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Noonan’s Notes Blog is written by a team of Hodgson Russ tax attorneys led by the blog’s namesake, Tim Noonan. Noonan’s Notes Blog regularly provides analysis of and commentary on developments in the world of New York and multistate tax law. Noonan's Notes Blog is a winner of CreditDonkey's Best Tax Blogs Award 2017.

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New York City Finally Releases Guidance on Impact of TCJA Business Interest Deduction Limitations on City Business Income Tax Returns

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New York City corporate tax returns have already been filed for the 2018 tax year and NYC unincorporated business tax (UBT) returns are due October 15th. But barely a week before the UBT filing due date, on October 8, 2019, NYC released its long-awaited guidance (https://www1.nyc.gov/assets/finance/downloads/pdf/fm/2018/fm-18-11.pdf) on the attribution of interest deductions for taxpayers whose interest expense deduction was limited under Section 163(j) of the Internal Revenue Code, enacted as part of the Tax Cuts & Jobs Act (TCJA). Under that provision, a taxpayer’s deduction for business interest expense is limited to 30% of adjusted taxable income except in certain circumstances. Any unused interest expense may be carried forward to the following tax year. Note that the NYC Finance Memorandum is numbered 18-11, suggesting that it was originally intended for release in late 2018.

The NYC guidance confirms that the 163(j) limitation applies to entities taxable under one of New York City’s income taxes; the amount of the interest expense deduction is the same for NYC as it is for the federal deduction. Thus, the issue for NYC for current year deductions is how to attribute the deduction between business income and exempt or investment income, depending on whether the entity is a federal C corporation or S corporation. The guidance is to be read in conjunction with Finance Memorandum 16-2, which addressed the attribution of interest expenses following the 2015 corporate tax reform changes. The bulk of the newly-released memo provides step-by-step guidance to calculate the deduction attributable to each type of income, starting with an “as-if unlimited” amount of the interest expense that is directly traceable and the amount subject to indirect attribution, and then determining the percentage of each of those attributable to a particular category of income.

But buried in the memorandum is the answer to a previously unanswered question that has troubled some practitioners as they were preparing UBT returns. As noted above, IRC Section 163(j) allows a carryforward of the unused business interest expense. The IRS has indicated that the carryforward for corporations, including S corporations, is at the entity level. But for partnerships, the carryforward is allocated to the partners as an excess business interest expense to be carried forward by the individual partner. This creates a problem for NYC UBT taxpayers, as the tax is imposed at the partnership level. Consequently, the memorandum notes that, “Because the unincorporated business taxable income of a partnership is based on its entity-level federal gross income, a partnership may only deduct business interest expenses up to the current year’s IRC § 163(j) limitation and no amount of interest expense allocated to a partner as excess business interest will be deductible on the partnership’s UBT return for any succeeding taxable year.” A lower-tier partnership may use excess interest expense allocated to it as a partner, but the partnership subject to the 163(j) limitation loses out permanently on any interest expenses not deductible in the current year.

This conclusion does seem consistent with the federal guidance regarding the treatment of the excess business interest expense for partnerships and the UBT laws as written, unless the carryforward of the excess interest expense could be considered part of the deduction allowable for federal income tax purposes under NYC Administrative Code Section 11-507. But it nevertheless highlights the problems with a tax on a pass-through entity that uses federal adjusted gross income as a starting point. We’ve seen this problem crop up previously with NYC’s attempts to apply the federal interest tracing rules in the UBT context and other such “disconnects” that arise with taxing a federal pass-through entity. Here, unfortunately, the result is that UBT taxpayers are treated differently than other NYC taxpayers and will lose out on a valid business expense unless the City decides to decouple from IRC Section 163(j).

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