Interaction of the AMT and S Corporation basis rules.

• Author: Walsh, Kevin J.
• Position: Part 1 - Alternative minimum tax

EXECUTIVE SUMMARY

* Depreciation is the most common AMT adjustment that results in a different basis for regular and AMT purposes.

* When S stock is purchased, the reversal of timing differences in assets Or attributes affect the new owner.

* Debt basis frequently varies for regular and AMY purposes.

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This article addresses the interaction between S corporations and the alternative minimum tax (AMT). S corporations are a popular form of business entity, as government statistics show. (1) The AMT affects an ever-increasing number of taxpayers. The growth rate in the number of S corporations and AMT taxpayers requires tax advisers to be aware of the many different situations in which the intersection will produce unanticipated results. Some of these scenarios are good for taxpayers, but some are not; in certain cases, there is no guidance and the adviser must try to determine the appropriate direction for clients. (2)

The discussion focuses primarily on how the AMT rules affect basis of stock and debt in S corporations, in the following areas:

* Timing differences leading to differing basis;

* Acquisition of S stock;

* Debt basis;

* Ordering rules;

* Gift and estate transactions;

* Compensation-related transactions;

* C-to-S conversions;

* Distributions; and

* Suspended carryovers.

Part I, below, covers the first three issues. The remaining items will be covered in Part II, in the February 2007 issue.

Basis

As the experienced tax adviser is well aware, basis limits the deduction of losses flowing from S corporations. Shareholder debt to the corporation can be used as additional basis for loss deductions, once stock basis is exhausted. Because losses for regular tax and AMT purposes can differ, stock basis and subsequent use of debt basis will differ for regular tax and AMT purposes as well. Finally, under Sec. 1368(b)(1), distributions from an S corporation with respect to stock (other than from accumulated earnings and profits) are tax free to the extent of basis. Thus, when basis differs for regular tax and AMT purposes, the taxation of distributions in excess of basis will vary between the two systems. Lack of attention to AMT basis schedules can result in taxpayers overpaying AMT.

Basis limits are also important in applying other Code provisions and limits. The Sec. 465 at-risk rules and Sec. 469 passive loss rules apply only to amounts allowed after application of the basis limits. (3) If the basis rules are not properly applied, errors in basis calculations will extend to the application of the at-risk and passive loss rules as well.

Under Sec. 59(h), taxpayers need to keep track of their basis in S stock separately for regular tax and AMT purposes:

The limitations of sections 704(d), 465, and 1366(d) (and such other provisions as may be specified in regulations) shall be applied for purposes of computing the alternative minimum taxable income of the taxpayer for the taxable year with the adjustments of sections 56, 57, and 58.

Because Sec. 1366(d) limits S losses to stock and debt basis and Secs. 56-58 deal with AMT adjustments, preferences and loss limits, Sec. 1366(d)'s limits on losses to stock and debt basis apply for both regular tax and AMT purposes.

Parallel Systems

Under Regs. Sec. 1.55-1(a), noncorporate taxpayers must apply all of the rules applicable to regular tax to the AMT arena:

General rule for computing alternative minimum taxable income. Except as otherwise provided by statute, regulations, or other published guidance issued by the Commissioner, all Internal Revenue Code provisions that apply in determining the regular taxable income of a taxpayer also apply in determining the alternative minimum taxable income of the taxpayer.

Allen (4) and Ventas (5) demonstrate why tax advisers must be careful in construing how tax rules apply for regular tax and AMT purposes. These cases dealt with a jobs credit provision that reduced the wage deduction by the credit amount. Because the credit was not allowed for AMT purposes, the taxpayers sought to return the wage deduction to the full amount for AMT purposes, arguing that a parallel system would allow for this result. However, the courts disagreed, indicating that unless an exception was provided, a regular tax inclusion or deduction applied equally for AMT purposes.

Timing Differences

The Sec. 56 AMT adjustments are the source of differing basis for regular tax and AMT purposes. The most frequently encountered is the depreciation adjustment, because depreciation is common to so many business enterprises. The different calculations of depreciation expense required under the regular tax and AMT systems will result in differing basis of an asset for regular tax and AMT purposes. (6) Coupled with the flowthrough nature of S corporations, this adjustment is the single biggest reason for S stock having a basis different for regular tax and AMT purposes.

Example 1: S corporation A is capitalized with $1 million and uses that money to purchase and place in use an asset. For the first year

of operation, this asset will be depreciated $200,000 for regular tax purposes, but only $150,000 for AMT purposes. (7) This difference in depreciation will produce a $50,000 AMT adjustment flowthrough to A's shareholders. If A's net loss for the year equals the depreciation, the stock basis will be $800,000 for regular tax purposes and $850,000 for AMT purposes.

Other adjustments are more industry-specific. Sec. 59 contains special sections for mining expenses, construction-contract accounting, circulation expenses and research and development (R&D) expenses. Tax advisers with clients in these industries should be aware of the varying effects on regular and AMT basis.

Circulation Expenditures

Sec. 173(a) allows an expense deduction for circulation expenditures. Sec. 56(b)(2) provides an AMT adjustment for the difference between the amount expensed and the deduction available under three-year amortization. Sec. 173 does not allow an election at the corporate level to capitalize and amortize such expenses over a longer period. Sec. 173(b) permits the capitalization and amortization allowed under Sec. 59(e).This would appear to be granted only at the shareholder level, not...