Business Interest Deduction Limitations Affect Some Health Care Entities
Affected businesses include hospitals, assisted living facilities, skilled nursing facilities, and continuing care residential communities that offer independent and assisted living and on-site skilled nursing care.
Changes to the Law
The statutory change generally limits a taxpayer’s business interest expense deduction to the sum of (i) its business interest income and (ii) 30 percent of its adjusted taxable income – ATI. In most situations, this means that a taxpayer’s net business interest expense deduction is limited to 30 percent of its ATI. In computing ATI, a taxpayer adds its net interest expense back to its taxable income or loss and, for taxable years beginning before 2022, also adds back its depreciation and amortization expenses, giving taxpayers time to adjust to the rules.
The 30 percent limitation does not apply to a taxpayer with average annual gross receipts over the previous three-taxable year periods of $25,000,000 – adjusted for inflation by rounding to the nearest million – or less, the so-called small business exception; but the statute aggregates the gross receipts of taxpayers under common ownership in calculating the small business exception. In addition, a taxpayer that cannot qualify for the small business exception but that is engaged in a real property trade or business (RPTB) can make an election to be excepted from the 30 percent limitation. One obvious strategy would be to move the taxpayer’s RPTB operations, including associated liabilities generating business interest expense deductions, to a related separate taxable entity and to lease the real property back to the taxpayer. However, proposed Treasury and IRS regulations published in December 2018 would prohibit an RPTB that leases substantially all its real property to the owner of the RPTB (e.g., the parent company of the RPTB) or to a related party of the owner (e.g., a sister subsidiary of the RPTB) from making an election to be treated as an excepted RPTB. Consequently, the RPTB would continue to be subject to the 30 percent limitation.
Options for the Health Care Industry
Trade associations such as the American Health Care Association are lobbying Treasury on behalf of their affected members that operate health care businesses to change this proposed rule to permit a taxpayer to create a new taxable entity that clearly would qualify as an RPTB, lease its real property back to its parent company or to a related taxpayer, and make the election to be an RPTB excepted from the 30 percent limitation.
Alternatively, lobbyists are advocating that Treasury and the IRS specifically designate, for example, that a skilled nursing facility qualifies as an RPTB that may elect to be excepted from the 30 percent limitation without having to divide its business into separate taxpaying entities.
If health care businesses cannot obtain the relief being requested by their trade associations, the proposed regulations offer another solution. Unfortunately, however, this regulatory solution may not be as robust as those described above and imposes a heavy compliance burden, requiring taxpayers first to determine which items of interest expense and other items are properly allocable to a trade or business of the taxpayer, then to apply the rules for allocating such items among the taxpayer’s various trades or businesses. Further, a taxpayer’s activities are not treated as a separate trade or business if those activities do not involve the provision of goods or services to persons other than the taxpayer. For example, if a taxpayer engaged in a manufacturing trade or business has in-house legal personnel that provide legal services solely to the taxpayer, the taxpayer is not treated as also engaged in the trade or business of providing legal services. Nevertheless, these rules would allow a taxpayer that operates more than one trade or business that may elect to be an excepted trade or business to allocate some portion of its income and expenses among its excepted and non-excepted trades or businesses for the purpose of determining the amount of interest expense that is subject to the 30 percent limitation.
The proposed regulations provide that the regulatory solution described above is the exclusive method for allocating tax items among a taxpayer’s various trades or businesses. The allocation rules are based on the approach that money is fungible, and that interest expense is attributable to all activities and property regardless of any specific purposes for incurring an obligation on which interest is paid. Although this seems harsh, the regulations provide that a taxpayer must allocate its interest expense and interest income that is properly allocable to the taxpayer’s trades or businesses among its various trades or businesses based on the relative amounts of the taxpayer’s adjusted tax basis in the assets that the taxpayer uses in its various trades or businesses. In the context of a taxpayer in a health care business that chooses to segregate its RPTB from its other trades or businesses, this likely would result in a favorable allocation because most of its adjusted tax basis would be allocated to land and other real property assets and improvements. In fact, the regulations provide that if 90 percent or more of the taxpayer’s basis in its assets is allocable to a particular trade or business, then all of the taxpayer’s interest expense and interest income is allocable to that trade or business, potentially excepting the taxpayer’s interest expense that otherwise would be more properly associated with its other operating businesses from the 30 percent limitation.
Complications and Dual Invoices
As a practical matter, many health care trades or businesses do not think of their business operations as being comprised of two or more separately identifiable trades or businesses; for example, hospitals and skilled-nursing facilities do not deem themselves to be ordinary course real property trades or businesses in whole or in part. Accordingly, such health care trades or businesses usually bundle their lodging-related or residency-related revenue with other revenue streams into a single customer invoice. Taxpayers wishing to divide their activities between those activities that are excepted from the interest expense limitation and those that are not excepted in order to take advantage of the proposed regulatory solution likely will change the way they present themselves to the consuming public, affecting the relationship between these taxpayers and their customers. For example, if taxpayers are engaged in both lodging or residential businesses and services businesses, they should be able to identify the component goods and services that they deliver to their customers with respect to excepted trades or businesses and trades or businesses that are not excepted, associate them with the proper revenue streams, and separately state them in the invoices that they provide to their customers. However, revising point-of-sale and other accounting systems to capture information from separately identifiable trades or businesses may be a massive undertaking that likely would be complicated further by the presence of third-party payers.
What To Do Now
While hospitals and nursing facilities wait for statutory or regulatory changes that would allow the enterprise either to be classified as an RPTB that may elect to be excepted from the 30 percent limitation or to divide themselves into separate taxpayers including a discreet RPTB that would lease its real property assets to its owner or another related company regardless of common ownership, we recommend that affected health care trades or businesses expend the effort to prepare their 2018 tax returns in the manner prescribed in the proposed allocation regulations. In doing so, they should begin to align their invoicing practices consistent with their delivery of goods and services to their customers and the proposed regulations so as to avoid the 30 percent limitation with respect to their excepted trades or businesses, which in the context of a health care business, most likely would be an electing RPTB.
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