The Section 163(j) business interest deduction limitation caps how much interest expense a business can write off in a tax year. For 2026, the ceiling equals your business interest income, plus 30 percent of your adjusted taxable income, plus any floor plan financing interest. Anything above that line isn’t lost; it carries forward. And if your business is small enough, you skip the rule entirely.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
Does the Limitation Apply to Your Business
The rule reaches almost every kind of business entity. C-corporations, S-corporations, and partnerships all run the calculation at the entity level. For partnerships and S-corporations, the limitation is applied before any results pass through to owners.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense Foreign corporations with income effectively connected to a U.S. trade or business are covered too, along with tax-exempt organizations that borrow to generate unrelated business taxable income.
Sole proprietors are not off the hook. If you file a Schedule C and pay business interest, you run 163(j) at the individual level, combining your sole proprietorship’s numbers with amounts flowing through from any partnerships or S-corporations you hold.2eCFR. 26 CFR 1.163(j)-6 – Application of the Section 163(j) Limitation to Partnerships and Subchapter S Corporations
The Small Business Exemption
If your average annual gross receipts for the three preceding tax years are $32 million or less, you qualify for the small business exemption and deduct all business interest without the 163(j) cap.3Internal Revenue Service. Revenue Procedure 2025-32 That $32 million figure is the inflation-adjusted threshold for tax years beginning in 2026, and the IRS updates it annually.
The math is simple: add gross receipts for the three prior tax years, divide by three, compare to the threshold. At or below $32 million, you’re exempt.4Internal Revenue Service. FAQs Regarding the Aggregation Rules Under Section 448(c)(2) That Apply to the Section 163(j) Small Business Exemption One catch worth flagging: entities classified as tax shelters cannot use the exemption regardless of size.
How to Calculate the Cap
For businesses above the gross receipts threshold, the maximum deductible business interest for the year equals three things added together:
- Business interest income
- 30 percent of adjusted taxable income (ATI)
- Floor plan financing interest, meaning interest on debt used to acquire motor vehicles, trailers, and campers held for sale or lease by a dealership
The work is in the ATI figure. Start with taxable income, strip out items unrelated to business activity, then make the specified adjustments. For 2026, you add back deductions for depreciation, amortization, and depletion, producing something close to EBITDA.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense Those add-backs raise the income base, which raises the 30 percent figure, which enlarges your deduction. Capital-intensive businesses benefit noticeably.
It wasn’t this generous a year ago. From 2022 through 2024, ATI was calculated on an EBIT-like basis with no depreciation or amortization add-back, and the deduction ceiling was tighter as a result. The One, Big, Beautiful Bill Act restored the EBITDA approach for tax years beginning after December 31, 2024. If you are working with carryforwards from that stretch, remember they were computed under the stricter rule.
What Counts as Business Interest
Business interest expense is interest properly allocable to a trade or business that isn’t an excepted trade or business. Treasury regulations define “interest” as compensation for the use or forbearance of money under an instrument treated as a debt instrument.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense Investment interest sits outside 163(j) and follows its own rules.
For 2026, the limitation applies before most interest capitalization rules. Interest you might otherwise capitalize into the cost of an asset runs through the 163(j) filter first, with narrow exceptions for straddle-related interest and interest on property produced for sale. Carried-forward interest from earlier years cannot be treated as capitalizable interest going forward.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
A New CFC Exclusion for 2026
U.S. shareholders of controlled foreign corporations face a change starting in 2026. Subpart F income inclusions, GILTI amounts, and related deemed-paid foreign tax credits are now excluded from ATI.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense Previously, a U.S. parent could use a portion of those inclusions to inflate ATI and expand its interest deduction. Not anymore. Multinationals that leaned on CFC income to absorb domestic borrowing costs will see their deduction ceilings shrink.
What Happens to Disallowed Interest
Interest expense above the annual cap carries forward indefinitely, but the mechanics depend on the entity type.
C-corporations treat the disallowed amount as business interest paid in the following year. If income rises or debt falls, the carryforward gets absorbed. This creates a deferred tax asset on the balance sheet that is recognized once capacity opens up.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
Partnerships work differently, and the mechanics catch taxpayers off guard. Disallowed interest does not stay at the partnership level. It gets allocated out to each partner as excess business interest expense (EBIE). A partner can only deduct that EBIE in a later year to the extent the same partnership produces excess taxable income.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense Disallowed interest from Partnership A cannot offset income from Partnership B, and losing track of the partner-level tracking is a common compliance error.
S-corporations follow the C-corporation pattern. Disallowed interest stays at the entity level and carries forward there rather than passing to shareholders.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
Electing Out of the Limitation
Two categories of businesses can permanently opt out: real property trades or businesses and farming operations. Regulated utilities are automatically excluded and don’t need to make an election.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
For real property businesses (developers, construction firms, landlords, property managers) and farming operations, electing out means full interest deductibility with no annual cap. The election requires an irrevocable statement attached to a timely filed return for the year it takes effect. Once made, there is no going back.
The trade-off matters. Businesses that elect out must depreciate certain property using the Alternative Depreciation System, which generally means longer recovery periods and straight-line depreciation. For real property businesses, this applies to nonresidential real property, residential rental property, and qualified improvement property. Those assets also become ineligible for bonus depreciation.5eCFR. 26 CFR 1.163(j)-9 – Elections for Excepted Trades or Businesses; Safe Harbor for Certain REITs Whether the election pays off depends on the ratio of interest expense to depreciable assets in your specific business. A highly leveraged developer with limited depreciable personal property will typically come out ahead. A business that just bought expensive equipment and planned to depreciate it aggressively should model both scenarios before making the call.
A Note on Acquisitions
Carryforwards don’t transfer freely when a business changes hands. In qualifying corporate reorganizations, the acquiring corporation inherits the target’s disallowed interest carryforwards under Section 381, but the acquirer can use only a prorated share of its 163(j) limitation for those inherited amounts in the first year after the transaction.6eCFR. Carryforward of Disallowed Business Interest If the deal also triggers an ownership change under Section 382, an additional annual cap applies, treating the disallowed interest as a pre-change loss.7Office of the Law Revision Counsel. 26 U.S. Code 382 – Limitation on Net Operating Loss Carryforwards and Certain Built-in Losses Following Ownership Change For companies sitting on large carryforwards, this can render much of the balance unusable for years.
Filing Form 8990
Any business with business interest expense, a disallowed interest carryforward, or excess business interest expense from a partnership generally files Form 8990 with its return.8Internal Revenue Service. Instructions for Form 8990 The form walks through the calculation, records the carryforward, and reports partnership-level EBIE allocations. Small business taxpayers that meet the gross receipts test are excused from filing unless they hold EBIE from a partnership.
There is no standalone penalty for missing Form 8990, but the exposure is real. If the omission produces an understated tax liability, accuracy-related penalties apply. If it renders the return incomplete or treated as unfiled, the failure-to-file penalty is 5 percent of unpaid tax per month up to 25 percent for individual and corporate returns.9Internal Revenue Service. Failure to File Penalty Partnerships and S-corporations face $255 per partner or shareholder per month, up to 12 months. Clean annual records of the 163(j) calculation are the only way to substantiate both current-year deductions and the carryforwards you’ll rely on later.