Reform Guidance: Partnership Interest Expense Nonconformity Adjustment
Beginning in 2018, the deduction for business interest expenses is limited for federal purposes under section 163(j) of the Internal Revenue Code. This limitation is calculated and reported on 2018 federal form 8990. Taxpayers are generally allowed to carry forward the disallowed portion of their business expenses and deduct these amounts in future years.
Iowa has not conformed to this new federal limitation on the business interest expense deduction for tax year 2018. Taxpayers whose business interest expense deduction was limited for federal purposes need to make certain adjustments to claim the larger Iowa deduction for 2018. For individuals, these adjustments are reported on the IA 1040, line 14, code U. For all other taxpayers, these adjustments are reported on the 2018 Nonconformity Adjustments Worksheet, line 3.
In the case of partnerships, the entity is not allowed to carry this deduction forward to future tax years for federal purposes. Instead, partnerships report the excess amount to their partners on the 2018 federal schedule K-1 (Form 1065), Line 13, Code K, and the partners use this amount to make adjustments to the partner’s own interest expense limitation (if any) in future years, following the instructions on the federal forms.
Iowa has conformed to the federal business interest expense deduction limitation for 2019 and subsequent tax years. This means that in the future, the Iowa interest expense deduction will generally be the same as the federal deduction for a given year, except that taxpayers who were allowed to deduct the full amount of interest expense in 2018 may have to make adjustments to any federal 2018 carryforward amounts claimed in future years. The Department will provide guidance, rules, and forms, where appropriate, in the future to assist taxpayers in calculating their Iowa business interest expense deduction for 2019 and subsequent tax years.
Partners or S-Corporation Shareholders who receive Iowa K-1s:
No 2018 Iowa nonconformity adjustment by owners of Iowa partnerships or S-corporations* for interest expense deducted by and passed through from an Iowa partnership or S-Corporation should be necessary. The Iowa partnership or S-Corporation should complete the 2018 Nonconformity Adjustments Worksheet, line 3 to deduct the full interest expense on the entity’s own Iowa return (IA 1065 or IA 1120S), and the reduction to the partner’s or shareholder’s share of the entity’s income will be included in the all source adjustments line of the partner’s or shareholder’s Iowa K-1.
If the partner or shareholder also had business interest expense deductions from other sources that were limited on the partner’s or shareholder’s own federal income tax return as calculated on federal form 8990, the partner or shareholder will also need to make an Iowa nonconformity adjustment to account for that limitation. As noted above, for individuals, these adjustments are reported on the IA 1040, line 14, code U. For all other taxpayers, these adjustments are reported on the 2018 Nonconformity Adjustments Worksheet, line 3. Partners and shareholders should take great care when making these nonconformity adjustments to avoid deducting any business interest expense amount attributable to an Iowa partnership or S-corporation, because those amounts were already deducted on the partner’s or shareholder’s own Iowa return as an all source adjustment from the partner’s or shareholder’s Iowa K-1.
In future tax years, a partner will have to make adjustments to their own Iowa interest expense deduction and limitation calculation (if any) to account for amounts the partnership deducted for Iowa purposes but not for federal purposes in 2018.
Shareholders in S-Corporations will not have to make similar adjustments in future years. Due to differences in how disallowed interest expenses are treated for partnerships versus S-Corporations at the federal level, Iowa S-Corporations will make the necessary future year Iowa adjustments at the entity level, without any need for action by the shareholders.
Partners and Shareholders who receive federal K-1s, but not Iowa K-1s:
Partnerships and S-Corporations with no Iowa activities likely will not file an Iowa return or issue Iowa K-1’s that account for this larger Iowa deduction in 2018. Generally, owners of passthrough entities will be limited to claiming the deduction actually passed through to them by the entity, without the ability to make any Iowa adjustments. This is because:
- the owner’s basis in the entity will be adjusted by the amount of the deduction actually passed through, and
- the entity is not required to provide the information to owners that would be necessary to make any Iowa adjustments.
This may result in a lower 2018 deduction for interest from these entities than the owner would have received had the entity filed a 2018 Iowa return, but the owners will be eligible to receive the full deduction amounts in future years when the entity is able to deduct the 2018 disallowed amount as a carryforward. This treatment applies to shareholders of S-Corporations which do not file Iowa returns or issue Iowa K-1s in 2018.
However, because partnerships and their partners report this deduction differently from S-corporations and their shareholders at the federal level, the Iowa treatment for deductions received from a partnership which does not file an Iowa return is also different. At the federal level, the excess business interest expense is allocated to partners in the current year (to be deducted by the partner in future years under certain circumstances) and the partner’s basis in the partnership is adjusted by the amount of excess business interest expense allocated in that year. This excess business interest expense amount is reported to the partners on the 2018 federal K-1 (Form 1065), line 13, code K. Because partners know the exact amount of the 2018 disallowed business interest deduction and because their basis in the partnership will be adjusted by that amount in 2018, those partners who receive interest expense deductions from partnerships which do not file Iowa returns, but who do file Iowa returns themselves, may still claim the larger Iowa deduction on business interest expenses actually passed through from the partnership, due to Iowa’s non-conformity for 2018. In order to claim the larger deduction, Iowa partners receiving a federal K-1, but not an Iowa K-1 should include as a business interest expense adjustment on their Iowa return a deduction equal to the amount shown on line 13, Code K of the federal K-1.
Like partners who receive an Iowa K-1, in future tax years, the partner will have to make adjustments to the partner’s own interest expense limitation calculation (if any) to account for amounts the partnership deducted for Iowa, but not for federal purposes in 2018. Because shareholders in S-Corporations which do not file Iowa returns or issue Iowa K-1s for tax year 2018 cannot make a 2018 Iowa business interest expense deduction adjustment, these shareholders will not be required to make any adjustments in future years, and will instead be allowed the full deduction, including carried forward excess business interest expense amounts in the years in which the S-Corporation actually deducts these amounts.
What does this mean?
- Iowa has not conformed to the federal interest expense limitations for 2018, meaning the 2018 Iowa deduction may be larger than the federal deduction, but Iowa adjustments may be required.
- Iowa does conform to the federal interest expense limitation for 2019 and all future tax years. Generally, taxpayers’ interest expense limitations will be the same for Iowa and federal purposes for these years, but taxpayers who made adjustments to the Iowa deduction in 2018 due to nonconformity may have to make adjustments for carryforward in 2019 and later years.
- Special reporting requirements may apply to entities that file as partnerships or S-Corporations and to their partners or shareholders.
*For purposes of this guidance, an “Iowa” partnership or S-Corporation is any partnership or S-Corporation that files or is required to file an Iowa return and issue Iowa K-1s for a given tax year.