The phantom income provision under sec. 55(d) (3).

• Author: D'Anna, Donald B., Jr.

The Technical and Miscellaneous Revenue Act of 1988 (TAMRA) modified Sec. 55(d)(3) to prevent an incentive for married taxpayers subject to the alternative minimum tax (AMT) to file separate returns. However, the provision has been improperly designed and should be changed. Sec. 55(d)(3) requires cetain married taxpayers who file separately (MFS taxpayers) to recognize phantom income when they never received any prior benefit. Taxpayers who choose to file separately for personal or business reasons may end up penalized by Sec. 55(d)(3). Further, not all taxpayers have the option to avoid this penalty; married nonresident alien taxpayers do not have the option to file jointly and are penalized involuntarily.

The congressional intent of the TAMRA was that the combined AMT exemption phaseout for MFS taxpayers should be the same as for married taxpayers filing jointly. Congress attempted to accomplish this goal by modifying Sec. 55(d)(3). This revised provision requires high-income MFS taxpayers to add an amount equal to their exemption to AMT income. Specifically, for 1995 tax years, Sec. 55(d)(3) states that MFS taxpayers must increase their taxable income by the lesser of 25% of the excess of alternative minimum taxable income (AMTI) over $165,000, or $22,500 (MFS penalty). While this measure was intended to equate the tax liabilities of MFS and joint taxpayers, the provision actually created inequities. Sec. 55(d)(3) carries out the intent of Congress only in very isolated fact patterns.

Under pre-TAMRA law, married taxpayers subject to AMT could reduce their tax liability by filing separate returns. If one spouse earned most of the couple's income, filing separately would reduce the couple's AMT exemption phaseout by 50%. Effectively, filing separately allowed one spouse to receive an AMT exemption that otherwise would have been phased out on a joint return. The TAMRA corrected this problem by requiring high-income taxpayers to add back an amount equal to the MFS exemption, thus equating MFS and joint tax liabilities. However, the provision was crudely drafted and creates inequities for high-income taxpayers. For example, if both spouses' AMTI exceeds the thresholds of Sec. 55(d)(3), the couple is forced to recognize additional income for which they received no benefit. Example 1 above depicts the inequities inherent in the MFS penalty.

Example 1: Married Filing Separately Versus Filing Jointly

A married couple, H and W, is subject to the...