Avoiding penalties for failure to pay AMT: computation's complexity may abate penalties for individuals.

• Author: Rook, Lance W.
• Position: Alternative minimum tax

In recent years, Congress has made several changes to the version of the alternative minimum tax (AMT) regime it enacted in the Tax Reform Act of 1986 (TRA).(1) The most recent changes, in the Revenue Reconciliation Act of 1993 (RRA), reduced the applicability of the corporate AMT ;primarily through changes to the depreciation computation for adjusted current earnings purposes), while increasing individuals' exposure to AMT. Under Sec. 55(b)(1)(A)(i), effective for tax years beginning after 1992, a 26% rate applies to the first $175,000 ($87,500, if married filing separately) of AMT income (after the AMT exemption); the balance is taxed at 28%. Sec. 55(d)(1) exempts the first $45,000 of AMT income in the case of a joint return or surviving spouse ($33,750 for a single taxpayer, $22,500 if married filing separately).

The increase in the AMT rate does not necessarily mean that more individuals are subject to the AMT. Because the regular tax rates were also increased by the RRA, regular tax will typically exceed tentative minimum tax (TMT).

The problem, however, is the 28% maximum capital gains rate, which equals the top individual AMT rate. When the Sec. 55(d)(3) exemption phaseout applies, a taxpayer's effective AMT rate can equal 35%, which significantly exceeds the top capital gains rate. For married taxpayers filing jointly land surviving spouses), the phaseout of the exemption results in an effective marginal AMT rate that exceeds 28% when AMT income falls between $150,000 and $330,000 2 The AMT exemption is reduced by $ 1 for every $4 by which the taxpayer's AMT income exceeds the lower figure of the range.

Example: H and W file a joint return; they have $230,000 of AMT income. Their AMT exemption is $25,000, computed as follows: AMT income $230,000 Less: Starting

phaseout amount (150,000) AMT income in excess

of starting phaseout

amount 80,000 Phaseout percentage 25% Exemption phased out 20,000

AMT income 230,000 Exemption

($45,000 - $20,000) 25,000 AMT income 205,000 AMT

$53,900(*) (*) 0.26 1$175,000) + 0.28 ($30,000).

Because of the exemption phaseout, H and W's effective marginal tax rate is 125% of the 28% rate, or 35%. If H and W have an additional $100,000 of capital gain, it will increase their regular tax liability by $28,000 (28% x $100,000), while increasing their TMT by $35,000 135% x $100,000) to $88,900.(3) The net effect is that the capital gain increases the taxpayers' likelihood of being subject to the AMT.

This result would change if the $100,000 was ordinary income, such as a compensation bonus. The ordinary income would be taxed, for regular tax purposes, at a marginal rate in excess of the 35% effective marginal AMT rate. Thus, the additional income would not increase H and W's chances of being subject to AMT.

The AMT remains a levy that few individuals think about. Since more individuals are subject to AMT following the RRA, there will probably be more instances of AMT noncompliance by individuals.

If the IRS determines that a taxpayer owed AMT, but neglected to compute and pay it, the Service will expect the taxpayer to pay the AMT due, and perhaps penalties as well. The individual taxpayer's prospects for avoiding such penalties is the focus of this article.(4) The courts have shown some sympathy for taxpayers who try to cope with the AMT's complications; to some extent, taxpayers have been helped by the Service's own difficulties with the AMT. The courts have sympathized with taxpayers trying to deal with a tax that the IRS sometimes has forgotten to apply(5) or has incorrectly computed.(6)

Typical Penalties in AMT Cases

Sec. 66621a) and 1b1 authorize the Service to impose a 20% penalty on a tax underpayment attributable to one or more of five specified transgressions, one of which is negligence or disregard of rules or regulations. Sec. 66621C) defines "negligence" as including any failure to make a reasonable attempt to comply with the provisions of the Code, and "disregard" as including any careless, reckless or intentional disregard. Regs. Sec. 1.6662-3(b)(1) is a bit more expansive, indicating that negligence includes the failure to exercise ordinary and reasonable care in the preparation of a tax return; under Regs. Sec. 1.6662-3(b)(2), a disregard of rules or regulations is "careless" if the taxpayer does not exercise reasonable diligence to determine the correctness of a return position contrary to the rule or regulation. A disregard is "reckless" if the taxpayer makes little or no effort to determine whether a rule or regulation exists, under circumstances that demonstrate a substantial deviation from the standard of conduct that a reasonable person would observe. A disregard is "intentional" if the taxpayer knows of the rule or regulation disregarded. The IRS routinely asserts the Sec. 6662(b)(1) negligence/disregard penalty when the taxpayer has neglected to compute and pay AMT.

Under Sec. 6662(b)(2), a second ground for penalty is the substantial understatement of income tax. For individuals, an understatement is...