In general, tax law says that there shall be allowed as a deduction all interest paid or accrued on indebtedness within the taxable year. Thus, tax law begins by saying that all interest expense is deductible. However, tax law then clarifies that no deduction shall be allowed for personal interest paid or accrued during the taxable year (for a taxpayer other than a corporation). Furthermore, tax law then defines personal interest as any interest other than business interest, investment interest, passive activity interest, mortgage interest, certain estate tax interest and educational loan interest.

Previously, even personal interest was deductible. However, the Tax Reform Act of 1986 (Oct. 22, 1986) denied the deduction for personal interest. Except for this disallowance of the deduction for personal interest, the only real limitations on interest expense deduction were the “thin capitalization rules” — rules developed by courts that permitted the courts to reclassify debt as equity, thereby reclassifying deductible interest expense as non-deductible distributions.

The thin capitalization rules were rules made without numerical guidelines and were difficult to enforce without costly litigation. Thus, Congress adopted the “earnings stripping rules” through the Omnibus Budget Reconciliation Act of 1989 (Dec. 19, 1989) designed to limit the deduction for disqualified interest paid or incurred by a corporation.

Basically, disqualified interest is any interest paid or accrued by a corporation to a related person if no tax is imposed on such interest. Furthermore, disqualified interest also includes any interest paid or accrued by a corporation to an unrelated person if there is a disqualified guarantee on the debt and no 30% withholding tax is imposed on such interest.

A corporation may be subject to the earnings stripping rules if such corporation had a debt to equity ratio in excess of 1.5 to 1. For such corporation, the deduction of disqualified interest expense cannot exceed 50% of adjusted taxable income. Generally, adjusted taxable income means taxable income without the deduction for net interest expense, net operating loss, or depreciation and amortization.

In the Tax Cuts and Jobs Act of 2017, Congress amended the earnings stripping rules to limit the deduction of business interest (rather than just disqualified interest). Furthermore, the act expanded the coverage to include all taxpayers (rather than just corporations). As amended, the new earnings stripping rules apply to tax years beginning after Dec. 31, 2017. Furthermore, the amount of the deduction was reduced to 30% of adjusted taxable income. Finally, the definition of adjusted taxable income mostly remained unchanged; however, the adjustment for depreciation and amortization will not be allowed for tax years beginning after Dec. 31, 2021.

Fortunately, this business interest expense limitation (or deferral) does not apply to a taxpayer with average annual gross receipts of $25 million or less for the preceding three years. However, for a taxpayer who does not meet this gross receipts test and is subject to the business interest expense limitation, there are no good options other than to try and reduce the amount of debt or increasing the amount of interest income since business interest income increases the amount of business interest expense that can be deducted. mbj

— Edmund E. Brobesong is the senior manager of the tax group at Ernst & Young, Guam. He can be reached at [email protected].