Business interest expense deduction shifts again in 2026

The National Association of Tax Professionals (NATP) understands that for many business owners, financing growth through debt is a standard strategy. However, the federal government limits how much of that interest you can actually deduct each year. This rule, found in §163(j) of the Internal Revenue Code, is a critical component of tax planning for companies of all sizes.

Qualifying for the small business exemption

Not every business has to worry about these limits. The law provides a small business exemption for eligible taxpayers that are not tax shelters and that meet a specific gross receipts test under §448(c). For the 2026 tax year, a business generally qualifies for this exemption if its average annual gross receipts for the prior three years are $32 million or less. If taxpayers don't have the full three years of data, the average is calculated based on the period the entity was in existence. This threshold is adjusted annually for inflation, so it’s vital to review your receipts every year to confirm whether the limitation applies.

Breaking down the limitation calculation

If a business exceeds the gross receipts threshold and no other exception applies, it must calculate its deductible business interest expense. The deductible amount is capped at the sum of three distinct components:

1. The business interest income for the year
2. 30% of the adjusted taxable income (ATI) for the year
3. The floor plan financing interest expense for the year

To illustrate how these figures interact, consider a corporation with $200,000 in interest income, $2 million in ATI and $50,000 in floor plan financing interest.

• Step 1: Determine the ATI percentage. 30% of $2 million equals $600,000.
• Step 2: Combine all three parts ($200,000 + $600,000 + $50,000).
• Step 3: Compare the total limit ($850,000) to the actual interest expense.

If this corporation paid $900,000 in business interest, only $850,000 is deductible in the current year. The remaining $50,000 isn't lost but becomes a disallowed business interest expense carryforward to the next taxable year.

Implementing the new calculation for 2026

The calculation of ATI is the cornerstone of §163(j). It’s essentially taxable income computed without regard to certain items. Under the One Big Beautiful Bill Act (OBBBA), there were significant changes to how this calculation starts. For tax years beginning after Dec. 31, 2024, taxpayers must add back any deductions for depreciation, amortization or depletion. This restoration of the earnings before interest, taxes, depreciation and amortization (EBITDA)-style calculation is generally favorable because it increases the ATI base, which in turn increases the 30% limit.

However, a new restriction applies for tax years beginning after Dec. 31, 2025. Taxpayers can no longer include certain inclusion items from a controlled foreign corporation (CFC), such as subpart F income and net CFC tested income under §951A, formerly known as global intangible low-taxed income (GILTI), when computing ATI. This change means U.S. shareholders can't increase their ATI by these inclusion items, potentially lowering their interest deduction cap.

How the rules apply to partnerships and S corporations

§163(j) applies differently depending on the business structure. For partnerships, the limitation is applied at the entity level. Any interest the partnership can't deduct is allocated to the partners as excess business interest expense (EBIE). Partners can only deduct this EBIE in future years if the same partnership allocates excess taxable income or excess business interest income to them. Conversely, S corporations handle disallowed interest at the corporate level, meaning it doesn't pass through to shareholders as a separate item.

Final considerations for practitioners

Recent legislation also expanded the definition of floor plan financing to include interest on loans for trailers or campers designed for temporary living or recreational use. Additionally, it’s important to remember that for tax years beginning after Dec. 31, 2025, §163(j) applies before most mandatory or elective interest capitalization provisions, except §§263(g) and 263A(f). Any interest that’s disallowed and carried forward is not treated as interest subject to capitalization in future years.

While the IRS provides relief from certain accuracy-related penalties for taxpayers who reasonably and in good faith rely on its published frequently asked questions, these guides don't have the same authority as statutory law.