With the appropriate planning, PE groups might avoid a tax liability spike from interest expense deduction limits 

For the 2022 tax year and beyond, companies face new, more restrictive limitations on interest expense deductibility that could have major implications on their tax liability. Enacted as part of the Tax Cuts and Jobs Act of 2017 (TCJA), Section 163(j) of the Internal Revenue Code created limits on the interest expense companies are allowed to deduct when computing taxable income. The legislation has been phased in over the last few years, but changes that took effect in 2022 place the most restrictive limits yet on companies’ ability to deduct interest.

When Section 163(j) originally was enacted, the limitation on interest expense was 30% of adjustable taxable income, generally defined as earnings before interest, taxes, depreciation, and amortization (EBITDA). The next phase, for tax years beginning in 2022, redefined adjusted taxable income as earnings before interest and taxes (EBIT).

Perfect storm of rising interest rates and limited deductibility of interest expense

Section 163(j) has a major impact on many private equity groups, which finance business acquisitions with substantial debt and historically could deduct 100% of their interest expense. Taxpayers who already had interest expense limited under Section 163(j) could receive no tax benefit for additional interest charges, and significantly more taxpayers now are subject to interest expense limitations.

Companies should not be surprised by these changes and might have forecasted tax expenses based on the more restrictive limits. However, in combination with rising interest rates, which also have driven up interest expense, many companies might find they have significantly higher tax liabilities than expected.

It’s a perfect storm that requires a thoughtful approach for managing the tax impact of interest expense limitations. Private equity groups need to be much more strategic about structuring transactions in a way that can mitigate the higher taxable income that can result from these changes.

Structuring transactions to limit taxable income

The good news for private equity groups is there are opportunities to minimize tax costs, including structuring transactions in different ways to take advantage of nuances in how interest expense limitations are computed.

For instance, consider an acquisition structured in two different ways: on the one hand, capturing a tax basis step-up via a Revenue Ruling 99-6 transaction; and on the other, through an IRC Section 754 election and Section 743(b).

With a Revenue Ruling 99-6 transaction, a buyer acquires 100% of a partnership’s interests from the sellers. This scenario is treated as a deemed asset purchase for tax purposes. If the buyer is a partnership, the partnership receives the depreciation and amortization deductions associated with the property acquired. These deductions can reduce significantly the adjusted taxable income to which the Section 163(j) limit applies.

On the other hand, in a partnership interest purchase where the acquirer receives a tax basis step-up through Section 754 and Section 743(b), the basis adjustment is a partner-level item. Partnership adjusted taxable income is not reduced by the partner-level depreciation and amortization adjustments. This scenario results in a higher base for computing the partnership interest expense.

To make this example more concrete, assume that under each scenario there is $100,000 of partnership income before EBITDA. Assume $30,000 of interest expense and $5,000 of state taxes. Under both the Revenue Ruling 99-6 and Section 754 and Section 743(b) transactions, assume $25,000 of depreciation and $40,000 of amortization.

In the examples provided, the Revenue Ruling 99-6 transaction results in $19,500 of taxable income to partners, with $19,500 of interest expense limited and carried forward to future periods that may or may not ever be useable. At a 50% blended federal and state tax rate, the partner’s tax due would be $9,750. On the other hand, the Section 754 and Section 743(b) transaction results in zero taxable income and zero interest expense carryforward.

Private equity groups can effectuate transactions in a number of ways, and the choices can have significant implications on interest expense deductions and tax liabilities. Thoughtful consideration should be given to a variety of acquisition structuring alternatives, to debt and preferred equity financing, and to structuring opportunities at exit in order to minimize the tax cost of Section 163(j) throughout the entire investment cycle.

While interest rates eventually will come back down, Section 163(j) is here to stay. Businesses that take a proactive and strategic approach to tax planning will reap the benefits of the highest possible interest expense deduction today and beyond.

This article was originally published in the Dallas Business Journal.