Dividends and the ACE adjustment: how to maximize the after-tax return on intercompany investments.

• Author: Gramlich, Jeffrey D.
• Position: Adjusted current earnings

The tax consequences of dividends have a significant impact on corporate finance and investment decisions. Both dividends received and dividends paid can affect the alternative minimum tax (AMT) adjustment for adjusted current earnings (ACE) and, thus, the amount of tax due. This article will explain how dividends affect the ACE adjustment; provide planning suggestions for minimizing the after-tax cost of corporate capital and maximizing the after-tax return on intercompany investments; and discuss whether a Sec. 1059 reduction in stock basis is necessary for ACE purposes.

The ACE Adjustment and the AMT Credit

The ACE adjustment is one component of the corporate AMT calculation. The ACE adjustment modifies AMT income by 75% of the sum of the Sec. 56(g)(4) components.(1) For this purpose, AMT income is taxable income modified by all the preferences and adjustments in Secs. 56, 57 and 58, other than the ACE adjustment and the alternative tax net operating loss (NOL) deduction. In March 1991, the Treasury issued regulations to clarify the ACE adjustment, including the treatment of dividends for ACE purposes. Note that a negative ACE adjustment is allowed to reduce AMT income to the extent that previous unrecovered positive ACE adjustments have increased AMT income.(2)

The AMT's cost is reduced by the present value of the AMT credit, which is generated when AMT is paid. The AMT credit can be carried forward and used to offset a firm's future regular tax liability to the extent that the regular tax exceeds the tentative minimum tax (TMT). The examples in this article assume that corporations face a 35% regular tax rate and a 20% AMT rate, but the AMT's cost varies depending on the cost of capital and the length of time until the AMT credit is used. Each firm's tax situation. is unique and should be treated as an individual case. However, a recent Treasury study indicates that only 22% of the AMT credits generated by corporations between 1987 and 1989 were recovered by the end of 1990.(3)

Deductions Disallowed for E&P That Are Also Disallowed for ACE Purposes

One component of the ACE adjustment is an umbrella provision that disallows deductions that are not permitted in determining earnings and profits (E&P).(4) Dividends received deductions (DRDs) reduce regular taxable income but do not reduce E&P and so are generally not allowed for ACE purposes.(5) However, certain 80% and 100% DRDs are allowed for ACE purposes (these exceptions will be discussed later).

Certain dividends paid reduce both taxable income and E&P, and are therefore deductible for ACE purposes. Examples include dividends paid on deposits by thrift institutions, to life insurance policyholders and by agricultural cooperatives that are not related to stock.(6) Other dividends paid reduce taxable income but not E&P and therefore are not deductible for ACE purposes (planning for these dividends will be discussed later).

* Returns from less-than-20%-owned stock investments

A corporation that owns less than 20% of either the voting power or the value of a dividend-paying corporation receives a 70% DRD for regular tax purposes.(7) Seventy percent DRDs always follow the general rule and are never allowed for ACE purposes.(8) Example 1 considers the cost of the disallowed DRD if the investor firm is subject to the AMT and receives a dividend from a less-than-20%-owned-corporation.

Example 1: A Corp. receives $6,000 of cash dividends from its $100,000 investment in 2% of the outstanding common stock of B Co. If A is in a regular tax position, it benefits from a 70% DRD and only 30% of the dividends received, $1,800, is included in taxable income. Applying a 35% regular tax rate, the tax is $630, and the after-tax return is $5,370 ($6,000 -- $630).

If A is subject to the AMT, 75% of the 70% DRD, $3,150 (0.75 x (0.7 x $6,000)), is included in AMT income in addition to the $1,800 of regular taxable income. Thus, the investment produces $4,950 of AMT income ($1,800 + $3,150), which is taxed at a 20% rate, producing a marginal tax of $990 ($4,950 x 0.2). Under the AMT, the dividends from B stock produce only $5,010 of immediate after-tax income. Note, however, that the $360 excess of TMT over regular tax ($990 -- $630) can be used as an AMT credit in future years.

Example 1 shows the computation of two marginal tax rates on dividend income from an investment representing less than 20% ownership. The firm receiving the dividend is subject to a 10.5% marginal tax rate if it pays only the regular tax. if the recipient firm pays the AMT, however, the immediate marginal tax rate becomes 16.5%, an increase of more than 57% over the marginal regular tax rate.

Planning suggestion: Corporations subject to the AMT should consider alternatives other than casual investments (less-than-20% shareholdings) in dividend-paying stocks.

Example 2 illustrates that, under certain circumstances, a corporation subject to the AMT can maximize its after-tax return by investing in fully taxable bonds rather than in dividend-paying stocks.

Example 2: As an alternative to the investment in B Co. described in Example 1, A Corp. could have invested $100,000 in 8% 0 Corp. bonds. If A is subject to the maximum regular corporate tax rate, the 0 bonds yield $5,200 after tax ($100,000 x 0.08 x (1 -- 0.35)). However, if A is subject to the AMT, the 0 bonds yield $6,400 ($100,000 x 0.08 x (1 -- 0.2)). Note that the present value of the reduced AMT credit, $1,200 ($100,000 x 0.08 x (0.35 -- 0.20)), reduces the after-tax return from the 0 bonds from $6,400 to $5,200 as the length of time until the AMT credit is used becomes shorter.

This example shows that higher-rate fully taxable bonds become more attractive investments, relative to lower-rate dividend-paying stocks, as the length of time until the AMT credit is used increases.

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