Understanding the 163j Small Business Exception: A Comprehensive Guide

For small businesses, navigating the Internal Revenue Code (IRC) can be a daunting task. With so many regulations to understand, it’s important to break things down to get a better grasp of what’s required. One of those areas of the IRC that small businesses may need to understand is the 163j small business exception.

What is the 163j Small Business Exception?

The 163j small business exception is a provision of the Tax Cuts and Jobs Act (TCJA) that applies to certain businesses that report their income on a pass-through basis, such as partnerships and S corporations. This provision limits the amount of interest expense that these businesses can deduct on their tax returns.

However, businesses with average annual gross receipts of $25 million or less for the three prior tax years are exempt from this provision, hence the term “small business exception.”

Why Was the 163j Small Business Exception Created?

The TCJA was enacted in 2017 to simplify the tax code and reduce tax rates. One of the measures to achieve this goal was to limit the amount of interest expense that businesses could deduct on their tax returns. The idea was to prevent businesses from loading up on debt to reduce their tax bills.

The 163j small business exception was introduced to ensure that small businesses would not be unduly burdened by this provision. By exempting them from the interest expense limitation, it would help these businesses grow and create jobs, which was one of the goals of the TCJA.

How Does the 163j Small Business Exception Work?

The 163j small business exception works by allowing eligible businesses to fully deduct their interest expense without being subject to any limits. This means that if your business meets the gross receipts test for the three prior tax years, you can deduct all of your interest expense, regardless of the amount.

However, if your business does not meet the gross receipts test, you may be subject to the interest expense limitation. In this case, your deduction for business interest expense is limited to the sum of your business interest income, 30% of your adjusted taxable income (ATI), and your floor plan financing interest. Any interest not deducted in the current year can be carried forward indefinitely.

Conclusion

Understanding the 163j small business exception is important for small businesses that report their income on a pass-through basis. By knowing whether you qualify for the exception, you can ensure that you’re taking advantage of all the deductions available to you. Keep in mind that eligibility for the exception depends on your average annual gross receipts for the three prior tax years. It’s always a good idea to consult with a tax professional to make sure you’re in compliance with all IRS regulations.