The Debt May Fit. The Deduction May Not.

Langston Tolbert
1 day ago
4 min read

A lender can approve the debt. The spreadsheet can show enough cash to pay it. The deal can still produce less after tax cash than the buyer expected.

The problem may be hiding in a line that looks routine: interest expense.

On August 19, 2026, the IRS updated its guidance on Section 163(j), the federal tax rule that can limit how much business interest a taxpayer deducts in a given year. The update reflects recent statutory changes and clarifications. It also offers buyers, founders, and CFOs a useful reminder: debt service and interest deductibility are related, but they are not the same question. (IRS Fact Sheet FS-2026-14)

The Model Usually Starts With the Payment

Acquisition models tend to make debt feel concrete. There is a principal balance, an interest rate, an amortization schedule, and a date each payment comes due.

The tax benefit can feel just as concrete. Interest is an expense, so the model may assume that interest reduces taxable income and preserves cash.

That assumption needs to be tested.

When Section 163(j) applies, the current deduction for business interest generally cannot exceed the sum of the taxpayer's business interest income, 30 percent of adjusted taxable income, and floor plan financing interest. Interest disallowed in the current year generally carries forward, but a deduction received later does not fund today's payroll, working capital, capital expenditures, or debt payment. (IRS Fact Sheet FS-2026-14)

That is the practical issue. The debt may be serviceable before taxes. The business may ultimately receive the deduction. But if the deduction arrives later than the model assumes, the cash available after taxes can be lower at exactly the moment the company has the least room for surprise.

The $32 Million Number Is Not a Free Pass

The IRS lists $32 million as the inflation adjusted gross receipts threshold for the small business exception for 2026. The test generally looks to average annual gross receipts over the prior three years. But the exception has conditions, including that the taxpayer not be a tax shelter, and aggregation rules can require receipts from related businesses to be considered together. (IRS Fact Sheet FS-2026-14; IRS aggregation FAQs)

That matters in the lower middle market. A company may appear to sit below the threshold when viewed alone. A buyer may also acquire a business whose historical receipts, ownership structure, or post closing group make the analysis less obvious than the headline number suggests.

Do not treat proximity to $32 million as the answer. Calculate the threshold. Do not guess it.

The 2026 Update Is Not All Bad News

For tax years beginning after December 31, 2024, adjusted taxable income once again includes an addback for depreciation, amortization, and depletion. That change can increase adjusted taxable income and, in turn, increase the amount of business interest that may be deductible for some taxpayers. (IRS Fact Sheet FS-2026-14; Instructions for Form 8990)

Do not translate “better than the prior rule” into “fully deductible.” The result still depends on the actual taxpayer, the actual structure, the applicable exceptions, and the company's projected taxable income.

Partnerships add another layer. The IRS explains that the limitation is applied at the partnership level. Disallowed partnership interest can become excess business interest expense allocated to the partners, with its later use tied to future allocations from that same partnership. (IRS Fact Sheet FS-2026-14)

That can make entity choice, rollover equity, and the placement of acquisition debt part of the economics rather than paperwork to finish after the price is set.

Before You Sign

Do not ask only whether the business can make the loan payment. Ask what the business looks like after the loan payment and the tax payment occur in the same period.

Before the financing terms and purchase structure harden, have the deal team run the model under at least three cases:

The expected interest deduction is available when projected.
Part of the deduction is deferred.
Earnings fall while debt service remains fixed.

Then ask the questions the base case can conceal. Does the borrower qualify for the small business exception? Do aggregation rules change that answer? Where will the debt sit? Is the acquisition vehicle a partnership, an S corporation, or part of a consolidated group? How much adjusted taxable income is actually expected? What happens to cash taxes if the deduction is limited? Does the company still have room under its covenants and working capital needs?

The point is not to turn the LOI into a tax return. It is to identify a material tax assumption while there is still time to change the debt, the structure, the price, or the reserves.

Debt capacity tells you whether the company may be able to borrow the money. A proper tax model helps tell you what that money will actually cost.

If you are evaluating an acquisition or recapitalization, Tolbert Legal can help coordinate the legal structure with the tax and financial assumptions before the documents lock them in. Schedule a transaction readiness conversation.

Disclaimer

This publication is for informational and educational purposes only. It is not legal, tax, accounting, financing, or investment advice. Section 163(j) is fact specific and subject to exceptions, elections, aggregation rules, entity level rules, and other limitations. Consult the appropriate legal, tax, accounting, and financial advisers regarding a particular transaction.