Section 163(j) of the Internal Revenue Code limits how much business interest expense a taxpayer can deduct in a year. The limit is built on a base called adjusted taxable income (ATI), and the definition of ATI has changed twice in recent years. For audit teams the section matters in three places: the current tax provision, the deferred tax asset for disallowed interest carryforwards, and the tax return reconciliation to Form 8990. Lenders also run covenants on interest coverage, but those use different definitions.
This page paraphrases the statute and the IRS instructions. The IRS draft instructions for Form 8990 are the source for the 2025 and 2026 changes described below. Read section 163(j), Treas. Reg. 1.163(j)-1 through -11 and the current Form 8990 instructions for the full rules, and have a tax professional apply them to a specific taxpayer.
What does the limitation say?
For a taxpayer subject to section 163(j), the business interest expense deduction for the year is limited to the sum of:
- business interest income,
- the applicable percentage of ATI, which is 30%, and
- floor plan financing interest expense.
Business interest expense that is not allowed is carried forward to the next year as disallowed business interest expense. The carryforward does not expire. Partnerships follow special rules: excess business interest is allocated to the partners rather than carried at the partnership level.
Who is exempt?
A small business taxpayer is not subject to the limitation and generally does not file Form 8990. It is a taxpayer that is not a tax shelter and meets the gross receipts test. For tax years beginning in 2025 the test is average annual gross receipts of $31 million or less for the three prior tax years, with the average computed by adding the three years' receipts and dividing by three. Tax shelters, as defined in section 448(d)(3), cannot use the exemption. Gross receipts of related entities are aggregated, so a small subsidiary of a larger group may fail the test.
Taxpayers can also elect out of the limitation for an electing real property trade or business or an electing farming business. Making the election has consequences for depreciation methods on related property, so it is a tax planning decision, not a default.
How is ATI computed, and what changed?
ATI starts from tentative taxable income and is computed without regard to items not allocable to a trade or business, business interest income and expense, the net operating loss deduction under section 172, the section 199A deduction, and, for some years, depreciation, amortization and depletion.
That last item is the point of change. The IRS instructions describe three periods:
| Tax years beginning | Treatment of depreciation, amortization, depletion in ATI | Effect |
|---|---|---|
| Before 2022 | Added back (the deduction is disregarded) | EBITDA-like base, higher limit |
| 2022 through 2024 | Not added back; ATI is after those deductions | EBIT-like base, lower limit |
| After 2024 | Added back again | EBITDA-like base |
P.L. 119-21, the One Big Beautiful Bill Act, amended section 163(j) to exclude any deduction allowable for depreciation, amortization or depletion from the computation of ATI for tax years beginning after 2024. Form 8990, line 11 was revised to reinstate that deduction as an adjustment to tentative taxable income.
Two more changes arrive for tax years beginning after 2025: limitations on business interest will generally include capitalized interest, other than interest capitalized under sections 263(g) and 263A(f), and ATI will exclude U.S. shareholder inclusions from controlled foreign corporations. The act also expanded the definition of floor plan financing interest expense to cover certain trailers and campers designed to be towed by or affixed to a motor vehicle.
A worked illustration
Illustrative numbers only. A manufacturer that is not a small business taxpayer has business interest expense of $900,000, no business interest income, tax depreciation of $600,000 and taxable income of $1,200,000 after deducting the interest. No NOL deduction applies.
| Step | 2025 (add-back applies) | Same facts under 2022 to 2024 rules |
|---|---|---|
| Taxable income | $1,200,000 | $1,200,000 |
| Add back business interest expense | $900,000 | $900,000 |
| Add back depreciation | $600,000 | $0 |
| ATI | $2,700,000 | $2,100,000 |
| 30% of ATI | $810,000 | $630,000 |
| Interest deductible | $810,000 | $630,000 |
| Disallowed, carried forward | $90,000 | $270,000 |
The 2025 column reads: $1,200,000 + $900,000 + $600,000 = $2,700,000; 30% of $2,700,000 is $810,000; $900,000 less $810,000 leaves $90,000 disallowed. The add-back changes the carryforward by $180,000 for the same facts.
How does it show up in the audit?
Practice observations built from how the provision works, not requirements of the statute:
- Provision. If section 163(j) limits the deduction, current tax payable is higher than a simple interest-deduction calculation would suggest. The income tax provision workbook should carry the 163(j) computation, not a plug.
- Deferred taxes. Disallowed business interest carries forward indefinitely, so it creates a deferred tax asset. The question is realizability: will future ATI be high enough to absorb the carryforward? See deferred tax assets and liabilities and valuation allowance. The deferred tax rollforward tracks the balance.
- Return tie-out. Compare Form 8990 to the provision inputs. Related-party interest, capitalized interest after 2025 and the gross receipts aggregation are the usual mismatches.
- Small business status. If management relies on the exemption, get the three-year gross receipts schedule and the aggregation analysis. A growing company can cross the threshold.
- Debt covenants and interest. Tax interest limitations do not change book interest expense. Do not let a covenant calculation borrow the tax ATI definition. The leverage and coverage ratios calculator shows the common lender definitions.
Related tax adjustments, such as the capitalization rules for research costs, interact with ATI and deserve separate review. The income tax audit program covers the provision procedures.
Frequently asked questions
Did the One Big Beautiful Bill Act restore the EBITDA basis for 163(j)?
Yes for tax years beginning after 2024. P.L. 119-21 excludes depreciation, amortization and depletion deductions from the ATI computation for those years, which raises ATI compared with 2022 through 2024.
What is the small business exemption threshold?
For tax years beginning in 2025, average annual gross receipts of $31 million or less for the three prior years, provided the taxpayer is not a tax shelter. The threshold is indexed annually.
Does disallowed interest expire?
No. Disallowed business interest expense carries forward to the following year and continues to carry forward until used, subject to special partnership rules.
Who files Form 8990?
A taxpayer with business interest expense, a disallowed business interest expense carryforward, or current or prior year excess business interest expense generally files it, unless an exclusion applies. A pass-through entity allocating excess taxable income or excess business interest income to its owners also files.
Sources
- IRC section 163(j) and Treas. Reg. 1.163(j)-1 through 1.163(j)-11
- IRS, Instructions for Form 8990 (draft for the 2025 tax year), including "What's New" for P.L. 119-21: irs.gov/form8990
- Public Law 119-21 (July 4, 2025)
Related
Part of CORAA University · Tax and compliance for CPA firms: related guides, calculators and templates.
AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error