What Happens to Excess Business Interest Expense in Final Year

As you're wrapping up your business's final year, it's essential to understand what happens to excess business interest expense. If your business has a net interest deduction of more than £2 million, the excess amount is subject to a 30% corporation tax charge.

This tax charge can be a significant blow to your business's profits, so it's crucial to plan ahead. You can't simply write off the excess interest as a loss, as it's not a deductible expense.

The excess interest is taxed as part of your business's corporation tax liability, which can be a complex and time-consuming process.

If a partner lends money to a partnership in which they hold a direct interest, they're deemed to receive an allocation of excess business interest income (BII) equal to the lesser of their excess business income from the borrowing partnership or the interest income on the loan.

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The self-charged interest rule applies to partnerships, but not to S corporations, because business income of an S corporation is carried over as a corporate-level attribute.

To allocate deductible business interest expense and excess items, partnerships follow an 11-step method, except when all items are allocated pro rata.

When a partnership allocates all items pro rata, partners can simply allocate section 163(j) items pro rata, without needing to follow the 11-step calculation method.

The pro rata exception doesn't provide a new calculation method, but rather an exception to the 11-step requirement for partnerships that allocate all items pro rata.

Partnerships and S corporations should plan for a potential change to the treatment of interest on existing indebtedness, as the 2018 Proposed Regulations don't contain a transition rule for interest expense incurred prior to finalization.

Debt financed distribution interest is allocated similarly to the long-standing rule in Notice 89-35, but with less flexibility and potential negative implications.

Here's a brief summary of the allocation rules:

In the case of partnerships, special rules apply to excess business interest expense, particularly for tax years beginning in 2019. The CARES Act introduced a rule that allows 50% of excess business interest expense to be treated as paid or accrued by the partner in their first tax year beginning in 2020.

This rule, known as the 50% of 2019 EBIE Rule, is a taxpayer-friendly outcome that provides relief to partners who may have been affected by the section 163(j) limitation. If a partner disposes of their partnership interest in the partnership's 2019 or 2020 tax year, the 50% of 2019 EBIE Rule still applies, and the disposition will not result in a basis increase with respect to such excess business interest expense.

The 2020 Proposed Regulations provide additional rules to clarify this special treatment, including the treatment of debt-financed distribution interest and the interaction with the debt-financed distribution exception to the partnership disguised sale rules.

The allocation of deductible BIE and excess items is a complex process that requires a specific 11-step method. This method is retained in the Final Regulations.

Taxpayers are required to follow these 11 steps to allocate deductible BIE and excess items, but there is an exception for partnerships that allocate all items of income and expense on a pro rata basis. In such cases, partners may simply allocate the partnership's section 163(j) items pro rata.

The pro rata exception does not provide taxpayers with a new calculation method, but rather allows them to use a method they were already entitled to under the 2018 Proposed Regulations. This exception only applies to partnerships where all items are allocated pro rata.

Partnerships, S corporations, and their owners should plan for a potential change to the treatment of interest on existing indebtedness. This is because the 2018 Proposed Regulations do not contain a transition rule for interest expense incurred by a partnership or S corporation prior to finalization.

A table outlining the allocation options for partnerships is below:

The 50% of 2019 Excess Business Interest Expense (EBIE) Rule is a taxpayer-friendly provision that allows 50% of excess BIE to be treated as paid or accrued by a partner in their first tax year beginning in 2020, without being subject to the section 163(j) limitation at partner level.

This rule applies to excess BIE allocated to a partner for any tax year beginning in 2019. The 2020 Proposed Regulations clarify that this rule still applies even if a partner disposes of their partnership interest in the partnership's 2019 or 2020 tax year.

The 50% of 2019 EBIE Rule is a welcome relief for taxpayers who were unsure about their eligibility to deduct 2019 excess business interest expense. The interpretation of this rule in the 2020 Proposed Regulations is a favorable outcome for taxpayers.

Here are the key points to remember about the Special Disposition Rule for 2019 Excess:

In the final year, excess business interest expense can be a significant concern for partners in a partnership return situation.

The $10,000 excess business interest disallowed in year 1 can be unlocked in year 2 if there is enough excess taxable income from PRS1.

If PRS1 passes out enough excess taxable income to unlock the prior year's excess business interest, it will be considered paid or accrued in the current year.

This means the $10,000 excess business interest from year 1 can be deducted in year 2, as long as PRS1 has enough excess taxable income to cover it.

PRS2's excess taxable income of $2,000 in year 2 helped deduct excess business interest of PRS1, but only because PRS1 had enough excess taxable income to unlock the previously disallowed interest.

In this case, the partner's ATI is $12,000, and 30% is $4,000, allowing for a deduction of $4,000 of the $10,000 excess business interest.

Check this out: First Year Business Taxes

Self-charged interest rules can be complex, but they're designed to prevent double counting of interest income. The 2020 Proposed Regulations provide a self-charged interest rule for partnerships with a direct interest in a lending transaction.

In such cases, the lending partner is deemed to receive an allocation of excess BII equal to the lesser of its excess BIE from the borrowing partnership for the tax year, or the interest income on the loan for the tax year. This rule is meant to prevent interest income from being used more than once in calculating the partner's section 163(j) limitation.

S corporations are exempt from this rule because BIE of an S corporation is carried over by the S corporation as a corporate level attribute, so they don't need to worry about self-charged interest rules.

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