Before the Tax Cuts and Jobs Act (TCJA), businesses could generally deduct most business-related interest expenses without restriction. However, the TCJA introduced Section 163(j), which places a cap on business interest deductions, subject to certain exceptions.
If your business incurs significant interest expenses, understanding how this limit impacts your tax liability is crucial. The good news? There are strategies that may help reduce the tax burden in 2025. See below.
Understanding the Deduction Limit
Unless your business qualifies for an exemption under Section 163(j), the maximum business interest deduction for a tax year equals:
= 30% of your company’s adjusted taxable income (ATI) + Your company’s business interest income (if any) + Your company’s floor plan financing interest (if any)
For businesses without significant business interest income or floor plan financing interest, the deduction is typically capped at 30% of ATI.
What Counts as Adjusted Taxable Income (ATI)?
ATI represents your company’s taxable income, excluding:
Nonbusiness income, gain, deduction, or loss
Business interest income or expense
Net operating loss (NOL) deductions
The 20% qualified business income (QBI) deduction for pass-through entities
Initially, ATI was calculated without considering depreciation, amortization, or depletion. However, since 2021, these items are now subtracted when calculating ATI, reducing the available business interest deduction for companies with substantial depreciable assets.
What Happens to Disallowed Deductions?
If a portion of your business interest deduction is disallowed under Section 163(j), it can be carried forward indefinitely. In future years, the carryforward amount is treated as business interest expense incurred that year and is subject to that year’s deduction limit.
Special Rules for Pass-Through Entities
Pass-through entities like partnerships, S corporations, and LLCs face special rules under Section 163(j). The deduction limit applies at both the entity and owner level, which may affect how much interest expense can ultimately be deducted.
Small Business Exemption
Businesses with average annual gross receipts under a specific threshold (adjusted annually for inflation) over the preceding three years are exempt from the business interest deduction limit. To prevent larger companies from splitting into smaller entities to qualify, related businesses are required to combine their gross receipts when determining eligibility.
Strategies to Manage the Limit
1. Elect out of Section 163(j)
Real estate and farming businesses can elect to opt out of the interest deduction limit. Real estate businesses include those engaged in:
Property development, construction, and reconstruction
Property acquisition, conversion, and leasing
Property management and brokerage
Opting out reduces depreciation deductions for certain business property by requiring longer recovery periods under the Alternative Depreciation System. Carefully weigh the benefit of higher interest deductions against the potential tax cost of slower depreciation.
2. Capitalize Interest Expense
Capitalized interest isn’t treated as interest under Section 163(j), which allows you to sidestep the deduction limit. The tax code permits businesses to capitalize certain interest expenses tied to the production or acquisition of property.
Interest capitalized to fixed assets can be recovered over time through depreciation.
Interest capitalized to inventory can be deducted as part of the cost of goods sold when the inventory is sold.
This strategy allows you to effectively shift the tax benefit from an interest deduction to a depreciation or inventory expense deduction.
3. Reduce Business Interest Expense
Lowering your business’s interest expense can help reduce the impact of the deduction limit. You could:
Shift from debt-to-equity financing
Pay down existing debt when possible
Generate business interest income (such as by extending credit to customers) to offset interest expenses
Looking Ahead
The business interest deduction limit is not set to expire with other TCJA provisions in 2025. However, Congress may act to modify or repeal the limit.
If your business is affected by the interest deduction cap, reviewing your financing strategy and tax planning options is essential. Consulting with us can help you identify the best approach for your situation and minimize the impact on your tax bill.
Tax season is here! The Business Tax Deadline is March 17th. Book a meeting with your VAAS Tax Consultant soon to plan and prepare. After reviewing your business’s needs, filing for an extension may be recommended.