Changes to tax law that limit interest expense deductions for businesses underscores that now might be a good time to start thinking about your 2022 taxes and the potential impact on next year’s cash tax flow.
What is Changing for Business Interest Expense Deduction
Under the Tax Cuts and Jobs Act (TCJA) in 2017 under I.R.C. § 163(j), U.S. Corporations have been allowed to deduct business interest expense to the extent it exceeds their business interest income, plus 30% of Adjusted Taxable Income (ATI). ATI is similar to EBITDA.
Starting in tax year 2022, businesses are no longer able to add back depreciation, amortization, or depletion in the calculation of ATI (essentially replacing 30% of EBITDA with 30% of EBIT).
Why This Matters for Business Owners
Prior to this update, companies weren’t as limited in the business expense deduction because they had the ability to add back depreciation, amortization, and depletion to calculate ATI. For many companies, the reduction to the interest expense deduction could result in a meaningful increase to their cash tax expense.
For ESOP companies, there is added meaning and opportunity. While this update may not impact S Corporations due to the income tax advantages afforded to ESOP-owned S Corps, the update has a different impact for leveraged ESOPs that own C Corps.
An increase in cash tax expense means less money to pay off debt acquired in formation of the ESOP. This means that it could take longer for owner-sellers to receive the full value of the sale while also creating a longer timetable for the employee-owners’ shares to be released.
How ESOP Businesses Can Mitigate
Business owners can work with their tax advisor to limit the impact of this change to ATI calculation and accelerate the realized value of the ESOP sale for owner-sellers and employee-owners by taking advantage of additional contributions or dividends to the ESOP via I.R.C. § 404(a) and (k).
As always, our team is available to help illuminate how these insights might benefit your succession planning efforts. If you or one of your clients are interested in pursuing this opportunity, please contact us to schedule a discussion as soon as possible.