On Friday, April 10, 2020, the IRS released Rev. Proc. 2020-22¹ providing procedural guidance to taxpayers wishing to implement changes made by the CARES Act to the section 163(j) business interest deduction limitation. Under the Tax Cuts and Jobs Act (TCJA), business interest deductions were generally limited to interest income and 30 percent of adjusted taxable income (ATI). The CARES Act loosens these limitations on deductibility, allowing taxpayers to apply a 50% ATI limitation in the 2019 and 2020 tax years, and allowing companies to choose to compute the 2020 limitation based on 2019 ATI. The Act further provides technical corrections to section 168(k) allowing qualified improvement property (QIP) to be eligible for bonus depreciation, correcting a legislative misstep made in the TCJA. For additional coverage on the QIP technical correction, please see Eversheds Sutherland’s March 30, 2020, article on the CARES Act changes to the QIP rules.

The interplay of these provisions, coupled with the allowance to modify a previous election under section 163(j), mean that companies should carefully consider how to implement the CARES Act. This alert describes the guidance and includes recommendations to utilize the new provisions.

Overview of the Law

TCJA Changes to Section 163(j)

The TCJA amended section 163(j) to limit the deduction of business interest expense for tax years beginning after December 31, 2017.² Specifically, the business interest deduction was limited to the sum of: (1) the taxpayer’s business interest income for the taxable year, (2) 30% of the taxpayer’s ATI for the taxable year, and (3) any floor plan financing interest.³ This limitation generally applies to all taxpayers with business interest expense, as defined by section 163(j)(5), other than taxpayers with annual gross receipts less than $25 million.

Section 163(j)(5) generally provides that “business interest” means any interest allocable to a trade or business. Section 163(j) does not define “trade or business” but it excludes certain types of businesses from, and allows others to elect out of, the business interest deduction limitation. Section 163(j)(7) allows two types of businesses to elect out of the business interest deduction limitation: a “real property business” or a “farming business.” Proposed Treas. Reg. § 1.163(j)-9 describes election procedures, including that any such election is irrevocable. Importantly, an electing business is also subject to the alternative depreciation system (ADS) rather than modified accelerated cost recovery system (MACRS) depreciation.

CARES Act Changes to Section 163(j)

The CARES Act adds a new section 163(j)(10), which sets forth special rules for 2019 and 2020 tax years in applying the business interest deduction limitation. Under section 163(j)(10)(A)(i), the CARES Act increases the 163(j) limitation by increasing the percentage of ATI that can be offset by business interest deduction to 50%. Under the CARES Act, however, a taxpayer may elect not to apply the 50% ATI limitation to any tax year beginning in either 2019 or 2020,⁴ retaining the 30% ATI limitation generally applicable under section 163(j). See Eversheds Sutherland’s March 31, 2020, alert on the CARES Act for additional considerations to elect out of the loosened 50% ATI limitation.

The CARES Act also adds section 163(j)(10)(B) to the Code providing that taxpayers may elect to use 2019 ATI in determining the section 163(j) limitation for any taxable year beginning in 2020.

Rev. Proc. 2020-22 Guidance Related to Section 163(j)

The IRS released Rev. Proc. 2020-22, which describes the time and manner for making elections under section 163(j)(10), the election not to apply the 50% limitation, and the election to use the taxpayer’s 2019 ATI for its 2020 ATI calculation.⁵ To elect out of the 50% limitation for the 2019 or 2020 taxable year, no formal statement is required, rather a taxpayer merely timely files its return or Form 1065 (or timely filed amended return, Form 1065 or AAR) by using the 30% ATI limitation. Similarly, no formal statement is required to use 2019 ATI in a taxpayer’s 2020 ATI computation, rather a taxpayer merely uses its 2019 ATI in its calculation on its timely filed return or Form 1065 (or amended return, Form 1065 or AAR).

Additionally, Rev. Proc. 2020-22 provides not only an extension of time for taxpayers to file an election under section 163(j)(7) to be treated as an electing real property or farming business for the 2018, 2019 and 2020 taxable years,⁶ but the revenue procedure also provides an opportunity for certain taxpayers to withdraw prior elections made under section 163(j)(7) to be treated as an electing real property or farming business.⁷ Unlike the section 163(j)(10) elections, to make a late section 163(j)(7) election, a taxpayer must file a formal election statement in accordance with the proposed Treas. Reg. § 1.163(j)-9 rules and procedures with an amended return. The time and manner to withdraw prior elections made under section 163(j)(7) is the same as to make a late election, i.e., with a timely-filed amended return, but the election statement rather than being in accordance with proposed regulations, should be in accordance with Section 5.03 of Rev. Proc. 2020-22, essentially, informing the IRS the taxpayer is withdrawing their previously-made election.

Recommendations to Consider

With the transitional guidance provided by the IRS in Rev. Proc. 2020-22, taxpayers will want to consider elections, past, present, and future, under section 163(j)(7) and (10). With the TCJA, certain companies elected to be treated as a real property or farming business. The benefit of the election is the exclusion from the business interest deduction limitation of section 163(j), while the cost of the election is the requirement to use ADS depreciation, which has longer recovery periods than MACRS depreciation and which does not allow bonus depreciation.

Absent the technical correction for QIP,⁸ the difference between ADS and MACRS depreciation was not significant. However, the increase in the ATI threshold together with the availability of bonus depreciation may mean that companies want to consider a change in this election. The revenue procedure provides an automatic extension of time allowing a taxpayer to file a section 163(j)(7) election to be treated as a real property or farming business for the 2018 to 2020 tax years. Rev. Proc. 2020-22 further allows taxpayers to withdraw previous-filed section 163(j)(7) elections.

Not all taxpayers will find the change to 50% of ATI under section 163(j)(10) advantageous. As with all of the changes made by the CARES Act, it is important to fully evaluate and model the interaction of these provisions with other Code sections not explicitly addressed in the CARES Act. For example, a change to 50% ATI allowing increased interest expense deductions could result in a loss of other deductions, such as deductions under section 250 for FDII and GILTI. Because the section 163(j) deductions are carried forward indefinitely, but section 250 deductions do not carry forward, a taxpayer may be better served to elect out of the higher 50% limitation. The election also may have implications for a company’s section 59A BEAT calculation.

Careful evaluation and modeling of the impact of proposed changes is important to ensure that taking advantage of facially taxpayer-favorable provisions in the CARES Act does not give rise to an overall adverse impact on the tax position.

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