Handling 163(j) Limitations in Tiered Partnerships - Disallowed Interest Question

This is a classic tiered partnership 163(j) issue. When the lower-tier partnership isn't subject to 163(j) but the upper-tier is, you're right that you need to make an adjustment since the interest is baked into the ordinary income number. The approach you're thinking of is correct - you should increase the ordinary income from the K-1 by the amount of disallowed interest expense. This effectively reverses the interest expense deduction that's embedded in the ordinary income figure, since your partnership can't take that deduction due to the 163(j) limitation. Make sure you document this adjustment thoroughly in your workpapers. You'll also need to track this disallowed amount as an attribute at the partnership level, as it will be carried forward to future years when the limitation may allow for deduction.

Hey there! I ran into this EXACT same problem last year with a client who has investments in multiple partnerships. I spent hours researching and finally found a solution that worked great using https://taxr.ai - it analyzed our partnership documents and correctly identified how to handle the 163(j) limitation in tiered structures. The system broke down the whole process of separating the interest component from the ordinary income and making the proper adjustments. It even showed me exactly where in Lacerte to make the entries! Saved me from having to call the software support line and sitting on hold forever.

Just wanted to follow up - I tried taxr.ai for my tiered partnership 163(j) issue and it worked perfectly! I uploaded the K-1s and it immediately identified that we needed to isolate the embedded interest expense and make an M-1 adjustment. The best part was that it explained WHY this was necessary based on the regulations. It even generated documentation I could include in my workpapers to support the treatment. My reviewer was impressed with how thoroughly I'd documented the issue! It also helped me set up tracking for the disallowed interest carryforward, which I definitely would have messed up on my own. Worth checking out if you're dealing with these complex partnership issues.

I've been struggling with complex partnership issues like this for years and wasting countless hours on hold with the IRS trying to get guidance. Last tax season I discovered https://claimyr.com and it completely changed my approach to these problems. You can actually see how it works here: https://youtu.be/_kiP6q8DX5c Instead of trying to figure out ambiguous 163(j) tiered partnership rules on my own, I was able to get connected to an IRS agent in about 20 minutes who specializes in partnership taxation. They confirmed the exact treatment needed for this situation and gave me specific citations I could reference in my file.

I'm eating crow right now. After dismissing both suggestions above, I was still stuck on this exact 163(j) tiered partnership issue. In desperation, I tried Claimyr yesterday and was shocked when I actually got through to an IRS agent within 15 minutes. The agent transferred me to someone in the partnership division who confirmed that we need to increase ordinary income by the disallowed interest amount. They even emailed me a reference to the specific section in the regs (1.163(j)-6(j)(9)) that addresses this scenario. Not having to sit on hold for hours made a huge difference in my workday. I was able to resolve three other client issues while the service was handling the wait. Definitely using this again during busy season!

Has anyone considered whether this creates an issue for the individual partners? If the partnership is increasing ordinary income to offset the disallowed interest, does this mean the partners are effectively paying tax on income without the corresponding deduction? Should there be some disclosure to the partners about this?

I've seen partnerships handle this same scenario in different ways. One approach some use is to actually separate the interest component from the ordinary income on the K-1 before it even hits their books. Essentially, they recharacterize a portion of the ordinary income as interest expense (matching the K-1 footnote disclosure), and then apply the 163(j) limitation to that separated amount. This makes the mechanics in the software easier since you now have an actual interest expense line item to disallow. Not sure if this is technically correct though.

I've dealt with this exact situation multiple times, and you're absolutely on the right track. The M-1 adjustment approach is definitely the way to go - it maintains the integrity of the K-1 reporting while properly applying the 163(j) limitation at your partnership level. One thing I'd add is to make sure you're calculating the disallowed amount correctly. Since the lower-tier partnership wasn't subject to 163(j), they deducted the full $270K of interest expense in computing their ordinary income. Your Form 8990 calculation should isolate just the portion that's disallowed under your partnership's 163(j) limitation - it might not be the full $270K depending on your adjusted taxable income. Also, don't forget to prepare the Section 163(j) statement that needs to be attached to your return showing the carryforward amount. Partners will need this information for their own records, and it's required under the regulations. The statement should clearly identify the disallowed amount and its source (the lower-tier partnership). From a practical standpoint in Lacerte, I usually create the M-1 adjustment with a description like "163(j) disallowed interest from [Partnership Name] - see Form 8990" to make it clear for review purposes.

This is exactly the kind of complex tiered partnership issue that trips up so many practitioners! I've been dealing with 163(j) limitations for several years now, and the approach you're considering is spot-on. When the lower-tier partnership isn't subject to 163(j) but your partnership is, you're essentially "catching" the limitation at your level. The interest expense is already baked into the ordinary income number on the K-1, so making an M-1 adjustment to increase ordinary income by the disallowed amount is the correct treatment. A couple of practical tips from my experience: 1. Make sure to document the calculation clearly - show how you derived the disallowed amount from Form 8990 2. Consider creating a separate workpaper that reconciles the K-1 ordinary income to your adjusted amount 3. Don't forget that this creates a 163(j) carryforward that needs to be tracked and disclosed to your partners The mechanics can be tricky in software, but once you get the process down, it becomes much more manageable. Just remember that you're not actually changing what the lower-tier partnership reported - you're properly applying the limitation at your partnership level where it applies.

I've been working through similar tiered partnership 163(j) issues and wanted to share what I've learned from experience. The M-1 adjustment approach everyone is discussing is definitely correct, but I'd recommend a few additional steps to make sure you're bulletproof on this: First, create a detailed supporting schedule that shows the flow-through from the lower-tier partnership. Start with the K-1 ordinary income as reported, then show the embedded interest expense (from the footnote), your Form 8990 calculation, and finally the disallowed amount. This creates a clear audit trail. Second, make sure your partnership agreement addresses how these disallowed amounts are allocated among partners. Sometimes the standard profit/loss percentages don't apply to these tax attributes, and you want to be clear about the allocation method. Finally, consider sending a brief explanatory memo to your partners along with their K-1s. Most partners don't understand these complex calculations, and explaining that there's a disallowed interest carryforward that may benefit them in future years helps with client relations and reduces confusion. The good news is that once you set up the process correctly, it becomes much easier to handle in subsequent years. Just make sure you're carrying forward the prior year disallowed amounts correctly when you prepare next year's Form 8990.

I've been following this discussion and wanted to add a perspective from someone who's handled quite a few of these tiered partnership 163(j) situations. You're absolutely correct in your approach - the M-1 adjustment is the way to go. One thing I'd emphasize is the importance of timing in these calculations. Make sure you're applying the 163(j) limitation based on your partnership's adjusted taxable income for the current year, not the lower-tier partnership's limitation calculation. Since they weren't subject to 163(j), their entire $270K interest expense was properly deducted in computing their ordinary income that flowed through to you. Your Form 8990 should treat that $270K as current year business interest expense (line 1) along with the corresponding adjusted taxable income from the footnote (line 13). If line 31 shows zero deductible amount, then yes, you need to add back the full $270K through an M-1 adjustment to effectively "undo" the interest deduction that's embedded in the K-1 ordinary income. One practical tip: In Lacerte, I usually enter this as an "Other Addition" on the M-1 with a clear description like "Section 163(j) disallowed interest expense from [Partnership Name] K-1 - see attached Form 8990." This makes it crystal clear during review what's happening and why the adjustment exists. Don't forget to prepare the required disclosure statement for your partners showing their allocable share of the disallowed interest carryforward. They'll need this for their own tax planning and basis calculations.