Interaction of the AMT and S corporation basis rules: this two-part article examines how the alternative minimum tax affects S corporation basis. Part II covers ordering rules, gift and estate transactions, compensation, C-to-S conversions, distributions, carryovers and other issues and planning considerations.

• Author: Walsh, Kevin J.
• Position: Part 2 - Alternative minimum tax

EXECUTIVE SUMMARY

* In many situations, a significant difference can occur between S corporation income and loss for regular tax and AMT purposes.

* AMT adjustments can change profits to losses, and vice versa.

* Well-maintained basis schedules help to identify clients with significant basis differences under the regular tax and AMT.

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This article addresses the interaction between S corporations and the alternative minimum tax (AMT). Part I, in the January 2007 issue, analyzed timing differences, acquisition of S stock and changes in debt basis. Part II, below, discusses the effect of the AMT on ordering rules, gift and estate transactions, compensation-related transactions, C-to-S conversions, distributions and suspended carryovers.

Ordering Rules

Basis adjustments must be made in the order prescribed in the Code and regulations. The differing treatment of items for regular tax and AMT purposes interacts with the basis-ordering rules to produce some interesting situations.

Under Sec. 1368(d)(1) and Regs. Sec. 1.1368-1(e)(2), basis is first adjusted by all income items passed through to the shareholder, whether separately stated or not. The second adjustment to basis is for any distributions made during the year. Distributions cannot reduce basis below zero. Any basis that remains after the reduction for distributions, losses and deductions (whether or not separately stated) can then be taken into account. If deductions or losses exceed basis, basis is reduced to zero; the excess deductions or losses are treated as having been incurred in the succeeding year, under Sec. 1366(d)(2).

As usual, when the AMT enters the picture, the thinking becomes counterintuitive. AMT adjustments can change profits to losses and losses to profits and, thus, change the effect of distributions when regular tax basis is insufficient to cover them.

Example 1: A is the sole shareholder in an S corporation. She has a stock basis of $90,000 for regular tax purposes and $95,000 for AMT purposes. She has a $25,000 nonseparately stated loss for regular tax purposes and a $4,000 Sec. 1231 gain. A took a $100,000 distribution from the corporation during the year. She has an AMT adjustment of $40,000 (for depreciation) and a negative $15,000 AMT adjustment related to the Sec. 1231 gain.

A does not have sufficient regular tax basis to cover the distribution and must report the $6,000 excess as capital gain under Sec. 1368(b)(2).The $25,000 nonseparately stated loss is carried over for regular tax purposes as a loss suspended due to lack of basis, but this is not the case for AMT purposes. For AMT purposes, the $25,000 nonseparately stated loss was adjusted upward by the $40,000 depreciation adjustment, to become $15,000 nonseparately stated income. Because this is a profit instead of a loss, it is added to AMT basis before taking into account distributions. As a result of this shift, A now has sufficient basis, for AMT purposes only, to absorb the entire $100,000 distribution. Because A has adequate AMT basis to cover the distribution, the $6,000 capital gain is reported only for regular tax purposes. For AMT purposes, a negative $6,000 adjustment needs to be made to taxable income to arrive at alternative minimum taxable income (AMTI).

The separately stated $4,000 gain for regular tax purposes was adjusted downward by the $15,000 AMT adjustment to become an $11,000 separately stated loss for AMT purposes. Due to the ordering rules, this is taken into account after the distribution has been given effect. After the distribution has reduced basis for AMT purposes, there is insufficient basis to fully deduct the separately stated loss. The $1,000 excess of loss over basis will be carried over for AMT, but not for regular tax, purposes.

It is not always as easy, in practice, to match AMT adjustments with the separately stated income or loss items. For example, the depreciation adjustment may relate to several different S corporation activities that are required to be separately stated. If an S corporation has an active trade or business and also has a separately stated item of income or loss (such as rental real estate reported as a passive activity), the AMT adjustment attributable to each activity could change the activity's net profit to a loss or vice versa. As shown in the exhibit on p. 100, this can change the order in which the activity is taken into account when determining the treatment of distributions. Sec. 1366(b) and Regs. Sec. 1.1366-1 require that an S corporation must report separately stated items. Regs. Sec. 1.55-1 requires these hales to be applied in making AMT computations. Yet, the Sec. 56(a) (1) depreciation adjustment will typically be reported as a single number on Form K-1, Shareholder's Share of Income, Deductions, Credits, etc. Additional information could change the outcome in a situation similar to Example 1; tax advisers should consider requesting additional information when necessary.

Gift and Estate Transactions

S corporations are often used for family businesses. It is not uncommon for the senior generation of a family to consult its tax practitioner about gifting stock in the family corporation. Consequently, tax advisers should be aware of some of the odd situations to be encountered in gift transactions of S stock, when the stock has a different basis for regular tax and AMT purposes. Gifts may result in different stock basis for regular tax and AMT purposes when basis is limited to lower of fair market value (FMV) or basis, and FMV lies above either regular or AMT basis or between the basis for regular tax and AMT purposes. (12)

Sec. 1015 and Regs. Sec. 1.1015-1 provide that the transferee assumes the transferor's basis in gifted property, unless the basis exceeds the property's FMV at the time of the transfer. For purposes of determining a loss, FMV is used as basis if it is less than the transferor's basis. The regulation gives an example (13) of property with a $100,000 basis and $90,000 FMV at the time of the gift. The basis for gain purposes is $100,000, while the basis for loss purposes is $90,000. The example indicates that, if the property is sold for $95,000, there is neither gain nor loss.

It is unclear how broadly the word "loss," as used in Sec. 1015, should be construed. Does it only apply to sale transactions, or would it apply as a lower limit on pass through losses and distributions? It would appear that it encompasses both losses by sale and operational losses passed through. There is no specific guidance on this point; the practitioner must apply his or her own judgment.

Is the $10,000 differential in Example 1 a permanent difference? Lack of any language indicating that the difference is temporary would seem to indicate that it is permanent. For example, assume the property in the regulation's example is 100% of the S corporation's stock; the corporation reports $10,000 income per year for five years ($50,000 total) and a $150,000 loss in year six, after the gift. Does the shareholder--donee deduct $150,000 ($100,000 donor basis + $50,000 income reported) in year six, or only $140,000 ($90,000 loss limit + $50,000 income reported)? It would appear that the lower limit would apply, with the excess loss being carried forward under Sec. 1366(d). Under this assumption, anyone preparing basis schedules for a client in this situation should...