IRS issues guidance for Section 163(j) elections

The IRS has released guidance (Rev. Proc. 2020-22) for making and revoking certain elections under Section 163(j) due to developments resulting from the Coronavirus Aid, Relief, and Economic Security (CARES) Act.

The guidance specifically includes procedures for making a late election or revoking a previously made election under Section 163(j)(7) (relating to an electing real property trade or business or an electing farming business), a welcome opportunity for taxpayers to reassess their circumstances in light of the modifications and technical corrections made by the CARES Act. It also includes procedures to make elections under Section 163(j)(10) as provided by the CARES Act.


 

Interest expense limitation rules under Section 163(j)

Section 163(j) was substantially amended by the Tax Cuts and Jobs Act to limit the deduction of business interest for tax years beginning after Dec. 31, 2017, to the sum of a taxpayer’s business interest income, floor plan financing interest and 30% of its adjusted taxable income (ATI) for a given taxable year.

Under Section 163(j)(7), certain real property trades or businesses and certain farming businesses may elect to be exempt from applying the rules. The procedures for making the election are prescribed under Prop. Treas. Reg. Sec. 1.163(j)-9, and the election is generally irrevocable once made. Electing excepted trades or businesses are required to depreciate nonresidential real property, residential rental property and qualified improvement property using the alternative depreciation system (ADS), which also makes the assets ineligible for bonus depreciation.

The CARES Act modified Section 163(j) to provide additional rules in Section 163(j)(10). First, a taxpayer that is not a partnership is required to use 50% of ATI to determine the deductibility threshold under Section 163(j), instead of 30% of ATI, for any taxable year beginning in 2019 or 2020. However, the taxpayer may elect not to use the 50% ATI limitation.

Partnerships may use the 50% of ATI limitation only for any taxable year beginning in 2020 and do not have the 50% of ATI limitation available to them for any year beginning in 2019. Partnerships may also elect not to use the 50% of ATI limitation for taxable years beginning in 2020. Additionally, with regard to the excess business interest of a partnership for any taxable year beginning in 2019 that is allocated to a partner and carried over by the partner to the next taxable year, 50% is fully deductible in the partner’s first taxable year beginning in 2020, and the remaining 50% is subject to existing limitations at the partner level. The partner may elect not to apply this excess business interest treatment.

Finally, the CARES Act also provides that a taxpayer may elect to use its ATI for the last taxable year beginning in 2019, subject to modifications for short taxable years, to determine the limitation under Section 163(j) for any taxable year beginning in 2020.


 

Elections under Section 163(j)(7)

Taxpayers that have not filed an election under Section 163(j)(7) have an extension of time to file the election for taxable years beginning in 2018, 2019 or 2020 if such taxpayer was otherwise qualified to make the election. To make an election, a taxpayer must timely file an amended federal income tax return, amended Form 1065 or administrative adjustment request (AAR), as applicable, for the taxable year in which the election was made on or before Oct. 15, 2021 (but not after the applicable period of limitations on assessment). The late election statement must include information specified in Rev. Proc. 2020-22, as well as Prop. Treas. Reg. Sec. 1.163(j)-9. A partnership subject to the audit regime in the Bipartisan Budget Act (BBA) may need to file an amended return for its 2018 or 2019 taxable year on or before Sept. 30, 2020, pursuant to Rev. Proc. 2020-23.

Taxpayers that have filed a valid election under Section 163(j)(7) may withdraw an election made in a taxable year beginning in 2018, 2019 or 2020. To withdraw an election, a taxpayer must timely file an amended federal income tax return, amended Form 1065 or AAR, as applicable, for the taxable year in which the election was made, with an election withdrawal statement, on or before Oct. 15, 2021 (but not after the applicable period of limitations on assessment). The withdrawal statement must include information specified in Rev. Proc. 2020-22. A BBA partnership may have a different time to file pursuant to Rev. Proc. 2020-23 as described above.

In either case, an amended return or AAR must include the adjustment to taxable income for the withdrawal or late election, and any collateral adjustments to taxable income or tax liability. If returns have been filed for years subsequent to the year that is being amended, such years must also be amended for all collateral adjustments to taxable income or tax liability. An example of a collateral adjustment would be depreciation expense for nonresidential real property, residential rental property and qualified improvement property that is required to be computed using the ADS, without bonus depreciation, because of the Section 163(j)(7) election.

Elections under Section 163(j)(10)

The revenue procedure also provides procedures for taxpayers to make elections to waive the 50% ATI threshold or use 2019 ATI for 2020 under Section 163(j)(10).

First, a taxpayer permitted to make an election can elect not to apply the 50% of ATI limitation for the 2019 or 2020 taxable year by using 30% of ATI in determining the Section 163(j) limitation on a federal income tax return or Form 1065 (including extensions) or an amended federal income tax return, amended Form 1065 or AAR. No formal election statement is required. The election is an annual election and must be made for each taxable year.

The IRS also grants the taxpayer consent to revoke the election not to apply the 50% of ATI limitation by timely filing an amended federal income tax return, an amended Form 1065 or an AAR, as applicable, using the 50% of ATI limitation for the applicable taxable year..

Second, the revenue procedure provides that a taxpayer makes an election to use its ATI for the last taxable year beginning in 2019, subject to modifications for short taxable years, by applying it on a timely filed federal income tax return or Form 1065 (including extensions), or an amended federal income tax return, amended Form 1065 or AAR. A taxpayer may revoke the election by timely filing an amended federal income tax return, amended Form 1065 or AAR, as applicable, that does not apply its 2019 ATI. No formal statement is required to revoke the election to use 2019 ATI.

Finally, the revenue procedure provides that a partner may elect out of the special excess business interest treatment by not applying it on a timely filed federal income tax return or Form 1065 (including extensions) or an amended federal income tax return, amended Form 1065 or AAR. A partner may revoke the election by timely filing an amended federal income tax return, an amended Form 1065 or an AAR, as applicable, applying the special excess business treatment.


 

Next steps

The guidance provides a welcome opportunity for taxpayers that have already made a valid election under Section 163(j)(7) to reassess their circumstances in response to changes made by the CARES Act. However, taxpayers should consider the time it may take to implement these changes and the impact they may have on other aspects of their amended returns.