The new rule limiting the deduction for interest expense goes into place in 2018. Under the new rule, a taxpayer can deduct interest only up to 30% of adjusted income. The interest expense in excess of the 30% is carried over to the next year.
Adjusted income means a company’s taxable income with an addback for interest, depreciation and amortization. In 2022 and forward, you no longer add back depreciation and amortization. Therefore, ATI will be significantly lower in 2022 and subsequent years.
The rules apply to every taxpayer. This includes LLCs, corporations and personal returns. Every LLC will have to compute its own 30% limit and the limit is applied to each separate LLC. Therefore, if you have several LLCs and one is losing money and the other has profit, the money losing LLC cannot deduct any interest expense as each LLC is looked at separately.
The limit does not apply to taxpayers with less than $25 million of gross receipts. The IRS just released guidance that if multiple LLCs or corporations are under common control, you have to add all their revenue together and then compare it to the $25 million mark.
There is an exception for entities owning real estate. If an LLC or corporation owns and leases out real estate, the LLC can elect to be exempted from the interest limitation rules. The trade off is that the LLC cannot use the 100% write off depreciation if the election is made.
A very real problem for closely held businesses is that the IRS has taken the position that if a LLC owning real estate leases the real estate to a commonly controlled company, i.e. your real estate LLC leases to your company, the LLC will not be treated as a real estate entity and cannot elect out of the rules.
The denial of the election out for a real estate entity leasing to a related operator is only in proposed form. The IRS will be taking comments from taxpayers until about the end of January and will then issue their final interpretation of the rules.
On a go forward basis, business owners who utilize a rental LLC should consider restructuring their business in order to be able to deduct the interest expense on the real estate company. For instance, if the tenant company and the real estate are both in LLCs, consider setting up an LLC holding company and having the holding company own 100% of both the tenant company and the real estate company. Since the interest limit is computed company by company, combining the two companies this way lets you deduct interest expense using the tenant company’s income.
In the alternative, instead of moving the tenant and the property owner closer together, move them further apart. Consider structuring the companies so that one person owns the tenant company and that same person owns only 49% of the property company. The owners can work out their economics through rent and pay. Doing so gets the owner the ability to be treated as a real estate company and to elect out of the interest limitation.
Moving the companies further apart could require some contortionism. As with everything else, the IRS always has the ability to challenge anything which saves you taxes. Also, changing around the ownership could have an impact on passive losses and other items on your return. Therefore, don’t do any of this without talking to a tax advisor first.