The Tax Cuts and Jobs Act (TCJA) imposed a limit on deductions for business interest for taxable years starting in 2018. When the TCJA took effect, many businesses were immediately buzzing about the new limitations and trying to assess the potential impacts.
In many cases, particularly for those within the entertainment industry involved in the production and distribution of content, the initial alarm quickly turned to indifference and then dismissal of the new law entirely, since it had no immediate tax impact. This is about to change in tax year 2022.
For tax years starting in 2018, the TCJA amended section 163(j) of the Internal Revenue Code (IRC). Under the amended rules, the deduction for business interest incurred by both corporate and noncorporate taxpayers is limited to the sum of:
The limit applies to all taxpayers, except those with average annual gross receipts of $25 million or less, real estate or farming businesses that elect to exempt themselves, and certain regulated utilities.
The key metric in the limitation is adjusted taxable income (ATI). ATI, in general, is a taxpayer’s income computed without regard to items not allocable to a trade or business, business interest income, net operating losses and depreciation/amortization/depletion for tax years beginning before January 1, 2022.
When 163(j) was originally implemented, taxpayers with large amounts of debt but high depreciation expenses were effectively given a grace period until January 1, 2022, before the limitation actually impacted them. Indeed, many production companies have plenty of ATI to support their interest expense deductions after large depreciation addbacks relating to their film libraries.
The termination of this grace period can impact all businesses subject to limitation. While this includes those with over $25M in gross receipts, it also applies to tax shelters regardless of their gross receipts.
A tax shelter includes any partnership or other entity if more than 35% of the losses of such entity during the taxable year are allocable to limited partners or limited entrepreneurs. The reality is that most film production companies have many passive equity investors receiving loss allocations from the business, therefore, they are likely to fall within the definition of a tax shelter.
All is not lost! You can manage the transition to the stricter 163(j) regime with proactive solutions. It is important to think about this now, as a disallowance of interest expense can rob your investors of an ordinary deduction on the front end and leave them with a capital loss upon an exit.
This deferral of tax benefit and increased overall tax due to rate differentials may be completely avoidable. Now is the time to assess whether these limitations may apply to your business, what the scope of the disallowance may be, and what can be done to reduce or eliminate the impact.
If you have questions or need assistance transitioning to the new rule, contact our experts. We are here to help.
