Sec. 58(c) (1) creates potential future AMT from PAL carryforwards.

• Author: Brooks, Marlene
• Position: Alternative minimum tax, passive activity loss

Due to the current economic climate, taxpayers and practitioners are becoming more adept in dealing with the tax aspects of discharge of indebtedness (DOI) income for insolvent or bankrupt taxpayers under Sec. 108. However, often overlooked is Sec. 58(c)(1), which deals with insolvent taxpayers and the alternative minimum tax (AMT) treatment of their passive activity loss (PAL) carryforwards.

The PAL rules for AMT purposes are generally the same as for regular tax purposes. Two major differences are addressed in Sec. 58(b). Sec. 58(b)(1) requires minimum tax rules to be used for measuring and allowing income and deductions in applying any limitations for passive activities. Also, Sec. 58(b)(2) disallows the phase-in rules of Sec. 469(m) for AMT purposes. The other main difference, described under Sec. 58(c)(1), applies only to insolvent taxpayers. Insolvent taxpayers' disallowed passive losses must be reduced by the amount the taxpayer is insolvent. In other words, PALS must be included for AMT purposes without any Sec. 469(m) limitations to the extent the taxpayer is insolvent, essentially converting PALs to active losses for purposes of calculating AMT in the year of insolvency. There are no regulations explaining this provision, nor is there any indication from the committee reports as to the intent behind it.

It appears that Sec. 58(c) was intended to provide tax relief to the insolvent taxpayer under the AMT system. However, by allowing the insolvent taxpayer to take PALs for AMT purposes to the extent of insolvency, Sec. 58(c)(1) may actually increase an individual's alternative minimum taxable income (AMTI).

Example 1: An insolvent taxpayer, T, files a joint return with 1989 regular taxable income of $50,000 and PALs of $300,000. Under Sec. 58(b)(2), T has an AMT adjustment of $60,000 for the phase-in allowed for regular tax purposes under Sec. 469(m). Without the relief allowed under Sec. 58(c), T would pay AMT of $4,723. If T is insolvent in excess of $300,000, the application of Sec. 58(c) reduces his AMTI to zero, therefore eliminating the $4,723 AMT.

Because the allowance of PALs is a timing difference between regular tax and AMT, the application of Sec. 58(c)(1) can cause the opposite effect (i.e., increasing an individual's AMTI) in future years.

Example 2: Assume the same regular taxable income and passive losses as in Example 1, with two differences: (1) T has a net operating loss (NOL) carryover of $125,000 for both regular...