Section 163(j) of the Internal Revenue Code limits how much business interest expense a company can deduct in a given tax year. The Section 163(j) business interest deduction is capped at the sum of three things: the business’s interest income, 30% of its adjusted taxable income, and any floor plan financing interest. Interest above that ceiling isn’t gone; it carries forward indefinitely. Two things matter most for 2026 filings: a 2025 law change made the income base more generous again, and smaller businesses often escape the cap entirely.
The Deduction Formula
In any tax year, a business subject to Section 163(j) can deduct business interest only up to the total of:
- Business interest income allocable to the trade or business.
- 30% of adjusted taxable income (ATI).
- Floor plan financing interest, meaning interest on loans secured by motor vehicle inventory held for sale or lease.
Floor plan interest sits outside the 30% cap. Because it’s a separate line in the formula, car dealerships and similar sellers effectively deduct that interest in full: it raises the overall ceiling rather than eating into the 30% bucket.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense Anything above the combined total is disallowed for the year and carried forward.
Adjusted Taxable Income Is the Number That Moves the Cap
Because 30% of ATI is usually the largest piece of the ceiling, ATI drives almost every planning decision under Section 163(j). ATI starts with taxable income and then strips out items that aren’t part of ordinary trade or business profit: it ignores net operating loss deductions, the Section 199A qualified business income deduction, and any income or deductions not tied to a trade or business.2Legal Information Institute (LII). Definition: Adjusted Taxable Income from 26 USC 163(j)(8)
The bigger question is how depreciation, amortization, and depletion are treated, because the answer has shifted three times:
- For tax years 2018 through 2021, businesses added depreciation, amortization, and depletion back to taxable income when computing ATI. That produced an EBITDA-like figure and a larger deduction ceiling.
- For 2022 through 2024, that addback expired. ATI became an EBIT-like figure, and capital-intensive businesses saw their allowable interest deductions shrink.
- For tax years beginning after December 31, 2024, the One, Big, Beautiful Bill restored the depreciation, amortization, and depletion addback. ATI once again resembles EBITDA.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense
For 2026 returns, this restoration is the practical story. A manufacturer with heavy annual depreciation now calculates ATI on a much larger base than it did in 2023 or 2024, and its allowable interest deduction goes up accordingly.
The Small Business Exemption
Most small and mid-sized companies never have to run the 30% formula at all. A business is exempt from Section 163(j) if it passes the gross receipts test under Section 448(c). For tax years beginning in 2026, that means average annual gross receipts of $32 million or less over the prior three years.3Internal Revenue Service. Revenue Procedure 2025-32 The threshold is inflation-adjusted; it was about $29 million for 2023–2024 and $30 million for 2025.
The math is straightforward: add gross receipts for each of the three preceding tax years and divide by three. A business without three full years of history uses whatever shorter period it has. Aggregation rules require combining the gross receipts of related entities under common ownership, so splitting operations to slip under the number doesn’t work.4Internal Revenue Service. FAQs Regarding the Aggregation Rules Under Section 448(c)(2) that Apply to the Section 163(j) Small Business Exemption
The Tax Shelter Trap
There’s a catch that surprises people. Even a business well under $32 million cannot use the small business exemption if it counts as a “tax shelter” under Section 448(d)(3).1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense A partnership or S corporation is treated as a “syndicate,” and therefore a tax shelter, if more than 35% of its losses for the year are allocated to limited partners or limited entrepreneurs.
This catches real estate partnerships and investment funds that would otherwise pass the gross receipts test with room to spare. If your entity allocates significant losses to passive investors, run the 35% number before assuming you’re exempt.
Electing Out: Real Property and Farming Businesses
Two categories of business can elect out of Section 163(j) at any size: a real property trade or business and a farming business.5eCFR. 26 CFR 1.163(j)-2 – Deduction for Business Interest Expense Limited The election trades unlimited interest deductions for slower depreciation.
A real property business that elects out must depreciate its real property under the Alternative Depreciation System (ADS), using straight-line recovery over longer periods than the standard rules, and those assets lose eligibility for bonus depreciation.6Internal Revenue Service. Publication 946 (2024), How To Depreciate Property A farming business that elects out must use ADS for any property with a recovery period of 10 years or more, and those assets are also ineligible for bonus depreciation.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense Shorter-lived farm equipment isn’t affected.
The election is irrevocable. It applies to the current year and every year going forward, and the only exit is disposing of substantially all the business’s assets. Model the long-term depreciation cost against the interest benefit before making the call.
How Partnerships and S Corporations Apply the Rules
For partnerships and S corporations, Section 163(j) applies at the entity level. The entity runs its own formula, calculates its own ATI, and figures out how much interest it can deduct.7eCFR. 26 CFR 1.163(j)-6 – Application of the Section 163(j) Limitation to Partnerships and Subchapter S Corporations Deductible interest flows through in the entity’s ordinary income or loss.
Partnerships handle disallowed interest differently from S corporations, and this is where compliance gets expensive. When a partnership’s interest expense exceeds its Section 163(j) limit, the disallowed amount doesn’t stay at the partnership. It’s allocated out to each partner as “excess business interest expense” (EBIE). A partner can only deduct that EBIE in a later year if the same partnership later allocates excess taxable income or excess business interest income to that partner.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense Excess taxable income from a different partnership does not unlock it.
A partner in several leveraged partnerships needs to track EBIE separately for each one, and the reconciliation is not trivial. S corporations are simpler: disallowed interest stays at the entity level and carries to next year, where it’s treated as interest paid in that year and run through the formula again. Shareholders don’t track anything separately.
What Happens to Disallowed Interest
Interest above the cap carries forward indefinitely, with no expiration.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense It stays on the books until the business generates enough room under the formula to absorb it.
Two situations often confuse taxpayers with carryforwards. If the business later drops below the small business gross receipts threshold, it stops being subject to Section 163(j) and can deduct current-year interest freely. But if the business instead elects out as a real property or farming business, previously disallowed interest stays trapped under Section 163(j); the election is not retroactive.8Internal Revenue Service. Instructions for Form 8990
Filing Form 8990
Any taxpayer with business interest expense, a disallowed carryforward, or current or prior year excess business interest expense generally files Form 8990 with the return. That includes individuals with sole proprietorships, C corporations, partnerships, and S corporations.8Internal Revenue Service. Instructions for Form 8990 The form walks through the limitation, determines the deductible amount, and tracks the carryforward to next year.
Businesses that qualify for the small business exemption and have no prior-year carryforwards generally don’t file. But if you have leftover disallowed interest from a year when the exemption didn’t apply, you still need the form to keep those balances alive, even if this year’s interest is fully deductible. Clean Form 8990 records are the only reliable way to preserve deductions you’re entitled to in a future year.9Internal Revenue Service. About Form 8990, Limitation on Business Interest Expense Under Section 163(j)