Tax Issues for Your Business in a Rising Interest Rate Environment
The Federal Reserve raised interest rates in June 2018, the second hike thus far in 2018, and indicated that there may be two more increases before the end of the year. While interest rates are still very low, the increases can impact your business. There are certain strategies to consider in a rising interest rate environment that can cut your tax bill.
Deducting business interest
Until now, businesses have been able to write off the cost of borrowing by deducting interest as an ordinary business expense. But the tax rules have been changed by the Tax Cuts and Jobs Act.
There is a new limitation on deducting interest that applies to tax year beginning after December 31, 2017. The annual deduction for business interest expense is limited to the total of:
- Business interest income
- 30 percent of adjusted gross income
- Floor plan financing, for car dealers and certain other businesses
Interest that can’t be deducted currently can be carried forward. For most businesses there is no limit on the carryforward period.
Pass-through entities. For partnerships and S corporations, which are pass-through entities, the limitation applies at the entity level and not at the owner level.
Small business exception. The limitation does not apply to businesses with average annual gross receipts in the three prior years not exceeding $25 million. Once business revenues exceed this threshold amount, the limitation applies.
Electing business exception. Farming businesses and real property businesses such as developers, contractors, leasing companies and realty brokerages can elect to be exempt from the interest limitation. In return, they must use slower depreciation for certain property. For example, farming businesses making the election would use slower depreciation for land improvements, barns and other farm buildings.
Strategies. Obviously, best business practices dictate that you control debt, and thus your interest expense. If you need additional capital, consider whether to seek equity investments or borrow the money. If you are in a business that can elect out of the limitation, weigh the benefit of the value of the interest deduction against the cost of slower depreciation, the loss of what would otherwise be currently deductible.
Underpaying estimated taxes can trigger a penalty that is essentially an IRS-set interest rate. When interest rates were at historic lows they stayed at a rate of 3 percent from October 1, 2011, through March 31, 2016, for individuals who underpaid their taxes. Many C corporations and owners of pass-through entities chose to underpay estimated taxes because the cost of the penalty wasn’t so severe. However, the rates in effect now are higher, 5 percent since March 1, 2018, and likely will go higher as the Federal Reserve hikes its interest rates.
And the penalty, even though essentially an interest rate, is not deductible for federal income tax purposes.
Strategies. Make better projections for estimated tax purposes to penalties on underpayments. Owners of pass-throughs can rely on certain estimated tax safe harbors to avoid any penalties. For example, if a sole proprietor who is single bases her 2018 estimated tax payments on 100 percent of her 2017 tax bill, assuming her adjusted gross income in 2017 wasn’t more than $150,000, she won’t owe any penalty regardless of her ultimate tax liability for 2018.
Rising interest rates not only mean you’ll pay more to serve debt, it also translates into tax consequences that you should address with the help of your tax advisor.
Barbara Weltman is an attorney, prolific author with such titles as J.K. Lasser’s Small Business Taxes, J.K. Lasser’s Guide to Self-Employment, and Smooth Failing as well as a trusted professional advocate for small businesses and entrepreneurs. She is also the publisher of Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® and host of Build Your Business Radio. She has been included in the List of 100 Small Business Influencers for three years in a row. Follow her on Twitter: @BarbaraWeltman or at www.BigIdeasforSmallBusiness.com