Business Tax Preparation · Business expenses, deductions and credits

Interest expense

Two questions decide an interest deduction and they are asked in order. Which activity does the interest belong to, and is the resulting business interest capped? The first is answered by tracing, and it is answered without reference to what secures the loan.

The rule

Allocation. interest follows the use to which the borrowed funds are put, so a single loan is allocated among business, investment and personal expenditures and only the business share is a business interest expense^TY2026 (Reg. § 1.163-8T(a)(3), (c)(1)). The security for the debt is irrelevant; the use of the proceeds is everything.

The cap. the deduction for business interest may not exceed the sum of business interest income, 30 percent of adjusted taxable income (never less than zero), and floor plan financing interest^TY2026 (IRC § 163(j)(1)). Three components, and the middle one is taxable income computed without any item not properly allocable to a trade or business, without business interest or business interest income, without the IRC § 172 net operating loss deduction, without the IRC § 199A deduction, without any deduction for depreciation, amortization or depletion, and without the IRC §§ 951(a), 951A(a) and 78 inclusions and their related deductions^TY2026 (IRC § 163(j)(8)(A)).

What is not capped. the limitation does not apply to a taxpayer, other than a tax shelter prohibited from using the cash method under IRC § 448(a)(3), that meets the IRC § 448(c) gross receipts test for the taxable year^TY2026 (IRC § 163(j)(3)), keyed to $32,000,000 — a corporation or partnership meets the gross receipts test for a taxable year beginning in 2026 if its average annual gross receipts for the 3-taxable-year period ending with the preceding taxable year do not exceed that amount. The figure for taxable years beginning in 2025 was $31,000,000, and the unindexed statutory base in IRC § 448(c)(1) is $25,000,000^TY2026 (IRC § 448(c)(1)).

What happens to the excess. business interest disallowed for a taxable year is treated as business interest paid or accrued in the succeeding taxable year, without limit^TY2026 (IRC § 163(j)(2)).

Partnerships. for a partnership the limitation is applied at the partnership level and the deduction enters non-separately stated income or loss, with the partners' own adjusted taxable income adjusted so that the same income is not counted twice^TY2026 (IRC § 163(j)(4)(A)).

Related lenders. where the payee will not include the amount until paid because of their method of accounting, and payee and payer are related persons at the close of the payer's year, the deduction is deferred to the day the amount is includible in the payee's gross income^TY2026 (IRC § 267(a)(2)), which reaches interest as expressly as it reaches any other expense.

Current figures

How it works in practice

Trace the money, not the collateral. interest follows the use to which the borrowed funds are put, so a single loan is allocated among business, investment and personal expenditures and only the business share is a business interest expense^TY2026 (Reg. § 1.163-8T(a)(3)). Interest is allocated in the same manner as the debt, and the debt is allocated by tracing disbursements of the proceeds to specific expenditures. A loan secured on the owner’s house but spent on stock in trade produces business interest; a loan secured on business premises but spent on a holiday produces non-deductible personal interest. This is the single most useful thing to know in the topic and it disposes of most questions.

A mixed-use loan is split. Where one borrowing funds more than one kind of expenditure, the interest is apportioned in the same proportions. There is no de minimis rule and no predominant-use shortcut.

Then ask whether the business is exempt from the cap at all. the limitation does not apply to a taxpayer, other than a tax shelter prohibited from using the cash method under IRC § 448(a)(3), that meets the IRC § 448(c) gross receipts test for the taxable year^TY2026 (IRC § 163(j)(3)). The test is the same IRC § 448(c) gross receipts test that governs the inventory and uniform capitalization exemptions, so a business either is a small business for all three or for none. Most businesses a preparer meets never reach IRC § 163(j)(1).

If it is not exempt, the cap has three components and one of them is usually zero. the deduction for business interest may not exceed the sum of business interest income, 30 percent of adjusted taxable income (never less than zero), and floor plan financing interest^TY2026 (IRC § 163(j)(1)). Business interest income is rarely material outside financial businesses. Floor plan financing interest belongs to vehicle and equipment dealers. For everyone else the cap is effectively the percentage of adjusted taxable income, and IRC § 163(j)(1) provides that that component is never less than zero — so a business with negative adjusted taxable income gets no allowance from it rather than a negative one.

Adjusted taxable income is a defined term and not a line on any return. taxable income computed without any item not properly allocable to a trade or business, without business interest or business interest income, without the IRC § 172 net operating loss deduction, without the IRC § 199A deduction, without any deduction for depreciation, amortization or depletion, and without the IRC §§ 951(a), 951A(a) and 78 inclusions and their related deductions^TY2026 (IRC § 163(j)(8)(A)). Six add-backs and exclusions, and the fifth of them — depreciation, amortization and depletion — is the one that moves the number most.

Disallowed interest is deferred, not lost. business interest disallowed for a taxable year is treated as business interest paid or accrued in the succeeding taxable year, without limit^TY2026 (IRC § 163(j)(2)). It becomes business interest of the next year and is tested again there, so a business with a strong year can absorb several years of disallowance.

In a partnership the limitation runs at the entity. for a partnership the limitation is applied at the partnership level and the deduction enters non-separately stated income or loss, with the partners' own adjusted taxable income adjusted so that the same income is not counted twice^TY2026 (IRC § 163(j)(4)(A)). That is the opposite of the excess business loss rule in IRC § 461(l)(4), which runs at the partner, and the two are easily confused because both appear in the same computation.

And interest to a related lender meets the matching rule. where the payee will not include the amount until paid because of their method of accounting, and payee and payer are related persons at the close of the payer's year, the deduction is deferred to the day the amount is includible in the payee's gross income^TY2026 (IRC § 267(a)(2)) — the subsection is headed “Matching of deduction and payee income item in the case of expenses and interest,” so an accrual method borrower accruing interest to a related cash method lender waits for the deduction until the lender includes it.

How this has changed

The depreciation add-back was restored, permanently, and it reaches back to 2025. the add-back for depreciation, amortization and depletion is permanent again — Pub. L. 119-21 § 70303(a) struck the words confining IRC § 163(j)(8)(A)(v) to taxable years beginning before 2022, with effect for taxable years beginning after 31 December 2024^TY2026. As enacted in 2017, IRC § 163(j)(8)(A)(v) added back depreciation, amortization and depletion only “in the case of taxable years beginning before January 1, 2022,” so from 2022 adjusted taxable income was computed on an earnings-before-interest-and-tax basis rather than an earnings-before-interest-tax-depreciation-and-amortization basis. Pub. L. 119-21 § 70303(a) struck that restriction, and § 70303(c)(1) applies the amendment to taxable years beginning after 31 December 2024 — a year before most of the Act’s other business provisions. For a capital-intensive business this is the largest single change in the topic.

The percentage never went back up. Pub. L. 116-136 § 2306 raised the share of adjusted taxable income in IRC § 163(j)(1)(B), but only for taxable years beginning in 2019 and 2020, through the special rule now at IRC § 163(j)(10). The figure in IRC § 163(j)(1)(B) itself was never changed. Material giving the higher share is describing two pandemic years.

Two 2026 changes narrow the base. Pub. L. 119-21 § 70341(b) added a sentence to IRC § 163(j)(5) providing that business interest “shall not include any interest which is capitalized under section 263(g) or 263A(f)” — business interest does not include interest capitalized under IRC § 263(g) or § 263A(f), for taxable years beginning after 31 December 2025^TY2026 — and § 70342(a) added IRC § 163(j)(8)(A)(vi), removing certain foreign inclusions and their related deductions from adjusted taxable income. Both apply to taxable years beginning after 31 December 2025, so 2026 is the first year for each.

Exam focus

Trace first. Most questions in this topic can be answered by asking what the borrowed money bought, and the facts always supply it. Reject any answer that turns on the security or on the label of the loan.

Then ask whether IRC § 163(j) applies at all. The IRC § 448(c) exemption takes most businesses out, and a question that gives you a gross receipts figure is telling you which side of the line the taxpayer is on.

Learn the three components of the cap and learn the statutory share as it reads in IRC § 163(j)(1)(B). The higher figure in circulation is a repealed temporary rule.

Finally, know that adjusted taxable income adds back depreciation again, and that the restoration applies to taxable years beginning after 31 December 2024 — so it is already in effect for the return in front of you.

Check yourself

1. A taxpayer borrows $50,000 secured on business premises and spends all of it on a family holiday. Is the interest deductible?

Answer: No. interest follows the use to which the borrowed funds are put, so a single loan is allocated among business, investment and personal expenditures and only the business share is a business interest expense^TY2026 (Reg. § 1.163-8T(a)(3), (c)(1)) allocates the interest by tracing the proceeds to the expenditure, and the expenditure is personal. What secures the loan does not enter the analysis.

2. A business with $60,000,000 of average annual gross receipts has $5,000,000 of business interest expense, $200,000 of business interest income and $9,000,000 of adjusted taxable income. What is disallowed?

Answer: $2,100,000. the deduction for business interest may not exceed the sum of business interest income, 30 percent of adjusted taxable income (never less than zero), and floor plan financing interest^TY2026 (IRC § 163(j)(1)) allows $200,000 plus the statutory share of $9,000,000, or $2,700,000 — $2,900,000 in all. The rest is disallowed and becomes business interest of the following year under business interest disallowed for a taxable year is treated as business interest paid or accrued in the succeeding taxable year, without limit^TY2026.

3. Does a business with average annual gross receipts below the IRC § 448(c) figure ever have to compute adjusted taxable income?

Answer: Not for this purpose. the limitation does not apply to a taxpayer, other than a tax shelter prohibited from using the cash method under IRC § 448(a)(3), that meets the IRC § 448(c) gross receipts test for the taxable year^TY2026 (IRC § 163(j)(3)) disapplies IRC § 163(j)(1) entirely, so the limitation and its computation never arise — unless the business is a tax shelter prohibited from using the cash method under IRC § 448(a)(3).

4. A manufacturer has $3,000,000 of taxable income before interest and $5,000,000 of depreciation. What is its adjusted taxable income for 2026?

Answer: $8,000,000, subject to the other adjustments. taxable income computed without any item not properly allocable to a trade or business, without business interest or business interest income, without the IRC § 172 net operating loss deduction, without the IRC § 199A deduction, without any deduction for depreciation, amortization or depletion, and without the IRC §§ 951(a), 951A(a) and 78 inclusions and their related deductions^TY2026 (IRC § 163(j)(8)(A)) adds back any deduction allowable for depreciation, amortization or depletion, and the add-back for depreciation, amortization and depletion is permanent again — Pub. L. 119-21 § 70303(a) struck the words confining IRC § 163(j)(8)(A)(v) to taxable years beginning before 2022, with effect for taxable years beginning after 31 December 2024^TY2026 — the restriction confining that add-back to years before 2022 was struck with effect for taxable years beginning after 31 December 2024.

5. An accrual method corporation accrues interest on a loan from its controlling shareholder, who reports on the cash method, and pays it four months after the year end. When is it deductible?

Answer: In the year of payment. where the payee will not include the amount until paid because of their method of accounting, and payee and payer are related persons at the close of the payer's year, the deduction is deferred to the day the amount is includible in the payee's gross income^TY2026 (IRC § 267(a)(2)) is headed “Matching of deduction and payee income item in the case of expenses and interest,” so the deduction moves to the day the amount is includible in the lender’s gross income.