Tax Reform – New Limitation of Net Business Interest Expense for Oil and Gas Partnerships
The Tax Cuts and Jobs Act (“TCJA”) was signed into law on December 22, 2017. One of the revenue raisers in the TJCA was amending IRC§163(j) to place limitations on the deductibility of business interest expense for all taxpayers, not just corporations (“Amended IRC §163(j)”). As discussed below, planning ahead should help minimize unexpected results for leveraged oil and gas partnerships.
Amended IRC §163(j)
Amended IRC §163(j) may limit a leveraged oil and gas partnership’s business interest expense deduction to 30% of adjusted taxable income (“ATI”). ATI is equal to the taxable income of the taxpayer computed without regard to:
- Income, gain, deduction or loss which is not properly allocable to a trade or business;
- Business interest or business interest income;
- NOL (net operating loss) deductions; and
- For tax years beginning before January 1, 2022, depreciation, depletion and amortization.
In tiered partnership structures, business interest expense is subject to Amended IRC §163(j) at every level. Special rules apply to prevent a partner from double counting a partnership’s ATI when determining a partner’s business interest limitation. Any disallowed business interest is carried forward indefinitely and treated as business interest paid or accrued in the succeeding tax year.
Amended IRC §163(j) also provides that a partner may use its distributive share of any excess taxable income limitation in computing its business interest limitation. Any excess taxable income allocated from a particular partnership in a tiered entity structure, however, must be first applied to offset all excess business interest allocated from the same entity before applying it to any other business interest.
A partner’s adjusted basis in its partnership interest is reduced (not below zero) by the amount of excess business interest allocated to the partner. Tax basis from the interest expense carryforward is restored when the taxpayer disposes of the partnership interest in either a recognition or non-recognition transaction by the amount of tax basis reduced over the amount of excess business interest allocated to the partner and treated as paid or accrued the following year.
Uncertainty for Small Oil and Gas Partnerships
There is an exception under Amended IRC §163(j) for certain small businesses that have annual gross receipts of less than $25 million for the prior three years and meet all the requirements under IRC §448(c). However, under Amended IRC §163(j), the exemption does not apply to a “tax shelter.” Partnerships with limited partners that are entitled to more than 35% of the entity's losses may not meet the exemption. While most likely an unintended result, it is uncertain whether a technical correction will be made to Amended IRC §163(j) as additional guidance from the IRS will most likely not be issued soon.
BIG LP is an oil and gas partnership that owns several working interests in West Texas. BIG LP has a non-economic GP and two limited partners: OIL LLC and GAS LLC. OIL LLC owns 60% and GAS LLC owns 40% of BIG LP. BIG Owner, an individual, owns 50% of OIL LLC and GAS LLC. BIG LP has made an election to fully expense intangible drilling costs (“IDC”) and none of the partners have made an election under IRC §59(e) (“59(e) Election”) to capitalize IDC. Big Owner does not actively participate in any of the partnerships’ business.
Below is the entity level tax information for BIG LP, OIL LLC, GAS LLC and BIG Owner and computations of ATI, business interest disallowed and excess taxable income limitations for tax years 2021 and 2022. For comparison purposes, the same entity level tax information is used for tax years 2021 and 2022.
|($ in millions)||BIG LP||OIL LLC||GAS LLC||BIG Owner|
|Lease Operating Expense||$5,000||$3,000||$0||$0|
|Business Interest Expense||$15,000||$5,000||$1,000||$2,000|
|Depletion & Depreciation||$15,000||$9,000||$0||
|Tax Year 2021|
|Entity Level Federal Taxable Income||$5,000||$7,000||($9,000)||($2,000)|
|Total Taxable Income||$5,000||$10,000||($7,000)||($30)|
|Depletion & Depreciation||$15,000||$9,000||$0||$0|
|Pass-Through Excess TI||N/A||$300||$200||$3,493|
|Subtract: Pass-Through Income||N/A||($3,000)||($2,000)||($1,970)|
|Business Interest Limitation||$16,500||$9,990||$60||$1,048|
|Entity-Level Interest Disallowed||$0||$0||$940||$952|
|Excess Taxable Income||$500||$6,986||$0||N/A|
|Excess Interest Allocated||N/A||$0||$0||$470|
|Excess Interest Carryforward||$0||$0||$940||$1,422|
|Final Taxable Income||$5,000||$10,000||($6,060)||$922|
|Tax Year 2022|
|Entity Level Federal Taxable Income||$5,000||$7,000||($9,000)||($2,000)|
|Total Taxable Income||$5,000||$15,400||($3,400)||$5,200|
|Add: Interest Expense||$15,000||$5,000||$1,000||$2,000|
|Pass-Through Excess TI||N/A||$0||$0||$0|
|Subtract: Pass-Through Income||N/A||($8,400)||($5,600)||($7,200)|
|Business Interest Limitation||$6,000||$3,600||$0||$0|
|Entity Level Interest Disallowed||$9,000||$1,400||$1,000||$2,000|
|Excess TI Allocated||$0||$0||$0||N/A|
|Excess Interest Allocated||N/A||$5,400||$3,600||$5,700|
|Prior Year Excess Interest C/F||N/A||N/A||N/A||$1,422|
|Excess Interest C/F||N/A||N/A||N/A||$9,122|
|Final Taxable Income||$14,000||$16,800||($2,400)||$7,200|
|YoY Increase to Taxable Income||$9,000||$6,800||$3,660||$6,278|
Tax Impact - 2021
BIG LP and OIL LLC were able to fully deduct business interest expense for tax year 2021 because business interest expense was less than the business interest limitation (ATI x 30%). In regard to OIL LLC, ATI was reduced by the amount of taxable income passed through from BIG LP (60% x $5,000 = $3,000) to avoid double counting.
Both BIG LP and OIL LLC also had excess taxable income that was allocated to each of its partners in accordance with profit and loss ratios and were included in the ATI’s of OIL LLC, GAS LLC and Big Owner because there was no business interest disallowed and carried forward. In the case of BIG LP, excess taxable income was first calculated by taking the difference between business interest limitation of $16,500 and business interest expense of $15,000 and dividing the total by business interest expense of $15,000 which is equal to 10%. The amount of excess taxable income of $500 was determined by multiplying 10% by taxable income of $5,000. OIL LLC’s excess taxable income limitation of $6,986 was calculated in the same manner of which 50% was allocated to BIG Owner.
For GAS LLC, the issue arises as to whether it can qualify for the small business exception to Amended IRC §163(j). For purposes of the examples above, it is assumed that GAS LLC is a tax shelter because GAS LLC was allocated 50% of its losses to BIG Owner who was not active in the business. Therefore, $940 of business interest was disallowed of which $470 was allocated to BIG Owner and carried forward to next year. If the definition of tax shelter under existing law is clarified by IRS guidance or corrected by a technical corrections bill, GAS LLC may be eligible for the small business exception if it meets the $25 million annual average of gross receipts threshold under IRC §448(c).
As for BIG Owner, it was required to reduce business interest expense by $952 even after increasing ATI by $3,494 due to excess taxable income being allocated from OIL LLC. ATI, however, was reduced by $1,970 by BIG Owner’s share of taxable income being passed through from OIL LLC and GAS LLC avoid double counting. Therefore, BIG Owner has a $1,422 excess interest carryforward ($2,000 of business interest - $1,048 of business interest limitation) at the entity level along with $470 of excess business interest to carryforward from GAS LLC for a total of $1,892. BIG Owner will only be able to use the excess business interest carryforward from GAS LLC to the extent GAS LLC allocates excess taxable income.
Tax Impact - 2022
For tax year 2022, all taxpayers in the example above had deductible interest expense partially or fully reduced due to the elimination of the ATI addbacks for IDC, depletion and depreciation. Taxable income for all taxpayers significantly increased from 2021 to 2022 and BIG Owner generated a $9,122 excess interest expense carryforward. BIG Owner’s excess interest carryforward can be broken down as follows:
|BIG LP||OIL LLC||GAS LLC||BIG Owner||Total|
BIG Owner will only be able to use the excess interest carryforwards to the extent the excess taxable is allocated to Big Owner from each respective partnership. Excess interest expense will not be able to be deducted even if there is additional ATI being generated at the partner level. However, to the extent a partner is allocated excess taxable income, it can be used against a partner’s non-partnership business interest expense once excess business interest from that partnership is reduced to zero.
Partners of oil and gas partnerships should inquire about the potential for business interest to be disallowed for purposes of estimated tax payments. Partnerships will need to be able to provide the amount of projected “business interest” as defined under Amended IRC §163(j), business interest disallowed and excess taxable income allocated to each partner separated by entity. Requesting information early from the partnership and modeling the impacts of Amended IRC §163(j) should help avoid interest and penalties for underpayment of tax. In addition, these items will need to be disclosed on Schedule K-1 for partners to file their annual tax return.
Unfortunately, there are not many opportunities to reduce the impact of Amended IRC §163(j). An option, of course, is to reduce partnership debt given that Amended IRC §163(j) has increased the after-tax cost of borrowing. The impact of Amended IRC §163(j) is especially exacerbated during periods of robust drilling activity starting in 2022 when IDC is no longer added back to ATI. Using a popular technique such as making a 59(e) Election to capitalize IDC does not produce a favorable impact. From tax years 2018 to 2021, there would be no impact since IDC is an addback to ATI and for tax year 2022 and beyond, the interest expense deduction would merely be increased $1 for every $3 of IDC given up as a deduction.
Partners should also closely track partnership tax basis as IDC, interest expense and disallowed interest expense can quickly erode tax basis and generate suspended losses or capital gain if cash distributed is greater than tax basis. In conclusion, planning for the impacts of Amended IRC §163(j) may be the best opportunity for investors in leveraged oil and gas partnerships to avoid any additional tax, penalties and interest.
About the Authors:
Jeff Borchers is a Managing Director with Opportune’s Energy Tax Advisory practice in Houston. Jeff has over 20 years of tax, treasury, accounting and legal experience serving clients in various segments of the energy sector. He has extensive experience in partnership and corporate tax law, tax accounting and tax compliance. Prior to Opportune, Jeff was with KPMG where he led the firm’s Alternative Investments practice serving private equity firms and portfolio companies in all facets of taxation. Jeff also signed off on large public company tax provisions. Prior to KPMG, he served as Vice President – Tax/Assistant Treasurer at Willbros Group Inc. where he re-domiciled and restructured the company, reducing its overall effective tax rate, promoted tax compliance across all business units in multiple U.S. and international tax jurisdictions, settled U.S. and international tax disputes, participated in buy-side due diligence and managed Willbros’ cash and covenants under its credit facility during challenging times. Jeff holds a Bachelor of Science degree in Accounting from DePaul University and a Juris Doctor (J.D.) degree from the John Marshall Law School.
Ryan Riddle is a Director in the Energy Tax Advisory group of Opportune. Ryan has 10 years of corporate tax experience, including eight years of service with Big 4 firms. Ryan has extensive experience in the area of international taxation, having joined Opportune from PwC’s global structuring group in Houston. He has conducted engagements all over the world and has worked extensively at EY’s global talent hubs in both India and Argentina. Ryan’s engagement highlights include performing tax compliance and provision work for various segments of the energy industry, such as exploration and production, midstream, downstream and oilfield services.