By David E. Kolan, CPA, Managing Director
For tax year 2021, business interest expense deduction limitations return to their pre-COVID levels, impacting a broad range of business activities, including merger and acquisitions (M&As). Affected companies must prepare to quantify how this reduced benefit will impact their bottom lines and these transactions going forward.
Under the Tax Cuts and Jobs Act (TCJA) enacted for tax years beginning in 2018, interest expense that exceeds the amount of a business’s interest income is only deductible to the extent of 30 percent of that business’s adjusted taxable income (ATI). The CARES Act, signed into law in response to the COVID-19 pandemic, offered businesses the ability to temporarily claim a larger, 50 percent of ATI deduction for tax years 2019 and 2020.
Effective for 2021, the 30 percent of ATI limit is reinstated. This limitation can have a substantial impact on the tax obligations of businesses and/or their owners that are involved in business acquisitions financed with significant debt.
Adjusted Taxable Income (ATI)
To determine the impact of the interest expense limitation, it is important to first understand what constitutes ATI. The item is calculated by adding back to taxable income deductions for depreciation and amortization and any deduction for interest expense.
The TCJA allows an exemption from the interest expense deduction limitation for businesses whose average annual gross receipts for the prior three years did not exceed $25 million. However, determining this $25 million threshold is not as simple as it may appear, especially when considering that businesses could be required to include in the calculation the gross receipts of its affiliated companies with common ownership.
To demonstrate the impact of the business interest expense deduction limitation, consider Target Corporation A, which has the following items of income and expense:
Gross receipts: $150
Cost of goods sol: (90)
Taxable Income before
Calculation of Interest Limitation: $10
To determine ATI, the business must add back to its taxable income the deductions it claimed for depreciation and interest expense.
Taxable income: $10
Add back depreciation: 20
Add back interest: 30
Adjusted Taxable Income (ATI): $60
In this example, the interest deduction is limited to 30 percent of ATI ($60), or $18. The business’s resulting interest expense disallowance is $12 ($30 less $18). The disallowed amount may be carried forward indefinitely until the business can deduct it in a subsequent year. However, if the business has similar results from operations in subsequent years and the terms of the loans bearing the interest remain constant, it may be difficult for the business to deduct the disallowance in a subsequent year, especially if those subsequent years create additional disallowances of interest.
It is clear that the disallowance of the interest deduction reduces the benefit of financing M&A transactions with significant debt. The cost of these transactions would be higher under the new law than before this provision took effect. In addition, if a target company involved in an M&A transaction has a carryover of disallowed interest, the acquiring entity may have limited use of that deduction in subsequent years after the transaction closes. This is due to limitations of certain tax provisions that limit tax attributes created before the transaction took place.
Alternative Depreciation System (ADS)
A special rule under the TCJA allows real estate businesses, including those involved in construction, property development and rental activities, to make an election to opt out of the interest limitation rules. Doing so, however, comes at a cost since those businesses would be required to depreciate real estate and certain property improvements over a longer period of time using the alternative depreciation system (ADS). For example, under the ADS, non-residential real estate must be depreciated over 40 years rather than the traditional 39-year period, while residential property requires a 30-year depreciation schedule rather than the normal 27.5 year depreciation life.
In addition, the ADS requires certain nonstructural improvements to real property to be depreciated over 20 years, rather than the typical 15 years. Moreover, the harshest consequence of the ADS is that nonstructural improvements to real property are not eligible for first-year bonus depreciation, which would otherwise allow businesses to fully write-off the asset’s cost in the year of expenditure.
On a prospective basis, buyers, sellers and private equity groups involved in M&As must plan ahead and structure upcoming transactions with these new rules in mind. Buyers should model-out the true cost of leverage by considering what may be the ability to deduct interest expense. Entities considering selling soon, should realize that any disallowed interest carryovers may be of limited value to an acquirer because of the rules noted above concerning limitations for tax attributes that were created before the transaction. Private equity groups may reconsider the mix of debt and equity injected into their portfolio companies.
Taxpayers can work with their CPAs and advisors to develop a tax-efficient strategy for completing these transactions in light of the changes in the tax code.
David Kolan, CPA