15.4 Business Interest Expense Limitation (§163(j)) & Business Taxes

Business Interest Expense Limitation (IRC §163(j))

Under IRC §163(j), the deduction for business interest expense in any taxable year is subject to a statutory limitation designed to prevent excessive corporate debt leverage and base erosion. The limitation applies to all business entities—including C corporations, S corporations, partnerships, and sole proprietorships—unless a specific statutory exemption applies.

The Statutory Limitation Formula

For any taxable year, the deduction for business interest expense cannot exceed the sum of:

1. The taxpayer's business interest income for the taxable year;
2. 30% of the taxpayer's Adjusted Taxable Income (ATI) for the taxable year (or zero if ATI is negative); plus
3. The taxpayer's floor plan financing interest for the taxable year.

IRC §163(j) Maximum Allowable Interest Deduction:
  Max Interest Deduction = Business Interest Income + (30% x ATI) + Floor Plan Financing Interest
  Excess Interest Paid   = Total Business Interest Expense - Max Interest Deduction
  Excess Amount          -> Disallowed currently; Carried forward INDEFINITELY

1. Adjusted Taxable Income for 2025

Start with tentative taxable income before applying §163(j). Add back business interest expense, the NOL deduction, the §199A deduction, and, for tax years beginning after 2024, deductions for depreciation, amortization, and depletion. Subtract business interest income and remove nonbusiness items as required by Form 8990. The 2025 law restored the depreciation, amortization, and depletion add-back: the 2022–2024 EBIT approach must not be carried into 2025.

2. Floor Plan Financing Interest

Floor plan financing interest is interest paid on debt secured by motor vehicle inventory held for sale or lease to retail customers (including automobiles, trucks, recreational vehicles, boats, and farm machinery). While floor plan interest is 100% deductible under §163(j)(1)(C), taking floor plan financing interest into account carries a major penalty: under IRC §168(k)(9)(B), if a business benefits from floor plan financing interest to deduct interest in excess of 30% of ATI, the business is prohibited from claiming bonus depreciation on any property placed in service during that tax year.

3. Indefinite Carryforward Mechanics

Any business interest expense disallowed under IRC §163(j) is carried forward indefinitely to subsequent tax years. The disallowed interest is treated as business interest expense paid or accrued in the following year and remains subject to the §163(j) limitation in that future year.

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Exemptions from the Section 163(j) Limitation

Congress enacted two major statutory carve-outs that exempt businesses from the 30% interest ceiling:

1. The Small Business Gross Receipts Exemption (§163(j)(3))

Under IRC §163(j)(3), the interest limitation does not apply to any taxpayer (other than a tax shelter) that satisfies the IRC §448(c) gross receipts test.

• The 3-Year Test: Average annual gross receipts for the prior three taxable years must not exceed the inflation-adjusted statutory threshold.
• 2025 Statutory Threshold: For Tax Year 2025, the threshold is $31,000,000.
• Aggregation Rules: Gross receipts of all entities treated as a single employer under IRC §52 (parent-subsidiary or brother-sister controlled groups) or §414 must be aggregated.

2. Electing Real Property Trade or Business (RPTOB) (§163(j)(7)(B))

An entity engaged in a real property trade or business (development, construction, acquisition, conversion, rental, operation, management, leasing, or brokerage under IRC §469(c)(7)(C)) may make an irrevocable election under IRC §163(j)(7)(B) to be exempt from the interest limitation.

• Benefit: The entity can deduct 100% of its business interest expense without regard to the 30% ATI cap.
• Statutory Cost: The electing RPTOB must depreciate its real property assets using the Alternative Depreciation System (ADS) under IRC §168(g):
  • Nonresidential real property: 40-year ADS recovery (vs. 39-year GDS);
  • Residential rental property: 30-year ADS recovery (vs. 27.5-year GDS); and
  • Qualified Improvement Property (QIP): 20-year ADS recovery (straight-line).
• Loss of Bonus Depreciation: Because IRC §168(k)(2)(D) bars bonus depreciation on any property required to be depreciated under ADS, electing RPTOBs forfeit 100% bonus depreciation on Qualified Improvement Property (QIP).

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Pass-Through Mechanics: Partnerships vs. S Corporations

The §163(j) limitation is applied at the entity level for both partnerships and S corporations, but the treatment of disallowed interest differs fundamentally:

1. Partnership Mechanics (Schedule K-1 Allocations)

• Excess Business Interest Expense (EBIE): Disallowed interest is not carried forward at the partnership level. Instead, it is allocated to each partner on Schedule K-1 (Box 13, Code K) as Excess Business Interest Expense (EBIE).
• Immediate Basis Reduction: Under IRC §163(j)(4)(B)(iii)(I), the partner's outside basis in the partnership is immediately reduced by the allocated EBIE, even though the partner cannot currently deduct it!
• Partner Suspended Loss: The partner carries forward the EBIE indefinitely. The partner can deduct the suspended EBIE only in a future year when that same partnership allocates Excess Taxable Income (ETI) or Excess Business Interest Income (EBII) to the partner.
• Disposition of Partnership Interest: If a partner sells or disposes of their partnership interest before utilizing all suspended EBIE, the unallowed EBIE is added back to the partner's outside basis immediately prior to the sale (preventing a permanent loss of tax basis).

2. S Corporation Mechanics

• In sharp contrast to partnerships, disallowed interest in an S corporation is retained and carried forward at the S corporation entity level.
• Disallowed interest does not flow through to shareholders on Schedule K-1 as EBIE.
• S corporation shareholder stock basis is not reduced until the tax year in which the interest is actually deducted by the S corporation at the entity level.

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Deductible Business Taxes Under IRC §164

Under IRC §164(a), a taxpayer may deduct taxes paid or accrued during the taxable year in carrying on a trade or business or an activity described in IRC §212. Business taxes are fully deductible above-the-line and are not subject to the individual Schedule A state and local tax (SALT) limitation.

Permissible Business Tax Deductions

1. Real Property Taxes: State, local, and foreign real property taxes imposed on business real estate (land and buildings).
2. Personal Property Taxes: State and local ad valorem personal property taxes on business equipment, machinery, and commercial vehicles.
3. Employer Payroll Taxes: Fully deductible as business taxes:
   • FICA Social Security: Employer's 6.2% share on employee wages up to the wage base ($176,100 for 2025);
   • FICA Medicare: Employer's 1.45% share on all employee wages (no cap);
   • FUTA: Federal unemployment tax of 0.6% (net of maximum 5.4% state credit) on the first $7,000 of wages per employee; and
   • SUTA / State Disability: State unemployment and employer disability taxes. (Note: Employee payroll taxes withheld from wages are not deducted as taxes; they are deducted as part of gross employee wages on the salaries/wages line).
4. Excise, License, and Franchise Taxes: State franchise taxes, commercial occupancy taxes, and municipal business license fees.

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Nondeductible Taxes Under IRC §275 & Capitalization Rules

1. Strictly Nondeductible Taxes (IRC §275)

Under IRC §275, no deduction is permitted for:

• Federal Income Taxes (including corporate income tax, alternative minimum tax, and accumulated earnings tax);
• Federal Estate, Gift, and Generation-Skipping Transfer Taxes;
• Employee Social Security and Medicare taxes withheld from paychecks; and
• Foreign income taxes if the taxpayer elects to claim the Foreign Tax Credit (IRC §901).

2. Capitalization of Sales Taxes (IRC §164(a) Flush Language)

3. Special Local Assessments (IRC §164(c)(1))

Taxes assessed against local benefits (such as paving streets, building sidewalks, or extending sewer mains) that tend to increase the value of the assessed property are nondeductible capital expenditures that must be added to the basis of the land. However, assessments levied strictly for the purpose of maintenance, repair, or interest charges are currently deductible under §164(c)(1).

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State Pass-Through Entity (PTE) Elective Taxes (Notice 2020-75)

Following the enactment of the TCJA's $10,000 individual limitation on state and local tax (SALT) itemized deductions on Schedule A, states enacted Pass-Through Entity (PTE) tax regimes.

Mechanics and IRS Blessing (Notice 2020-75)

• The Mechanism: A partnership or S corporation elects to pay state income tax directly at the entity level based on each owner's share of pass-through income.
• IRS Guidance (Notice 2020-75): The IRS issued formal guidance confirming that Specified Income Tax Payments made by a partnership or S corporation to a state or local government are allowed as a trade or business deduction under IRC §164(a) in computing the entity's non-separately stated ordinary business income on Form 1065 (Line 22) or Form 1120-S (Line 21).
• The Tax Advantage: Because the PTE tax is deducted at the entity level, it reduces the ordinary business income passed through to partners and shareholders on Schedule K-1. The owners report lower net business income on their individual Form 1040, effectively achieving a 100% federal tax deduction for state income taxes, completely bypassing the individual Schedule A SALT limitation!

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Comprehensive Worked Example: Section 163(j) & Business Taxes

Omni Logistics Corp, a calendar-year domestic C corporation, reports the following financial and tax data for Tax Year 2025. Omni's average annual gross receipts for the prior three years are $45,000,000 (exceeding the $31,000,000 small business threshold), making Omni fully subject to IRC §163(j):

Income & Expense Statement:
  - Gross Receipts:                                              \$50,000,000
  - Cost of Goods Sold (excluding depreciation):                (\$32,000,000)
  - Operating Expenses (wages, rent, utilities):                (\$10,000,000)
  - Tax Depreciation (MACRS):                                    (\$3,000,000)
  - Business Interest Income:                                        \$200,000
  - Total Business Interest Expense Paid:                         \$2,500,000
  - Floor Plan Financing Interest:                                         \$0

Step 1: Compute 2025 ATI
  Tentative taxable income before §163(j):                       \$2,700,000
  Add back business interest expense:                           +\$2,500,000
  Subtract business interest income:                              (\$200,000)
  Add back MACRS depreciation:                                  +\$3,000,000
  ATI:                                                          \$8,000,000
Step 2: Apply the interest limitation
  30% × \$8,000,000 + \$200,000:                                  \$2,600,000
  Actual interest expense:                                       \$2,500,000
  Deductible interest (lesser amount):                            \$2,500,000
  Disallowed interest carryforward:                                      \$0
Business Taxes Paid by Omni in 2025:
  - Employer FICA and FUTA payroll taxes:                         \$420,000 -> Deductible (§164)
  - Real property taxes on corporate headquarters:                \$110,000 -> Deductible (§164)
  - Federal corporate income tax paid:                            \$350,000 -> Disallowed (§275)
  - State sales tax paid on new \$500,000 manufacturing machine:     \$35,000 -> Capitalize to basis

Official reference

December 2025 Form 8990 instructions, checked October 17, 2026. Use its 2025 rules for this testing cycle.