What is the primary purpose of the Section 163(j) limitation?

The primary purpose of the Section 163(j) limitation is to restrict the amount of business interest expense that a taxpayer can deduct in a given taxable year. This provision was significantly broadened by the 2017 Tax Cuts and Jobs Act (TCJA) to prevent businesses from excessively deducting interest, thereby ensuring a more stable tax base and discouraging debt-financed acquisitions or operations that might otherwise lead to aggressive tax planning. It aims to level the playing field between equity and debt financing.

Who is generally subject to the Section 163(j) limitation for the 2026 tax year?

For the 2026 tax year, the Section 163(j) limitation generally applies to all taxpayers with business interest expense, including C corporations, S corporations, partnerships, and sole proprietorships. However, there are key exceptions: small businesses meeting the gross receipts test (average annual gross receipts of $25 million or less, adjusted for inflation, in the prior three years) and certain 'excepted trades or businesses' such as electing real property trades or businesses, electing farming businesses, and regulated utility trades or businesses.

How is Adjusted Taxable Income (ATI) calculated for Section 163(j) purposes in 2026, and what are the key changes?

ATI is a crucial component for calculating the Section 163(j) limitation. It starts with taxable income and is then adjusted by adding back certain deductions and subtracting certain income items. For tax years beginning after December 31, 2025 (which includes 2026), significant changes from the One, Big, Beautiful Bill (OBBBA) impact ATI. Specifically, a U.S. shareholder’s controlled foreign corporation (CFC) income inclusion items under Sections 951(a), 951A(a), and 78 (including associated portions of deductions) will be excluded from the computation of ATI. This change will generally reduce ATI for taxpayers with CFC subsidiaries, potentially leading to a lower deductible business interest expense.

What happens to business interest expense that is disallowed under Section 163(j)?

Any business interest expense that cannot be deducted in the current taxable year due to the Section 163(j) limitation is carried forward to the next taxable year. This disallowed amount is referred to as 'excess business interest expense' (EBIE). It can be carried forward indefinitely and may be deducted in a future year if the taxpayer's business interest limitation allows for it. Special rules apply to partnerships and S corporations regarding how EBIE is allocated and utilized by partners and shareholders.

What are the implications of electing to be an 'excepted real property trade or business' or 'farming business'?

While electing to be an 'excepted real property trade or business' or 'farming business' can exempt a taxpayer from the Section 163(j) limitation, it comes with specific tax consequences. For instance, certain assets held in an electing real property trade or business must be depreciated using the Alternative Depreciation System (ADS) and are not eligible for bonus depreciation under Section 168(k). Similar ADS requirements apply to property with a recovery period of 10 years or more for electing farming businesses. Taxpayers should carefully weigh these trade-offs before making such an election.

How do the ordering rules for interest capitalization change for 2026 under Section 163(j)?

Starting in 2026, the One, Big, Beautiful Bill (OBBBA) revises the ordering rules for interest capitalization. Section 163(j) will now be applied before any mandatory or elective interest capitalization provisions, with the exception of Sections 263(g) (relating to interest on debt to finance the production of certain property) and 263A(f) (relating to uniform capitalization rules for interest). This means that all business interest expense (except that capitalized under 263(g) and 263A(f)) must first be subjected to the Section 163(j) limitation before any other capitalization can occur. This change limits the ability of taxpayers to avoid the Section 163(j) limitation by electing to capitalize interest expense.

Business Interest Expense Limitation — 2026 Guide

Q: Are there any specific forms required to claim the business interest expense deduction under Section 163(j)?

Yes, taxpayers subject to the Section 163(j) limitation must use Form 8990, 'Limitation on Business Interest Expense Deduction Under Section 163(j),' to calculate their deductible business interest expense and any disallowed amounts that are carried forward. This form is essential for proper compliance and accurate reporting of the limitation.

Overview: Understanding the Business Interest Expense Limitation (Section 163(j))

The Business Interest Expense Limitation, codified under Internal Revenue Code (IRC) Section 163(j), is a critical provision impacting how businesses deduct interest paid or accrued on their debt. Originally enacted to address certain corporate tax avoidance strategies, its scope was significantly broadened by the 2017 Tax Cuts and Jobs Act (TCJA) to apply to nearly all businesses, regardless of their legal structure. Further amendments by the Coronavirus Aid, Relief, and Economic Security (CARES) Act and the One, Big, Beautiful Bill (OBBBA) have introduced additional complexities and modifications, particularly for the 2026 tax year and beyond. This guide provides a comprehensive overview of Section 163(j) for the 2026 tax year, helping businesses understand its implications, navigate compliance, and avoid common pitfalls.

What is the Business Interest Expense Limitation?

At its core, Section 163(j) limits the amount of business interest expense a taxpayer can deduct in a given taxable year. Prior to the TCJA, this limitation primarily affected large corporations. However, post-TCJA, it applies to most businesses, including partnerships and S corporations, with certain exceptions for small businesses and specific industries. The deductible amount of business interest expense generally cannot exceed the sum of:

The taxpayer's business interest income for the taxable year.
30% of the taxpayer's adjusted taxable income (ATI) for the taxable year.
The taxpayer's floor plan financing interest expense for the taxable year.

Any business interest expense disallowed due to this limitation is carried forward to subsequent taxable years, subject to the same limitations in those years. The OBBBA introduced significant changes effective for tax years beginning after December 31, 2025, particularly concerning the calculation of ATI and the ordering rules for interest capitalization.

Who Qualifies for the Limitation (and Who is Excepted)?

General Applicability

For taxable years beginning after December 31, 2017, the Section 163(j) limitation applies to all taxpayers with business interest expense, unless they meet specific exemption criteria. This includes C corporations, S corporations, partnerships, and sole proprietorships.

Small Business Exemption (Gross Receipts Test)

Certain small businesses are exempt from the Section 163(j) limitation if they meet the gross receipts test under Section 448(c). A business generally meets this test if it is not a tax shelter and has average annual gross receipts of $25 million or less in the previous three taxable years. This $25 million threshold is adjusted annually for inflation. For the 2025 tax year, the inflation-adjusted gross receipts amount is $31 million. While the IRS has not yet released the official inflation-adjusted amount for 2026, it is expected to be slightly higher than the 2025 figure. Businesses whose average annual gross receipts fall below this threshold are generally not subject to the Section 163(j) limitation.

Excepted Trades or Businesses

Even if a business does not meet the small business exemption, it may still be exempt if it falls under one of the following categories of “excepted trades or businesses”:

The trade or business of providing services as an employee.
Certain real property trades or businesses that elect to be excepted.
Certain farming businesses that elect to be excepted.
Certain regulated utility trades or businesses.

Taxpayers with eligible real property trades or businesses or farming businesses can elect to be excepted by following specific procedures outlined in Treasury Regulation §1.163(j)-9, which generally involves attaching a statement to a timely filed federal income tax return. It is crucial to note that making such an election has consequences, particularly regarding depreciation methods. For instance, electing real property trades or businesses must depreciate certain assets using the Alternative Depreciation System (ADS) and are not eligible for bonus depreciation under Section 168(k).

How to Claim the Business Interest Expense Deduction

Taxpayers subject to Section 163(j) must calculate their deductible business interest expense using Form 8990, “Limitation on Business Interest Expense Deduction Under Section 163(j).” This form helps determine the amount of current-year business interest expense that can be deducted and any disallowed amounts that are carried forward. The process generally involves:

Calculating Business Interest Expense: This includes any interest expense properly allocable to a non-excepted trade or business. For tax years beginning after December 31, 2025, Section 163(j) is applied before most mandatory or elective interest capitalization provisions, except for Sections 263(g) and 263A(f). This means interest capitalized under these two sections is excluded from business interest expense, while all other business interest expense is included.
Determining Business Interest Income: This is interest income includable in gross income and properly allocable to a non-excepted trade or business.
Calculating Adjusted Taxable Income (ATI): ATI is a crucial component of the limitation. It starts with taxable income and is then adjusted by adding back certain deductions and subtracting certain income items. For tax years beginning after December 31, 2024, depreciation, amortization, and depletion are added back in determining ATI. However, for tax years beginning after December 31, 2021, and before January 1, 2025, these deductions are not added back. This change, introduced by the OBBBA, significantly impacts the ATI calculation for 2025 and 2026.
Applying the Limitation: The deductible business interest expense is limited to the sum of business interest income, 30% of ATI, and floor plan financing interest expense.
Carrying Forward Disallowed Interest: Any business interest expense that cannot be deducted in the current year due to the limitation is carried forward to the next taxable year. Special rules apply to partnerships and S corporations regarding these carryforwards.

For partnerships and S corporations, the Section 163(j) limitation is applied at the entity level. Disallowed business interest expense (Excess Business Interest Expense or EBIE) is allocated to partners and carried forward at the partner level, increasing their Adjusted Taxable Income (ATI) in future years when excess taxable income or excess business interest income is allocated from the partnership. For S corporations, disallowed interest is carried over at the corporate level.

2026 Limits, Amounts, and Rates

The primary limitation rate for business interest expense remains at 30% of Adjusted Taxable Income (ATI) for the 2026 tax year. However, several key changes from the OBBBA become effective for tax years beginning after December 31, 2025, which will significantly impact the calculation of this limitation:

ATI Calculation: For tax years beginning after December 31, 2025, the definition of ATI will be further refined. Specifically, a U.S. shareholder’s controlled foreign corporation (CFC) income inclusion items under Sections 951(a), 951A(a), and 78 (including associated portions of deductions) will be excluded from the computation of ATI. This change will generally result in a reduction of the amount of business interest expense that is currently deductible for taxpayers with income from CFC subsidiaries.
Ordering Rules: Starting in 2026, Section 163(j) is applied before any mandatory or elective interest capitalization provisions, with the exception of Sections 263(g) and 263A(f). This means that all interest expense (except that capitalized under 263(g) and 263A(f)) must first pass through the Section 163(j) limitation before any other capitalization can occur. This change limits the ability of taxpayers to minimize the impact of Section 163(j) by electing to capitalize interest expense into inventory or amortizable assets.
Small Business Gross Receipts Threshold: While the official 2026 inflation-adjusted gross receipts amount has not yet been released by the IRS, it is expected to be slightly higher than the $31 million for 2025. Businesses should monitor IRS announcements for the precise figure.
Floor Plan Financing Interest: For tax years beginning after December 31, 2024, the definition of a motor vehicle for floor plan financing interest purposes was expanded to include any trailer or camper designed for temporary living quarters and towed by or affixed to a motor vehicle. This expanded definition will continue to apply in 2026.

Common Mistakes That Cost Taxpayers Money

Navigating Section 163(j) can be complex, and several common mistakes can lead to disallowed deductions and potential penalties:

Incorrect ATI Calculation: Misinterpreting the adjustments required for ATI, especially the changes related to depreciation, amortization, and depletion, can lead to an inaccurate limitation amount. The OBBBA changes for 2025 and 2026 make this even more critical.
Failing to Identify Excepted Businesses: Businesses that qualify as excepted trades or businesses (e.g., certain real property or farming businesses) may mistakenly apply the limitation, unnecessarily restricting their interest deductions.
Improperly Applying Ordering Rules: For 2026, the new ordering rules for interest capitalization are crucial. Failing to apply Section 163(j) before other capitalization provisions (except 263(g) and 263A(f)) can result in incorrect deductions.
Ignoring Partnership/S Corporation Rules: The flow-through nature of partnerships and S corporations requires specific application of Section 163(j) at the entity and partner/shareholder levels. Errors in allocating EBIE or understanding its impact on partner ATI are common.
Not Tracking Disallowed Interest Carryforwards: Disallowed business interest expense can be carried forward indefinitely. Failing to properly track and utilize these carryforwards in future years means lost deductions.
Overlooking Inflation Adjustments: The gross receipts test threshold is adjusted annually for inflation. Using an outdated figure can lead to a small business incorrectly applying the limitation.
Lack of Documentation: The IRS requires thorough documentation to support all deductions. Inadequate records for business interest expense, interest income, and ATI calculations can result in disallowed deductions during an audit.

IRS Code Reference

The primary Internal Revenue Code section governing the business interest expense limitation is Section 163(j). Related regulations can be found in Treasury Regulation §§1.163(j)-1 through 1.163(j)-10. Additionally, taxpayers should refer to relevant IRS pronouncements, such as Revenue Procedures and Notices, for the latest guidance and inflation adjustments.

Take Control of Your Tax Strategy

Understanding and accurately applying the Business Interest Expense Limitation under Section 163(j) is vital for optimizing your business's tax position. With the ongoing changes and complexities, especially those effective for the 2026 tax year, expert guidance is more important than ever. Don't leave money on the table or risk compliance issues. Our experienced tax strategists at Uncle Kam are here to help you navigate these intricate rules, ensure accurate deductions, and develop a proactive tax plan tailored to your business needs. Book a consultation today to secure your financial future.

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