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.

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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.