The IRS Provides Guidance Regarding Business Interest Expense Deductions and Expanded Bonus Depreciation under the CARES Act

The Internal Revenue Service (“IRS”) released Revenue Procedure 2020-22 to provide guidance regarding the increased ability to deduct business interest expenses (and elections resulting from the change) and the expansion of bonus depreciation to include qualified improvement property under the Coronavirus Aid, Relief, and Economic Security Act, Pub. L. 116-136, 134 Stat. 281 (the “CARES Act”). For additional information regarding the tax provisions of the CARES Act, see our Client Alert on this topic.

The CARES Act tax provisions provide immediate benefits to taxpayers by allowing adjustments to 2018 and 2019 tax returns and carryback of net operating losses (“NOLs”) from those years to prior years to obtain refunds of taxes paid in earlier years. The CARES Act changes to the limitations on business interest deductions may result in, or add to, NOLs that can be carried back to previous taxable years. NOL carrybacks are discussed in greater detail in our Client Alert regarding the impact of the CARES Act on M&A transactions and our Client Alert regarding extensions of time to apply for expedited tax refunds for certain NOLs and certain other NOL elections and refund requests. 

Background for the Issues Addressed by Rev. Proc. 2020-22

The Tax Cuts and Jobs Act (“TCJA”) limited the amount of business interest expense that could be deducted for tax years beginning after December 31, 2017 to the sum of the taxpayer’s business interest income, 30% of the taxpayer’s adjusted taxable income for the taxable year, and the taxpayer’s floor plan financing interest (the “Section 163(j) Limitation”). This was a significant change from pre-TCJA law, which generally allowed the full deduction of business interest expense (with exceptions for certain interest paid or accrued by a corporation). The TCJA allows a “real property trade or business” or a “farming trade or business” to elect out of the Section 163(j) Limitation. However, if a taxpayer elects out of the Section 163(j) Limitation, the taxpayer must depreciate property over a longer period of time using the alternative depreciation system and would not be eligible for increased bonus depreciation (discussed immediately below).

The TCJA also increased the bonus depreciation percentage from 50% to 100% for “qualified property” acquired and placed in service after September 27, 2017 and before January 1, 2023. Due to a drafting oversight in the TCJA, “qualified improvement property” (“QIP”) was not eligible for increased bonus depreciation.  Generally, QIP is any improvement made by a taxpayer to an interior portion of a building that is nonresidential real property if such improvement is placed in service after the date that the building was first placed in service.

The CARES Act changes the Section 163(j) Limitation for tax years beginning in 2019 or 2020 by increasing the adjusted taxable income percentage from 30% to 50%. In addition, a taxpayer may elect to use its 2019 adjusted taxable income limitation in lieu of its 2020 adjusted taxable income to compute the Section 163(j) Limitation for a 2020 tax year. A partnership is only eligible for the increased business interest deduction for tax years beginning in 2020.  Any excess business interest of a partnership for a tax year beginning in 2019 is allocated among the partners and 50% of the interest so allocated to a partner is deductible by such partner in its 2020 tax year. The CARES Act relaxation of the business interest deductions limitations may result in, or add to, NOLs that can be carried back to previous taxable years. For more information regarding implications of the changes to the Section 163(j) Limitation on M&A transactions, please see our Client Alert on this topic.

Rev. Proc. 2020-22

Rev. Proc. 2020-22 provides additional guidance regarding certain elections (and withdrawals of previous elections) related to the Section 163(j) Limitation in light of the CARES Act changes.

• Withdrawal of a previous election out of the Section 163(j) Limitation. A taxpayer that is a “real property trade or business” or a “farming trade or business” that previously elected out of the Section 163(j) Limitation (including a taxpayer who elected out pursuant to the automatic extension procedure discussed below) for a tax year beginning in 2018, 2019, or 2020 may withdraw that previous election. A taxpayer might prefer to withdraw the election to be eligible for 100% bonus depreciation and to avoid restrictions on the depreciation of certain depreciable assets. For some taxpayers, the increase in the adjusted taxable income percentage for the Section 163(j) Limitation and the expansion of bonus depreciation to include QIP may change the analysis regarding whether to elect out of the Section 163(j) Limitation.

To withdraw the election, the taxpayer must file an election withdrawal statement with its timely filed amended federal income tax return (including extensions) or with an administrative adjustment request (“AAR”) for the tax year of the election. The tax return or AAR must include the adjustment to taxable income for the withdrawn election and any collateral adjustments to taxable income or tax liability. The taxpayer must file the statement, attached to the tax return or AAR, on or before October 15, 2021. Regardless of this deadline, the taxpayer must file no later than the applicable period of limitations on assessment for the tax year for which the amended return is filed (or, in the case of an AAR, no later than the applicable period of limitations on making adjustments for the reviewed year). If necessary, the taxpayer must file amended tax returns or AARs for any affected succeeding tax year (along with any necessary adjustments to taxable income or tax liability).

If a partnership were to file an AAR to change a tax item in its Form 1065 due to the CARES Act, a partner would only be able to receive tax benefits from that relief on a tax return for the current year and would not be eligible to apply for a tax refund for the year at issue or preceding years.  Thus, using the AAR procedure would delay a partner’s CARES Act tax benefits until 2021 (i.e., when the partner’s 2020 tax return is filed), even when the AAR affects 2018 or 2019 tax years. For more information regarding amendments to partnership tax returns in light of the CARES Act, please see our Client Alert on this topic.

• Extension of time to elect out of the Section 163(j) Limitation. Proc. 2020-22 provides an automatic extension to elect out of the Section 163(j) Limitation for any taxpayer who is eligible to elect out of the Section 163(j) Limitation or who withdrew its election out of the Section 163(j) Limitation (as described above). This automatic extension allows a taxpayer to elect out of the Section 163(j) Limitation for a tax year beginning in 2018, 2019, or 2020. To make an election pursuant to the automatic extension, the taxpayer must file an election statement with an amended tax return or AAR on or before October 15, 2021 (but in no event later than the applicable period of limitations on assessment for the tax year of the amended return or the AAR). Revenue Procedure 2020-23 provides special timing and procedure rules that apply to most partnerships, as discussed in our Client Alert on amended partnership tax returns (linked above). The tax return or AAR must include the adjustment to taxable income for the late election and any collateral adjustments to taxable income or tax liability. If necessary, the taxpayer must file amended tax returns or AARs for any affected succeeding tax year (along with any necessary adjustments to taxable income or tax liability).
• Guidance regarding the time and manner to make certain Section 163(j) Limitation elections. Proc. 2020-22 also sets forth the details and procedures for taxpayers to make certain elections related to the changes to the Section 163(j) Limitation. The Revenue Procedure provides guidance regarding an election: (1) by a taxpayer to use the 30% adjusted taxable income limitation for the Section 163(j) Limitation, (2) by a taxpayer to use its 2019 adjusted taxable income to calculate the Section 163(j) Limitation for a tax year beginning in 2020, and (3) by a partner in a partnership to not deduct 50% of excess business interest expense for a tax year beginning in 2020. In general, a taxpayer may make any of these elections on a timely filed tax return or AAR. No formal statement is required to make the election.

Please reach out to us with any questions about the CARES Act and its implications for the Section 163(j) Limitation and bonus depreciation.