Unforeseen Consequences of 163(j) and Floorplan Interest
With the lack of a tax extenders bill at the end, CPAs and taxpayers are wrestling with the expiring provisions of the Tax Cuts and Jobs Act (TCJA). While much of the press has been on the 174 amortization, there are other expiring provisions that may lead to headaches this tax season. One of these is a consequence of the 163(j) change that could affect bonus depreciation for certain taxpayers. First, it’s important to step back and review 163(j).
Under 163(j), a taxpayer is limited in the amount of business interest they can deduct. This limitation is set at 30 percent of the adjusted taxable income (ATI) plus any floor plan interest. Before January 1st, 2022, the calculation for adjusted taxable income was closely following EBITDA. As of 2022, this calculation changes to EBIT, meaning businesses with significant depreciation and amortization expenses may be limited in the amount of interest than can deduct. But what does this have to do with bonus depreciation?
Under the 168(k) rules for bonus depreciation, property that is “used in a trade or business that has had floor plan financing indebtedness” is excluded from taking bonus depreciation. The IRS addressed this issue in its final regulations on bonus depreciation. Under Section 1.168(k)-2(b)(2)(ii)(G), a taxpayer whose total interest, including floorplan interest, is less than the allowable amounts under 163(j), can still take bonus.
This means that companies taking floor plan interest can utilize bonus, but only if the total amount of interest taken is less than the 30 percent threshold. This is now complicated by the change to 163(j). Now that depreciation and amortization are included in the calculation for adjusted taxable income, the amount of interest companies can take is drastically lowered. This is especially true for companies that have large bonus depreciation deductions. Unfortunately, companies taking floor plan interest deductions do not have the option of limiting their deductions. Most policy experts and CPAs expected a tax extenders bill to be adopted by the end of 2022. However, this did not happen.
This means that while taxpayers did not plan for this change, they need to address it with their 2022 filing. Take a taxpayer that renovated their dealership in 2022 at a cost of $3 million. Also, for sake of simplification let’s assume that the entire $3 million was Qualified Improvement Property, subject to bonus depreciation. Also, let’s assume that the taxpayer had $5 million in ATI using the EBITDA calculation and $1 million in floor plan interest. Under the old rules, the taxpayer would have been able to deduct both the interest and the $3 million in bonus depreciation for the buildout. Under the new rules, the ATI is changed to EBIT meaning that the ATI is reduced to $2 million ($5 million less $3 million in bonus, assuming no other depreciation expenses for the year).
Since the 30 percent test is now applied to $2 million, the taxpayers’ limit on 163(j) is $600,000. This means the taxpayer exceeds the $600,000 limit with their $1 million in floor plan interest, the taxpayer is no longer eligible for bonus depreciation, and the $3 million in QIP will be depreciated over a 15-year straight line. Assuming a mid-year convention, the taxpayer’s depreciation deduction will go from $3 million to $100,000, increasing their taxable income by $2.9 million.
For the example above, with a 30 percent tax rate, the taxpayer will now owe an additional $870,000. Since most practitioners and taxpayers expected an extenders bill, and since these calculations are done at year-end, most taxpayers will not have prepared for this change. This means that many companies with floor plan interest could be unaware of increasing tax bills. Car dealerships are often capital-intensive and rely on bonus depreciation to offset some of their income, which is why they should be aware of the 163(j) changes. This new limitation on bonus depreciation is one of the many unforeseen consequences of the tax extenders bill not passing at the end of 2022.
David McGuire is a leading expert on cost segregation, fixed assets and depreciation law and a co-founder of McGuire Sponsel.
McGuire is an expert on for how tax law affects depreciation. His knowledge in determining asset costs and classifications has held up against IRS scrutiny and has built the firm into a trusted industry partner.