guidance tools to help examiners and agents navigate complex tax laws consistently and effectively. These materials often focus on key areas of tax law subject to audits or enforcement actions, such as international tax, transfer pricing, and corporate tax matters.

One notable area that taxpayers should watch closely is the "U-turn" transaction concept, which was first introduced in Battelstein v. Commissioner and Davison v. Commissioner. The May 2023 LB&I Concept Unit addresses the interest expense limitation on related foreign party loans under IRC section 267(a)(3). The concept of U-turn transactions was reintroduced in Chief Counsel Advice (CCA) 201334037, and the IRS has since applied this concept to disallow deductions for interest payments in specific situations.

In CCA 201334037, the IRS concluded that wire transfers of funds to related foreign persons, which the taxpayer claimed as interest payments, were not deductible under IRC section 267(a)(3). The taxpayer, USS, recorded what it considered interest payments for funds advanced by FP, a related foreign party. However, the IRS found that USS obtained sufficient funds to cover these payments either through additional loans from FP or through draw-downs on lines of credit with FP, which were credited to USS’s general account shortly before or after the claimed interest payments. Citing Battelstein and Davison, the IRS disallowed these deductions, citing the circular nature of the cash flow.

The IRS’s position was that when funds are loaned by FP to the taxpayer and "paid" back via wire transfers, the U-turn transaction does not alter the economic position of either the lender or borrower. While the wire transfers appeared in form to be interest payments, they did not lead to any substantive economic change. Additionally, because FP had an equity interest in the taxpayer, it was willing to indefinitely defer the realization of returns on its investment. Applying the Tax Court’s analysis in these cases, the IRS concluded that the borrowed funds used to “satisfy” the interest obligation were, in essence, the same funds advanced by FP. Consequently, the claimed interest payments were deemed superficial, and the taxpayer was not entitled to a deduction for interest under the cash method of accounting.

Once again, the IRS’s characterization of transactions for tax purposes hinges on substance rather than solely on form. Enterprises with debt arrangements involving foreign parents or affiliates should carefully consider the U-turn transaction concept to avoid conflicts with the IRS when deducting interest payments.

For additional details, please see LB&I Concept Unit May 16, 2023  Interest Expense Limitation on Related Foreign Party Loans Under IRC 267(a)(3) (irs.gov)

For tax years beginning after 2022, the Inflation Reduction Act of 2022 amended section 55 to impose a new corporate alternative minimum tax (CAMT) based on the adjusted financial statement income (AFSI) of an applicable corporation.

An appliable corporation is liable for the corporate alternative minimum tax to the extent that its “tentative minimum tax” exceeds its regular U.S. federal income tax liability plus its liability for the base-erosion and anti-abuse tax (BEAT). An applicable corporation’s tentative minimum tax is 15% of its adjusted financial statement income to the extent the tax exceeds the corporate alternative minimum tax foreign tax credit for the tax year. The corporate alternative minimum tax applies to any corporation (other than an S corporation, regulated investment company, or real estate investment trust) whose average annual adjusted financial statement income exceeds $1 billion for any three consecutive tax years preceding the tax year. When determining adjusted financial statement income for the $1 billion qualification test, the act generally treats adjusted financial statement income of all persons considered a single employer with a corporation under Sec. 52(a) or (b) as adjusted financial statement income of the corporation.

For a corporation that is a member of a foreign-parented multinational group, (1) the three-year average annual adjusted financial statement income must be over $1 billion from all members of the foreign-parented multinational group (without regard to certain adjustments as specified in Sec. 59(k)(2)(A)), and (2) the corporation must have average annual adjusted financial statement income, determined without regard to loss carryovers, of $100 million or more. A foreign-parented multinational group means two or more entities if (1) at least one entity is a domestic corporation and another is a foreign corporation; (2) the entities are included in the same applicable financial statement; and (3) the common parent of those entities is a foreign corporation (or the entities are treated as having a common parent that is a foreign corporation).

The IRS has issued series of notices providing targeted guidance.  The following notices contain interim rules, prior to the issuance of Treasury regulations, related to CAMT:

• Notice 2023-3, Internal Revenue Bulletin: 2023-03 | Internal Revenue Service (irs.gov)
• Notice 2023-10, Internal Revenue Bulletin: 2023-10 | Internal Revenue Service (irs.gov)
• Notice 2023-26, Internal Revenue Bulletin: 2023-26 | Internal Revenue Service (irs.gov)
• Notice 2023-40, Internal Revenue Bulletin: 2023-40 | Internal Revenue Service (irs.gov)
• Notice 2024-03, Internal Revenue Bulletin: 2024-03 | Internal Revenue Service (irs.gov)

As the CAMT is effective for tax years beginning after December 31, 2022, taxpayers potentially subject to the CAMT should consider how guidance in the Notice may impact previous positions that may have been taken based on a reasonable interpretation of the statute and prior interim guidance. Treasury and the IRS have indicated an intent to issue proposed regulations in early 2024 consistent with the interim guidance provided in, and modified and clarified by, the Notice.

The four key limitations on loss deductions for high-net-worth individuals include the basis limitation, at-risk limitation, passive activity loss limitation, and the excess business loss limitation. Each of these restrictions is grounded in specific sections of the Internal Revenue Code (IRC) and plays a crucial role in determining how and when individuals can deduct losses on their tax returns.

The basis limitation is found in IRC §§ 704(a) and 1367(a) and restricts the deductibility of losses to the taxpayer’s adjusted basis in a partnership or S corporation. If a taxpayer's basis is insufficient to absorb the loss, that loss is suspended and can only be deducted when additional basis becomes available. This basis can be increased through capital contributions, direct loans made to the entity (in the case of S corporations), recourse and non-recourse debts in the case of partnerships or earnings that increase the partner’s share of the entity’s value. In situations where a taxpayer’s basis is too low to deduct current losses, a strategic infusion of capital or loans could unlock those suspended losses.

The at-risk limitation, under IRC § 465, limits the amount of losses a taxpayer can deduct to the extent they are economically at risk in the activity. This typically includes the amount of money invested or any loans for which the taxpayer is personally liable. Non-recourse loans, where the taxpayer is not personally liable, do not increase the at-risk amount, thus restricting the ability to deduct losses.  Yet the qualified non-recourse or recourse debts increase at-risk limitation.  To navigate this limitation, one could convert non-recourse loans into recourse loans or increase equity contributions, thereby raising the at-risk amount and unlocking the ability to deduct more losses.

The passive activity loss limitation, as laid out in IRC § 469, prevents taxpayers from offsetting passive activity losses against non-passive income. A passive activity is one in which the taxpayer does not materially participate, such as rental real estate or limited partnerships. Losses from these activities can only be used to offset income from other passive activities. To avoid this limitation, a taxpayer could materially participate in the business or activity, making it "active" rather than passive, which would allow the losses to be deducted against non-passive income. Grouping certain activities together under the aggregation rules could help meet material participation requirements, which would increase the likelihood of deducting those losses.  Additionally, some sophisticated individuals with large volume of investment in real properties can explore a tax strategy provided for ‘real estate professionals.’

The excess business loss limitation, governed by IRC § 461(l), applies to noncorporate taxpayers and limits the amount of aggregate business losses that can be deducted. For 2023, the deductible loss is capped at $305,000 for individuals, or $610,000 for married couples filing jointly. Losses that exceed this threshold are carried forward as part of a net operating loss for use in future tax years. One potential strategy to mitigate this limitation involves spreading out deductible losses across multiple years, thereby avoiding triggering the threshold in any one year.

Overall, these limitations are designed to prevent taxpayers from taking excessive deductions in a single year and to ensure that loss deductions are grounded in the economic reality of the taxpayer’s involvement and investment in the activity. However, with careful planning, high-net-worth individuals can often structure their investments, participation, and financing in a way that maximizes the deductibility of losses while staying compliant with tax regulations.