Section 163(j) of the Tax Code: Exemptions, Elections, and Form 8990

The Section 163(j) business interest deduction rule caps how much business interest expense you can deduct in a year at the sum of three things: your business interest income, 30% of your adjusted taxable income (ATI), and any floor plan financing interest. Interest above that ceiling is not lost; it carries forward. Some businesses avoid the cap entirely through a small business exemption or an industry-specific election, and partnerships apply a different set of carryforward mechanics than corporations do.¹

“Business interest” means interest paid or accrued on debt tied to a trade or business. Investment interest (governed by Section 163(d)) and personal interest like a home mortgage do not count. A holding company earning passive investment income cannot use that income to inflate its business interest deduction. Floor plan financing interest is a narrower category: interest on debt used to finance motor vehicles, boats, or farm equipment held for sale or lease, secured by that inventory.²

Calculating Adjusted Taxable Income

ATI is the biggest lever for most businesses, and the rules just changed. You start with taxable income and add back several items to build a broader income base. The critical question is whether depreciation, amortization, and depletion get added back.

From 2022 through 2024, they did not. ATI was calculated on an EBIT basis (earnings before interest and taxes only), which tightened the cap significantly for capital-intensive businesses. The One Big Beautiful Bill Act reversed this for tax years beginning after December 31, 2024. For 2025 and 2026, depreciation, amortization, and depletion are again added back, returning to the more generous EBITDA formula.³ For a manufacturer with $10 million in depreciation expense, the restored formula produces an additional $3 million of deductible interest room.

Two further changes take effect for tax years beginning after December 31, 2025. Income inclusions from controlled foreign corporations under Sections 951(a) and 951A(a) are excluded from ATI, so multinationals can no longer use foreign subsidiary income to raise their interest ceiling. And the 163(j) limitation now applies before most mandatory or elective interest capitalization rules, which changes how certain interest gets classified in the first place.³

Who the Limitation Applies To

Any taxpayer with business interest expense is potentially subject to 163(j), regardless of entity type. C corporations, S corporations, partnerships, and individuals with trade or business activity all fall within its scope. Partnerships must run the calculation at the partnership level rather than passing raw interest expense through to partners, which prevents partners from mixing partnership interest with unrelated income to work around the cap.¹

Certain businesses avoid the limitation entirely through the exemption or elections below. Everyone else files Form 8990.

The Small Business Exemption

The most common way out is the gross receipts test under Section 448(c). If your average annual gross receipts over the three prior tax years were $31 million or less, 163(j) does not apply. The threshold is indexed for inflation and rises to roughly $32 million for the 2026 tax year.⁴ The test applies to corporations, partnerships, and individuals alike.

Aggregation Rules for Related Entities

You cannot split a large business into smaller pieces to slip under the threshold. Aggregation rules require related entities to combine gross receipts. For a parent-subsidiary group, aggregation applies when a common parent owns more than 50% of the voting power or total value of at least one other corporation. For brother-sister groups, the trigger is five or fewer individuals, estates, or trusts owning at least 80% of each corporation.⁵ If the group’s combined receipts exceed the threshold, every entity in the group loses the exemption.

Tax Shelters Do Not Qualify

Gross receipts don’t matter if you’re a tax shelter. The definition here is broader than the label suggests.¹ It reaches any non-C-corporation enterprise whose interests were offered in a registered securities offering, any syndicate where more than 35% of losses are allocated to limited partners or limited entrepreneurs, and any entity meeting the tax shelter definition under the substantial understatement penalty rules.⁶ Many private equity fund structures and syndicated partnerships land in this category even when the people running them would never describe the entity that way.

The Real Property and Farming Election

Real estate businesses and farming operations can make an irrevocable election to opt out of 163(j). The tradeoff is real: electing businesses must use the alternative depreciation system (ADS) instead of MACRS on certain assets and lose bonus depreciation on those assets.⁷

For a real property trade or business, the affected assets include nonresidential real property, residential rental property, and qualified improvement property.³ ADS uses longer recovery periods and straight-line depreciation. A commercial building goes to 40 years instead of 39 under MACRS; residential rental property goes to 30 years instead of 27.5. Across a portfolio with frequent acquisitions, the compounding is significant.

Because the election is permanent, the decision comes down to weighing the present value of unlimited interest deductions against slower depreciation. Heavily leveraged properties usually benefit from opting out. Low-debt portfolios usually don’t.

Carryforward of Disallowed Interest

Interest above the cap is not permanently lost. The disallowed amount carries forward to the next year and is treated as business interest paid in that year, with no expiration date. A C corporation can stack disallowed interest across multiple lean years and deduct it when ATI eventually grows enough to absorb the backlog.⁸

Partnerships Handle This Differently

This is where taxpayers most often go wrong. Disallowed interest at the partnership level does not carry forward inside the partnership. Instead, it is allocated out to each partner as “excess business interest expense” in the same proportion as the partnership’s nonseparately stated income or loss.¹

Once a partner receives that allocation, three rules apply:

The partner can deduct the excess business interest only in a future year when the same partnership allocates “excess taxable income” to the partner, and only up to the amount of that excess taxable income. It cannot be used against income from a different partnership or the partner’s own business.
The partner’s basis in the partnership interest is reduced (but not below zero) by the allocated amount immediately.
If the partner sells the interest before fully using the carryforward, basis is increased immediately before the sale by the unused portion. Neither the seller nor the buyer gets an interest deduction for the amount that generated the basis increase.¹

The sale mechanic is worth walking through. Say the partnership allocates $100,000 of excess business interest to you, dropping your basis by $100,000. Over the next two years, enough excess taxable income flows through for you to deduct $40,000 of it. You then sell your interest. Your basis is increased by the remaining $60,000 immediately before the sale, which reduces your gain or increases your loss. You permanently lose the $60,000 ordinary interest deduction and get capital treatment instead, which is usually less valuable.

Filing Form 8990 and Penalty Exposure

Any taxpayer subject to 163(j) files Form 8990, Limitation on Business Interest Expense Under Section 163(j), with their annual return. Corporations attach it to Form 1120, partnerships to Form 1065, and S corporations to Form 1120-S.⁸ Even businesses that qualify for the small business exemption may still need to file in certain situations, such as carrying forward disallowed interest from a prior year when the exemption did not apply.

Getting the calculation wrong exposes you to the accuracy-related penalty under Section 6662, which is 20% of any underpayment attributable to negligence or a substantial understatement of income tax.⁹ Overstating interest above the cap, miscalculating ATI, and ignoring the aggregation rules for the small business exemption are all common triggers. Disclosing an aggressive but reasonable position on Form 8275 can eliminate the substantial understatement component of the penalty, though it does not protect against a negligence finding.

1
Office of the Law Revision Counsel. 26 USC 163 – Interest
2
Legal Information Institute. 26 USC 163(j)(9) – Floor Plan Financing Interest Defined
3
Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
4
Internal Revenue Service. Revenue Procedure 2024-40
5
Internal Revenue Service. FAQs Regarding the Aggregation Rules Under Section 448(c)(2) that Apply to the Section 163(j) Small Business Exemption
6
Office of the Law Revision Counsel. 26 USC 461 – General Rule for Taxable Year of Deduction
7
eCFR. 26 CFR 1.163(j)-9 – Elections for Excepted Trades or Businesses
8
Internal Revenue Service. Instructions for Form 8990
9
Internal Revenue Service. Accuracy-Related Penalty