Navigating the Changing Rules for Section 266: Strategic Tax Planning for M&D Companies

The One Big Beautiful Bill Act (OBBBA) introduces significant tax reforms that will reshape the landscape for Manufacturing and Distribution (M&D) companies. Key provisions include 100% bonus depreciation, immediate expensing of domestic R&D costs, and relaxed limitations on interest deductibility under IRC Sec. 163(j). However, the bill also adds a new restriction in how IRC Sec. 266 interacts with the business interest limitation under IRC Sec. 163(j).  

Key Takeaways  

• Old Law (through 2025): Companies could elect to capitalize interest under IRC Sec. 266, thereby avoiding the IRC Sec. 163(j) business income expenses deduction limitation, with deductions recovered through depreciation or cost of goods sold. 
• New Law (beginning in 2026): The limitation under IRC Sec. 163(j) applies first, and only after that can taxpayers capitalize interest under IRC Sec. 266, eliminating the ability to use Sec. 266 to bypass the limitation.  

What Changed Under the OBBBA? 

Under the previous version of the tax code, taxpayers could elect to capitalize interest under IRC Sec. 266. This election effectively allowed the capitalized interest to circumvent the IRC Sec. 163(j) limitation, since it would later be recovered through depreciation or cost of goods sold.  

Beginning with taxable years starting after December 31, 2025, the order of operations changes.  IRC Sec. 163(j) will now apply first, and only then may taxpayers elect to capitalize interest under IRC Sec. 266. This means elective capitalization will no longer offer a pathway to bypass the interest deduction limitation. While IRC Sec. 266 remains available, its strategic value in managing interest expense is significantly reduced.  

Overview of IRC Sec. 266 

IRC Sec. 266 has allowed taxpayers to elect to capitalize all or some carrying charges; deferring their deduction and instead treating them as part of an asset’s basis. This approach enables recovery of these costs over time rather than in the year incurred. Carrying charges typically arise during the development of real property, such as buildings and facilities, or during the acquisition and installation of personal property like inventory as well as machinery and equipment.  

Examples of carrying costs include: 

• Property taxes 
• Interest expense 
• Insurance and maintenance costs 

 It is important to distinguish IRC Sec. 266 from IRC Sec. 263A, which requires the capitalization of direct, indirect, and overhead costs related to production or resale activities into inventory. Interest expense is one of the most significant costs that can be capitalized under IRC Sec. 266. Its interaction with the business interest limitation rules under IRC Sec. 163(j) has been especially relevant for companies using this strategy.  

How IRC Sec. 266 and IRC Sec. 163(j) Work Together 

IRC Sec. 266 has long provided M&D companies with flexibility in managing taxable income. This has been particularly useful for deferring deductions and navigating the limitations imposed by IRC Sec. 163(j),as introduced by the Tax Cuts and Jobs Act. Under this rule, business interest expense was limited to 30 percent of Earnings Before Interest and Taxes (EBIT), or adjusted taxable income (ATI). Accordingly, capitalizing interest into personal property assets has been a great strategy to avoid the 30 percent limitation and to obtain the benefits through increased depreciation and cost of goods sold. 

The OBBBA modifies this limitation by reverting it to 30 percent of EBITDA, which includes depreciation and amortization. This change, effective for tax years beginning after December 31, 2024, expands ATI and allows companies to deduct more interest expense. 

The result of this change is that the benefits of IRC Sec. 266 are reduced. However, Section 266 remains available through 2025, and the inclusion of depreciation and amortization in ATI, combined with the revival of 100% bonus depreciation and catch-up amortization of previously capitalized IRC Sec. 174 costs, presents a unique opportunity to optimize taxable income before the ordering rules under IRC Sec. 163(j) change.  

What M&D Companies Should Do Now 

With the reduced strategic value of IRC Sec. 266 for taxable years beginning after 2025, proactive tax planning is critical. M&D companies should:  

• Model the impact: Forecast how the new ordering rules will affect taxable income and cash taxes. 
• Coordinate cost segregation and bonus depreciation: Accelerated depreciation can increase ATI, supporting greater interest deductions under the revised IRC Sec. 163(j) rules. 
• Leverage Sec. 174 amortization: Catch-up amortization of Research and Development under IRC Sec 174A costs may also enhance ATI and improve interest deductibility.  

With the tax law changes under the OBBBA, taxpayers have a limited time to take advantage of IRC Sec. 266. Contact us below to learn how we can assist.