Does Your CPA Really Know You? Ask Yourself 5 Questions

Date February 9, 2024
Article Authors

Each day I talk to business leaders about what they like best – and least – about their Certified Public Accountants (CPAs). The responses range from, “I won’t buy a mobile phone without checking with Mary,” to “Mark is okay, but he likes my rival football team and that’s unacceptable.”

Clearly, there are many factors that can solidify or dissolve a relationship with a trusted advisor such as your CPA. Some, while not preferred, are tolerable; others are absolute deal breakers. Still, the services of a CPA are crucial to the success of any company. That’s why you should ask yourself these five questions to determine if your CPA is meeting your needs, or it’s time to move on to someone else.

Does my CPA understand my business and industry?

As the business development manager of a “Top 50” accounting and wealth management firm, I hear the term “generalist” quite often. In the accounting world, the label applies to a professional with clients in multiple industries. Traditionally, a CPA’s role was to have a working knowledge of each of their clients’ industries. Today, top firms specialize in precise areas of focus to ensure they are experts in the tax laws that govern their clients’ industries. For example, if you own a construction company and the only construction company your CPA works with is your own, are you certain you are taking advantage of every potential tax benefit and functional process available to streamline and grow your operations?

Am I getting the value I deserve?

Value has different meanings for different people. Accounting value is leverageable by:

  • Knowing your CPA is always there when you have questions
  • Trusting your CPA is current with the ever-changing tax laws that govern business owners
  • Counting on your CPA to complete important tasks on time

Value is essentially whatever you perceive it to be. Knowing what is important to you and your business will help you identify problems when your expectations of value are not being met. Make sure you can define “value” when working with your CPA, who must be a trusted advisor to be effective.

Have I outgrown my CPA?

You likely have a good relationship with your CPA. He or she has been with you since the beginning, seen your kids grow up, been there through tough times and good. But does that alone ensure he or she is the best partner for your company today? Can he or she guide you through the complex scenarios your business faces? In many cases after a consultation with their CPA of so many years, a business owner realizes the CPA is not only overwhelmed by the company’s growth, but also ill-prepared to help the company capitalize on its success. This is a dangerous place for a business owner.

Am I receiving the level of service I have come to expect from my CPA?

Do you feel like every time you call, your CPA isn’t in, and it takes forever to get a return call? Are you only meeting with your CPA once a year to drop off your tax documents? Have you ever had to write an unexpectedly large check to the IRS without knowing in advance why you owed so much? Think about what services you believe are most valuable to you, then ask yourself, are you receiving the level of service that you expect from your current CPA?

Are accounting services the only services the firm offers?

In today’s world, accounting firms must take a holistic approach to providing added value and top-level financial services. Does Mike from XYZ Tax do your accounting, Mary from the bank your 401k, and Diane from ABC Investments a business succession plan? What if your business could work with one company in a single location for all that? When the left hand knows what the right hand is doing, you gain significant efficiencies. Can you afford to not have all of your trusted business advisors working together, sharing information, and strategizing about your best options?

Having a trusted advisor as your CPA is more than simply hiring someone who belongs to your club or likes the same sports teams you do. It’s about partnering with a reliable professional who is a specialist in your field of business and who will help guide you and your company to the next level of financial success and security.

Speak to one of our professionals about your organizational needs

"*" indicates required fields

HBK uses the contact information you provide to send you information about our products and services. You may unsubscribe from these communications any time. For information on how to unsubscribe, as well as our privacy practices and commitment to protecting your privacy, check out our Privacy Policy.



PPP Loan Borrowers Should Consider Potential Tax Obligations Related to Loan Forgiveness

Date October 30, 2020
Categories
Paycheck Protection Program (PPP) loan borrowers need to think beyond applying for loan forgiveness to the tax ramifications associated with forgiveness, especially as the calendar year-end nears and tax issues are top of mind. According to the CARES Act, PPP loan funds are not taxable. However, in May the IRS issued notice 2020-32 making the expenses used to generate forgiveness taxable. Congress has expressed disappointment with the IRS position but has not yet passed legislation to overturn it. Many believe it will be addressed in the next round of stimulus legislation. However, several pieces of proposed PPP legislation do not address the IRS position, leaving the question of whether Congress fully intends to act on the IRS position. Several tax credits and deductions available to businesses, including the research and development (R&D) tax credit, work opportunity tax credit (WOTC), and qualified business income (QBI) deduction rely at least partially on employee wage calculations. Due to the IRS ruling, borrowers using wages to support PPP loan forgiveness could lose those tax credits and deductions. As such, they should carefully consider how they support forgiveness, including using costs other than gross payroll on their forgiveness applications. Unless Congress legislates otherwise, borrowers should prepare to pay taxes on PPP loan forgiveness expenses, including in their estimated payments and year-end tax planning. As program regulations disallow the use of PPP funds and many COVID-19 relief grants and loans to pay taxes, borrowers should consult their CPAs before dedicating any relief program funds to tax obligations. Borrowers also need to be vigilant about how their states will treat tax obligations relating to PPP loans. Many states have yet to declare a position on how PPP loans or the associated forgiveness expenses could be taxed. Borrowers should watch for guidance and be prepared to meet any tax obligations. To discuss your tax obligations with respect to your PPP loan and associated forgiveness, contact your HBK Advisor.

Speak to one of our professionals about your organizational needs

"*" indicates required fields

HBK uses the contact information you provide to send you information about our products and services. You may unsubscribe from these communications any time. For information on how to unsubscribe, as well as our privacy practices and commitment to protecting your privacy, check out our Privacy Policy.



IRS Says No Deduction for Expenses Generating Loan Forgiveness

Date May 1, 2020
Categories
Article Authors

Late yesterday the IRS issued Notice 2020-32 clarifying that no deduction is allowed for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a covered loan pursuant to section 1106(b) of the CARES Act. Sen. Chuck Grassley, the chairman of the Finance Committee, said Thursday that he was disappointed in the IRS decision. “The intent was to maximize small businesses’ ability to maintain liquidity, retain their employees and recover from this health crisis as quickly as possible…this Notice is contrary to that intent.” This is evident in the law’s provision to exclude the amount forgiven from taxable income. For example, if the amounts were taxable, and the expenses deductible, taxpayers would be in the same place. Said another way, why exclude the forgiven amount from income at all just to deny the deductions and put taxpayers in the income position? Section 1106(i) of the CARES Act addresses certain Federal income tax consequences resulting from covered loan forgiveness. Specifically, that subsection provides that, for purposes of the Code, any amount that would be includible in gross income of the recipient by reason of forgiveness described in section 1106(b) “shall be excluded from gross income.” Section 1106(i) of the CARES Act operates to exclude from the gross income of a recipient any category of income that may arise from covered loan forgiveness. Neither section 1106(i) of the CARES Act nor any other provision of the CARES Act addresses whether deductions otherwise allowable under the Code for payments of eligible section 1106 expenses by a recipient of a covered loan are allowed if the covered loan is subsequently forgiven under section 1106(b) of the CARES Act as a result of the payment of those expenses. In its decision the IRS Notice points to section 265(a)(1) of the Internal Revenue Code which provides that no deduction is allowed to a taxpayer for any amount otherwise allowable as a deduction if it is allocable to tax exempt income. Loan forgiveness results in tax exempt income, therefore §265(a)(1) disallows the deduction of expenses generating forgiveness. Congress could pass a law allowing the deductions and overriding the IRS ruling, but for now, the expenses will not be deductible. If you have any questions regarding the Notice 2020-32, please consult your HBK tax advisor. We are standing by and ready to help.

Speak to one of our professionals about your organizational needs

"*" indicates required fields

HBK uses the contact information you provide to send you information about our products and services. You may unsubscribe from these communications any time. For information on how to unsubscribe, as well as our privacy practices and commitment to protecting your privacy, check out our Privacy Policy.



Court Case Denies S Corp Shareholder’s Losses for Insufficient Debt Basis

Date July 10, 2019
Categories
Article Authors

S corporation shareholders can deduct losses only to the extent of their adjusted stock and debt basis in the corporation (see Can You Deduct Your S Corp Losses?, Passive Activity Loss Rule).

A shareholder creates stock basis by contributing capital, and debt basis by lending money to the S corporation, both of which are considered “actual economic outlays” by the shareholder. As described in a recent court case (Meruelo v. Comm., 123 AFTR 2d. 2019), to claim a loss from the activity the shareholder must have been “left poorer in a material sense after the transaction.”

Meruelo
In Meruelo, the S corporation suffered a nearly $27 million loss after banks foreclosed on its condominium complex. The taxpayer claimed he had sufficient basis to claim his $13 million share of the loss. His basis comprised of $5 million of capital contributions and more than $9 million of debt basis for transfers from other businesses in which he was an owner. The IRS ruled, and the Tax and Appellate Courts confirmed, that the taxpayer was entitled to claim a $5 million loss, but denied the deduction for any loss claimed on the debt as it was not directly from the shareholder.

The Problem with Debt Basis
It’s clear that a loan from a shareholder to their S corporation creates debt basis. Debt basis is also established when the shareholder borrows funds that it then loans directly to the S corporation, commonly referred to as a “back-to-back loan.” However, the IRS and courts have consistently ruled that anything outside a direct loan from the shareholder to the S corporation does not create debt basis.

In Meruelo, the taxpayer’s CPA was aware of this rule and drafted a promissory note from the S corporation to the taxpayer for a $10 million unsecured line of credit with a 6 percent interest rate. The CPA also reported the taxpayer’s share of related entity debt as shareholder loans on the S corporation’s tax return. The Court rejected the taxpayer’s argument that the arrangement was in effect a back-to-back loan, because there was no evidence that the funds had been lent to the taxpayer and then back to the S corporation. It explained that a shareholder could create debt basis by borrowing from an affiliated company and then lending the funds to an S corporation. But it also held that taxpayers are bound by the form of the transaction they initially choose; the funds advanced as intercompany loans cannot later be reclassified as shareholder loans to create basis.

What Should Shareholders Do?
The fact pattern in Meruelo is one we often encounter, a taxpayer with ownership in multiple entities using earnings from one or more to fund the losses of another. The case highlights the potential tax pitfalls of using this arrangement without proper planning. Shareholders should avoid using intercompany transfers to fund operations where basis limitations could become an issue. Instead, they should consider taking distributions or loans from their related businesses and either contributing or loaning the funds to the entity in need of cash. Done properly, this will create basis.

For questions on this or related tax matters, please contact Ben DiGirolamo at BDiGirolamo@hbkcpa.com.

Speak to one of our professionals about your organizational needs

"*" indicates required fields

HBK uses the contact information you provide to send you information about our products and services. You may unsubscribe from these communications any time. For information on how to unsubscribe, as well as our privacy practices and commitment to protecting your privacy, check out our Privacy Policy.



Qualified Opportunity Zone Funds – UPDATE

Date March 11, 2019
Article Authors
HBK CPAs & Consultants

Of the many changes that came from the Tax Cuts and Jobs Act (“The TCJA”), Qualified Opportunity Zones (“QOZ”) have been one of the most talked about provisions as the 2018 tax season progresses. As a recap, through QOZs, taxpayers may elect to temporarily defer the tax to be paid on capital gains until the 2026 tax year that are invested in a Qualified Opportunity Fund (“QOF”) within 180 days of gain recognition, the QOF must invest 90 percent of its capital in QOZ Property. Taxpayers who hold investments in a QOF for at least five years may exclude 10 percent of the original deferred gain, and investments held for more than seven years qualify for an additional five percent exclusion of their original deferred gain. In what could be the most attractive feature of the new law, after 10 years, post-acquisition appreciation is 100 percent excluded from taxable income for federal tax purposes. Many states are still evaluating how they are going to deal with the new QOZ rules.

Click here to read the full update.

Speak to one of our professionals about your organizational needs

"*" indicates required fields

HBK uses the contact information you provide to send you information about our products and services. You may unsubscribe from these communications any time. For information on how to unsubscribe, as well as our privacy practices and commitment to protecting your privacy, check out our Privacy Policy.



IRS Denial of Certain Cannabis-Based Tax Deductions is Confirmed

Date January 25, 2019
Article Authors

In a United States Tax Court case1 decided November 29, 2018, the court reaffirmed the Internal Revenue Service’s disallowance of certain deductions for companies operating in the cannabis industry. Background Patients Mutual Assistance Collective Corporation d/b/a Harborside Health Center (HHC) is a California medical marijuana dispensary, operating four industry-related activities. HHC believed each of its activities was a unique trade or business. The activities are: Brand Development, Therapeutic Services, Sales of Products Containing No Marijuana, Sales of Marijuana and Products Containing Marijuana. Internal Revenue Code (“Code”) Section 280E (“280E”) states:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of Schedule I and Schedule II of the Controlled Substances Act) which is prohibited by Federal Law or the law of any state in which the trade or business is conducted.

Resolutions 1) 280E The Code allows a business to deduct all its “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” However, as stated previously, Code Section 280E contains an exception disallowing expenses related to … “carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of Schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.” HHC argued that “consists of” means an exhaustive list or in other words “Section 280E only applies to business that exclusively or solely traffic in controlled substances and not to those that also engage in other activities.” The IRS argued that a single business can have multiple activities and that 280E applies to an entire trade or business if any one of its activities is trafficking in a controlled substance.2 The Tax Court ruled “Following the most common usage of ‘consists of’, as HHC suggests, would indeed make Section 280E ineffective. If this section denies deductions only to businesses that exclusively traffic in controlled substances, then any street-level drug dealer could circumvent it by selling a single item that was not a controlled substance … This reading would edge us close to absurdity, which is another result our reading of a statute should avoid if possible.” 2) More Than One Trade or Business “An activity is a trade or business if the taxpayer does it continuously and regularly with the intent of making a profit… A single taxpayer can have more than one trade or business.”3 Also, taxpayers may have multiple activities that nevertheless are only a single trade or business. HHC stated that if 280E applies to its marijuana sales, the business should be entitled to deduct expenses for any separate, non-trafficking trades or businesses. HHC argued it had four activities. The IRS argued HHC operated only as one trade or business, whose business was “trafficking in a controlled substance” and therefore subject to 280E. The Tax Court analyzed the sales volume, floor space, and employee time spent on the four different operations and ultimately determined that HHC’s primary operation was selling marijuana and marijuana-related products and its other activities were “neither economically separate nor substantially different.” 3) Cost of Goods Sold All taxpayers, even drug traffickers pay tax only on gross income, which is defined as gross receipts less the cost of goods sold. This means HHC is not limited to owing taxes based on its gross receipts. However, the definition of cost of goods sold came into question. The Code has three sections that address cost of goods sold – Section 263, Section 263A and Section 471. Since there are multiple sections the question becomes which section applies to HHC? The IRS argued the applicability of Section 471, enacted in 1954 which was in place when Congress enacted Section 280E in 1982. Section 471 has separate regulations for resellers and producers. The regulations state “resellers” use as their cost of goods sold, the price they pay for inventory plus any “transportation or other necessary charges incurred in acquiring possession of the goods.” The regulations for “producers” are more complex. Producers must include in cost of goods sold both direct and indirect costs of creating their inventory. The regulations state to inventory: “cost of raw materials”, “expenditures for direct labor” and “indirect production costs incident to and necessary for production of the particular article”. HHC argued that limiting its cost of goods sold to “only the actual cost used to purchase inventory” violates the Sixteenth Amendment and that “section 263A represented the most accurate tax-accounting method for calculating cost of goods sold.” The Constitution does limit Congress to taxing only gross income,4 and HHC argued that not letting marijuana dispensaries use 263A forces them to pay tax on more than their gross income.” The Tax Court ultimately ruled “Section 263A capitalization rules don’t apply to drug traffickers. Unlike most businesses, drug traffickers can’t capitalize indirect expenses beyond what’s listed in the section 471 regulations. Section 263A expressly prohibits capitalizing expenses that wouldn’t otherwise be deductible and drug traffickers don’t get deductions. Because federal law labels HHC a drug trafficker, it must calculate its cost of goods sold according to Section 471”. Next the Tax Court had to determine whether HHC is a “producer” or a “reseller” in accordance with Section 471 since there are different rules for producers versus resellers as far as how to calculate its cost of goods sold. The IRS argued that under Section 471 “production” means “manufacturing” while the Tax Court added that “producers” retain title to the items throughout the production process. The question became did HHC own what its growers grew? HHC argued that “it exercised a high degree of control over the growers it purchased marijuana from. HHC only purchased marijuana from its members and even then, only if the members used HHC clones (which they purchase or received for free), took HHC growing class, followed HHC’s best practices and met HHC quality control standards”. The IRS stated HHC “didn’t create the clones, maintain tight control over them, order specific quantities, prevent sales to third parties or take possession of everything produced. HHC bought clones from nurseries and either sold them to growers with no strings attached or gave clones to growers expecting that they’d sell the bud back to HHC. Nothing prevented either type of grower from selling to another collective and [HHC’s owner] Steve DeAngelo thought it would be futile to try to use the courts to stop them. HHC had complete discretion over whether to purchase what bud the growers brought in, paid growers only if it purchased their bud, and at times rejected the ‘vast majority’ of its growers’ bud. And HHC thought growers could do whatever they wanted with the rejected bud.” The Tax Court ruled “HHC merely sold or gave members clones that it had purchased from nurseries and bought back bud if and when it wanted. In between these two steps it had no ownership interest in the marijuana plants. HHC is therefore a reseller for the purposes of Section 471 and must adjust for its cost of goods sold according to Section 1.471-3(b).” This is the most restrictive calculation regarding the costs of goods sold and thereby the lowest calculation for the cost of goods sold. Thus, HHC could only include its purchase of the products and related transportation costs. Conclusion The Patients Mutual Assistance Collective Corp. case further denies ordinary and necessary business expenses for entities they operate in the cannabis industry. The case also defines the criteria to determine cost of goods sold. If you have questions about the case, its impact on the cannabis industry, or any related matter, please contact a member of the HBK Cannabis Industry group at Cannabis Industry Inquiry. Our team will walk you through the options and help you decide what strategies may be best for your cannabis-based business.   Footnotes
  1. PATIENTS MUTUAL ASSISTANCE COLLECTIVE CORPORATION d.b.a.HARBORSIDE HEALTH CENTER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent, Docket Nos. 29212-11, 30851-12, 14776-14, Filed November 29, 2018.
  2. PATIENTS MUTUAL ASSISTANCE COLLECTIVE CORPORATION d.b.a.HARBORSIDE HEALTH CENTER v. COMMISSIONER, 2018, p25.
  3. Ibid, p37.
  4. Gross income is defined as gross receipts minus direct costs.

Speak to one of our professionals about your organizational needs

"*" indicates required fields

HBK uses the contact information you provide to send you information about our products and services. You may unsubscribe from these communications any time. For information on how to unsubscribe, as well as our privacy practices and commitment to protecting your privacy, check out our Privacy Policy.



Proposed Rules on Qualified Opportunity Zones

Date October 22, 2018
Categories
Article Authors
HBK CPAs & Consultants

The Internal Revenue Service has just released its first installment of the much anticipated proposed rules relating to Qualified Opportunity Zones (QOZ) that will help investors use a new tax incentive created by 2017 Tax Cuts and Jobs Act. QOZs are underdeveloped areas that have been certified by the federal government allowing for special tax breaks to promote investment in these nearly 9,000 U.S. regions. These proposed rules would govern investments made in QOZs to provide various tax advantages to investors in two ways. First, capital gains placed in certified opportunities zone funds will be deferred and not be taxed through the 2026 tax year, or until the time in which the investment is sold, whichever occurs first. Second, gains from these QOZ investments are “permanently” shielded from income taxes if such investments are held for at least 10 years. Otherwise, gains from the initial investments in qualified opportunity funds will be discounted by up to 15% if held for 7 years and 10% for 5 years. The proposed rules state that any type of capital gains including from marketable securities are eligible for this preferential tax deferral. Additionally, the opportunity to invest in these qualified opportunity funds is available to individual taxpayers, business entities, REITs and estates and trusts. The proposed rules also clarify how to calculate substantial improvements in the property. and The rules state that taxpayers do not need to include the value of the land for the purpose of calculating how much the law requires they spend on qualifying renovations, or refurbishments of the property. For example, if a taxpayer paid $10 million for a warehouse and land, with the building being valued at $500,000, the fund must spend at least what the building is valued, or $500,000 as opposed to the total $10 million purchase price, in renovations. This exclusion of land value for the purposes of determining substantial improvements made within a QOZ applies to both tangible property, such as equipment, and realty. This will create an increased importance as to the qualified valuations performed on property located in within the boundaries of a QOZ. Additionally, investors will have 180 days from the sale of stock or businesses to place the proceeds from those sales in opportunity funds to qualify for these tax breaks. The Internal Revenue Service (IRS) also stated in these proposed rules that funds have 30 months from when the money is placed in them to perform the required renovations. The Treasury also created a 70-30 rule that measures whether a given business counts as having “substantially all” of its assets in an opportunity zone. Under that rule, as long as 70% of a business’s tangible property is in a zone, the business doesn’t lose its ability to qualify for the tax break. In the proposed regulations, Treasury does ask for input on a couple of technical questions, such as what happens if a business abandons property in an opportunity zone and how to treat movable property, such as vehicles, that may possibly spend part of their time outside the QOZ. While these rules have provided some of the answers to questions on the minds of taxpayers, some additional items still remain unanswered.
  • Will grace periods will be permitted related to the proceeds of large scale asset sales?
  • Will the emerging cannabis and gambling industries will be permitted benefit from these tax advantages?
  • What benefits will be able to be yielded by lessees of QOZ properties?
  • Will partnerships and partners need to invest as a singular unit or if partners are permitted to invest their portions of asset sales individually into their own qualified opportunity zones?
The Treasury is expected to announce additional guidance on opportunities zones before the end of the year and are currently under review by the IRS. In the meantime, taxpayers can rely on the proposed regulations while the IRS solicits comments and considers changes in the final version. Since this is a developing area, HBK will continue to provide updates on the QOZ issue as it becomes available. Committing capital to a QOF is an option with many variables and it is a decision investors/taxpayers should weigh carefully. If there are any questions on this, please contact your local HBK team representative to discuss further. For more details or other related questions, please contact a member of the HBK Tax Advisory Group.

Speak to one of our professionals about your organizational needs

"*" indicates required fields

HBK uses the contact information you provide to send you information about our products and services. You may unsubscribe from these communications any time. For information on how to unsubscribe, as well as our privacy practices and commitment to protecting your privacy, check out our Privacy Policy.



Proposed Regulations on Pass-Through Deduction Released Today

Date August 8, 2018
Categories
Article Authors

Proposed Regulations under Section 199A (i.e. The 20% Pass-Through Deduction) were released this morning, and can be found here: https://www.irs.gov/pub/irs-drop/reg-107892-18.pdf. There will be a public hearing on the rules on October 16th.

The Tax Advisory Group will be reviewing the regulations and providing additional information in the coming days. Additionally, we will pass along related updates as they unfold.

Speak to one of our professionals about your organizational needs

"*" indicates required fields

HBK uses the contact information you provide to send you information about our products and services. You may unsubscribe from these communications any time. For information on how to unsubscribe, as well as our privacy practices and commitment to protecting your privacy, check out our Privacy Policy.



Business Interest Deduction Limitation

Date May 31, 2018
Article Authors
HBK CPAs & Consultants

Overview

The Tax Cuts and Jobs Act (the Act) created a new Business Interest Deduction limitation, effective for tax years starting after December 31, 2017. This new provision limits the deduction for business interest for all businesses, though an exception to the limitation applies for businesses who meet the gross receipts test, discussed below.

What is the Business Interest Deduction?

Businesses are allowed to deduct any interest paid or accrued on debt that is properly allocable to a trade or business, and is not considered investment income. Historically, this interest deduction has not been subject to many limitations.

Scope: Then and Now

Internal Revenue Code (IRC) Section 163(j) is the code section that provides for a limitation on the deduction for business interest. Prior to the Act, this provision had a limited application and only applied to U.S. corporations or U.S. branches of foreign corporations to prevent businesses from stripping earnings and avoiding U.S. taxation. The Act changed this code section to apply to all taxpayers and all debt, even if the debt arises from a related-party transaction.

The Limitation

The deduction is limited to the sum of business interest income, 30 percent of adjusted taxable income (ATI), and floor plan financing interest. ATI is generally taxable income, computed without regard to:

  • activity that is not allocable to the trade or business;
  • business interest expense or business interest income;
  • depreciation, amortization, or depletion (for tax years beginning before January 1, 2022);
  • net operating losses under Section 172; or
  • the new 20% qualified business income deduction under Section 199A.

Floor plan financing interest is generally defined as interest paid or accrued on debt used to finance the acquisition of motor vehicles held for sale or lease, and which is secured by the inventory acquired.

If the limitation applies, the disallowed business interest will carry forward to the succeeding taxable year.

Gross Receipts Test Exemption – Small Businesses

There is an exemption from the limitation for small businesses with average annual gross receipts for the three taxable years ending prior to the taxable year at hand that is less than $25,000,000. However, taxpayers in controlled groups and partnerships may be required to aggregate gross receipts, so this should be considered when calculating whether or not the limitation should apply.

Carve Outs

Farming, real estate businesses, dealerships and certain public utility businesses successfully lobbied to avoid the application of this limitation. For dealerships, floor plan financing is fully deductible without limitation. However, these dealerships are excluded from 100% bonus depreciation on any of their assets.

Farming and real estate businesses may elect out of the new 30% limitation, but they will be required to use the Alternative Depreciation System (“ADS”) to depreciate their depreciable assets. Businesses using ADS are not eligible for 100% bonus depreciation. If the election is made, it is irrevocable, and ADS treatment will apply to all depreciable assets that are already owned or will be purchased in the future.

Real Property Business – Election Comparison

   Application of Interest Limitation Election Out of Interest Limitation
Asset Category Depreciable Life (years) Eligible for Bonus Depreciable Life Eligible for Bonus
Nonresidential Real Property 39 NO 40 NO
Residential Rental Property 27.5 NO 30 NO
Qualified Improvement
Property – under current law
39 50%
168(k)(2)(A)(iv)
40 NO
Qualified Improvement
Property – if corrected
15 YES 20 NO

So, How does it Work?

Let’s use a hypothetical company, ABC Corporation, and assume it exceeds the small business exemption. ABC Corporation is in the business of residential rental property and, for illustration purposes, will not elect out of the business interest limitation. For the taxable year, ABC Corporation has the following income statement:

Application of Interest Limitation
Gross receipts 100,000,000
Interest income 1,000,000
Cost of goods sold 0
Interest expense -50,000,000
Amortization -500,000
Depreciation -25,000,000
Taxable income before interest limitation 25,500,000
 
Adjusted Taxable Income
Taxable income before interest limitation 25,500,000
Add back: net interest expense 49,000,000
Add back: Amortization 500,000
Add back: Depreciation 25,000,000
Adjusted taxable income 100,000,000
 
Business Interest Deduction Limitation
Adjusted taxable income 100,000,000
Multiply by 30% x 30%
Business interest deduction limitation 30,000,000
 
Taxable Income AFTER Interest Limitation
Gross receipts 100,000,000
Interest income 1,000,000
Cost of goods sold 0
Interest expense -30,000,000
Amortization -500,000
Depreciation -25,000,000
Taxable income before interest limitation 45,500,000

ABC Corporation can only deduct $30,000,000 of its $49,000,000 of net interest expense. The remaining $19,000,000 of disallowed interest expense will carry forward until used in a future year. The $19,000,000 disallowance is calculated as follows:

Disallowed Deduction Carried Forward
Net Interest Expense -49,000,000
Business Interest Deduction Limitation 30,000,000
Disallowed Deduction -19,000,000

$50,000,000 interest expense – $1,000,000 interest income = $49,000,000 net interest expense

$49,000,000 net interest expense – $30,000,000 interest expense limitation = $19,000,000 disallowance

ABC Corporation will have taxable income of $45,500,000 if they do not elect out, but will have taxable income of $25,500,000 if they do elect out. Therefore, the election out is most beneficial in the current year where there is high business interest expense. However, electing out will likely decrease the depreciation deduction for the current year and future years, thus slightly increasing taxable income. The decision of whether or not an election out should be made should therefore take into account the impact on current and future depreciation.

Effect of Depreciation, Amortization, and Depletion on ATI and the Deduction

The larger the ATI, the larger the deduction. Starting in 2022, ATI will be reduced by depreciation, amortization, and depletion. Therefore, the deduction will likely decrease for many businesses at that point. Looking at our example above, if depreciation and amortization were included in the calculation of ATI, ABC corporation would have $52,150,000 of taxable income. The following shows this calculation:

ABC Corporation YR 2022 Interest Limitation & Taxable Income
ATI $74,500,000.00
2022 Limitation $22,350,000.00
Taxable Income $52,150,000.00

ATI would be $74,500,000 because depreciation and amortization amount are not added back. ATI of $74,500,000 is then multiplied by 30%, which results in a limitation for business interest in the amount of $22,350,000. Taxable income ($74,500,000) is then reduced by the limitation amount ($22,350,000) to equal $52,150,000 of taxable income.

Conclusion

The new business interest expense limitation can be complicated, depending on the type of business and the business’s average gross receipts. For businesses that qualify to elect out of the limitation, it is important to compare the effects of the deduction limitation and the depreciation adjustments on overall taxable income for the current and future years. For businesses that will be subject to the limitation, planning should focus on the method of providing future financing since the limitation may restrict cash flow.

Please consult your tax advisor or a member of the HBK Tax Advisory Group to determine whether or not this limitation applies to your business.

Speak to one of our professionals about your organizational needs

"*" indicates required fields

HBK uses the contact information you provide to send you information about our products and services. You may unsubscribe from these communications any time. For information on how to unsubscribe, as well as our privacy practices and commitment to protecting your privacy, check out our Privacy Policy.