Tax Matters

Taxpayer Precluded From Itemizing Deductions for AMT
Congress enacted the alternative minimum tax (AMT) provisions found in IRC sections 55 to 59 to establish a floor so individuals would pay some tax regardless of the exclusions, deductions and credits otherwise available to them under the regular income tax statutes. The AMT provisions accomplish this goal by eliminating the favorable treatment the regular income tax gives to certain items. The AMT applies only if, and to the extent that, the “tentative minimum tax” exceeds the taxpayer’s “regular tax.”

An election to claim the standard deduction or to itemize deductions is binding for both regular taxable income and alternative minimum taxable income (AMTI). CPAs can help taxpayers weigh the benefit associated with either option by doing parallel tax computations. Once a taxpayer elects to itemize or claim the standard deduction for regular tax purposes, he or she must make section 56(b) adjustments that directly correspond to the deduction(s) claimed for that purpose. The limitation on itemized deductions under section 68 does not apply when computing AMTI. However, to apply the AMT adjustment, the taxpayer must have itemized deductions for regular tax purposes and had them reduced by section 68.

During 1999 Marx was employed by Sun Microsystems Inc. as a programmer. On his timely filed 1999 form 1040, Marx reported more than $1 million in income. Since his adjusted gross income exceeded $126,000, the phaseout amount under section 68, he was required to significantly reduce his otherwise allowable itemized deductions. Marx took the standard deduction for a single individual in lieu of electing the lesser and more limited itemized deductions. Because he claimed the standard deduction, he did not have to file schedule A. However, Marx filed a blank schedule A with his tax return reporting absolutely no information or deductions. He also did not report any AMT on his 1999 return, nor did he include Form 6251, Alternative Minimum Tax—Individuals.

The IRS informed Marx he needed to file form 6251 so it could process his return. Marx completed and filed the form in accordance with a narrow interpretation of section 56 adjustment provisions. In computing his AMT, Marx

Increased AMTI for state and local income taxes paid.

Increased AMTI for tax-exempt interest from private activity bonds.

Decreased AMTI for the amount that would have been allowed as itemized deductions if not for the section 68 limitation.

Marx did not adjust his AMTI for the standard deduction he actually took to compute his regular tax. As a result, he determined he owed no AMT for 1999.

The IRS disallowed Marx’s AMTI adjustments for the itemized deductions he did not use in computing his regular taxable income. With the exception of the standard deduction claimed on form 1040, the IRS ignored all other adjustments and said Marx was subject to the AMT for 1999.

Marx did not dispute that he was subject to the AMT but argued he had no AMT liability. He asserted that, even though he elected to claim the standard deduction for regular tax purposes, he was entitled to use the full value of his itemized deductions when computing the AMT because section 56(b)(1)(F) provides that the section 68 overall limitation on itemized deductions does not apply when determining AMTI.

Result. For the IRS. The court disagreed with Marx’s narrow interpretation of the code. The court said when read as a whole, section 56(b) requires taxpayers to make adjustments for AMT purposes in a manner consistent with decisions they make for regular tax purposes. Taxpayers who claim the standard deduction for regular tax purposes are required to adjust for the standard deduction amount in arriving at AMTI. Further, the court said the code simply does not allow a taxpayer to pick and choose which section 56(b) adjustments apply in an attempt to get favorable AMT treatment. Because Marx claimed the standard deduction in computing taxable income for regular tax purposes, he must use that amount when determining AMTI.

Marx v. Commissioner, TC Summary Opinion 2003-23.

SCIN Between Family Members Is Bona Fide Transaction
A self-canceling installment note (SCIN) is a debt obligation that by its terms is extinguished at the death of the seller-creditor, with the remaining note balance canceled automatically. The advantage of a SCIN over an ordinary installment note is that, if the seller dies before the debt is paid, the remaining value of the installments is not included in his or her estate. Although a SCIN between family members is presumed to be a gift rather than a bona fide transaction, the Sixth Circuit Court of Appeals recently overturned a Tax Court ruling, indicating a taxpayer may rebut this presumption by showing that at the time of the transaction he or she had a real expectation of repayment and intended to enforce collection of the indebtedness.

Duilio Costanza owned two parcels of real estate in Flint, Michigan. On one, he operated an Italian restaurant. He built a small office plaza on the other. Together, the two properties were appraised in 1991 at $830,000. In 1992 Duilio decided to retire to his native Italy. After seeking advice from his attorney, he sold the properties to his son Michael in exchange for an $830,000 SCIN. The note, fully secured by a mortgage on the properties, provided for monthly installments over 11 years.

At his father’s request, Michael remitted the payments quarterly to ease the burden of Duilio’s having to make a monthly trip to the bank. Michael made the first quarterly payment by issuing three checks on March 8, 1993. He altered the dates on the checks to indicate they were written on January 1, February 2, and March 1, 1993.

Duilio, who had suffered from heart disease during the final 15 years of his life, died unexpectedly on May 12, 1993, due to complications from surgery. As his father’s executor, Michael filed a federal estate tax return declaring the estate had no tax liability. The return identified the SCIN as an asset of the estate but claimed the note had no value due to the cancelation-upon-death provision.

The IRS issued a deficiency notice that proposed an increase in Duilio’s gross estate because the sale was not a bona fide transaction or, alternatively, the transaction was a “bargain sale” that would increase the estate’s adjusted taxable gifts. Following a trial, the Tax Court concluded the sale was in fact not a bona fide transaction. The court questioned the parties’ sincerity, expressing concerns about the actual date the documents were signed, the date Michael made the three payments and the fact he had altered the dates on the checks. Consequently, the Tax Court held that the SCIN provided no consideration for the properties and that their full value, less the three payments Michael made, was a taxable gift from Duilio to Michael and thus includible in the father’s gross estate.

Michael appealed, contending the Tax Court erred in finding the SCIN transaction was not bona fide.

Result. For the taxpayer. The Sixth Circuit reversed the Tax Court and held that the SCIN was bona fide. According to the court, Michael effectively rebutted the presumption against the enforceability of an intrafamily SCIN by affirmatively showing a real expectation of repayment existed at the time of the transaction and the deceased’s intent to enforce collection of the indebtedness. The Sixth Circuit found that Duilio’s oral instructions about quarterly payment explained their timing and Michael’s alteration of the check dates. The appeals court also noted that Duilio’s premature death due to complications from surgery was clearly not anticipated. In addition, the Sixth Circuit explained that the fact the SCIN was fully secured by a mortgage on the properties refuted any inference the sale was not bona fide.

The IRS urged the Sixth Circuit to remand the case to the Tax Court to determine the true value of the SCIN, contending it was considerably less than the value of the properties transferred. The appeals court followed this recommendation to address the IRS’s alternative argument that the note was a bargain sale which subjected the estate to gift tax under IRC section 2512.

Estate of Costanza v. Commissioner, no. 01-2207 (6th Cir., 2/19/03).

Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting, Christian Brothers University, Memphis, Tennessee, and Tina Quinn, CPA, PhD, associate professor of accountancy, Arkansas State University, Jonesboro.