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.

 Allen⁴ and Ventas⁵ 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 the corporate level. If the three-year amortization election under Sec. 59(e) is made at the shareholder level, there is no AMT adjustment.

R&D Expenditures

Under Sec. 174(a), R&D expenses may be deducted immediately, or amortized over 60 months under Sec. 174(b). Sec. 1363(c) indicates that elections affecting the computation of items derived from an S corporation shall be made by the corporation. Under Sec. 56(b)(2)(A)(ii), only R&D costs deducted under Sec. 174(a) generate an AMT adjustment. However, an important exception applies under Sec. 56(b)(2)(D), which provides that shareholders who materially participate (as defined in Sec. 469(h)) in the activity, do not have to recognize an AMT adjustment for their share of costs expensed under Sec. 174(a). Also, R&D costs amortized over 60 months under Sec. 174(b) do not produce an AMT adjustment.

The AMT adjustment for Sec. 174(a) costs is the difference between the amount deducted and the amount that would be deductible if the same costs were capitalized and amortized over 10 years. Sec. 59(e) further provides that a taxpayer may elect to capitalize and amortize its allocable share of Sec. 174(a) costs over 10 years and avoid the AMT adjustment entirely.

Mining Development Costs

Under Sec. 616(a), mining development costs may be deducted immediately. Alternatively, an election is available, under Sec. 616(b), to capitalize such costs and recover them ratably, on a units-of-production basis, against mining production income. Under Sec. 1363, this election is at the corporate level. If the corporation elects to expense such costs, an AMT adjustment is created under Sec. 56(a)(2), to the extent the immediate deduction exceeds 10-year amortization of the same costs.

An S corporation incurring mining exploration costs described in Sec. 617 must pass them to shareholders. Sec. 1363(c)(2)(A) provides that the Sec. 617(a) election to deduct these costs immediately must be made at the shareholder level. Sec. 56(a)(2) provides that an AMT adjustment is created if the costs are deducted. The adjustment equals the difference between the full deduction for regular tax purposes and the amount that would be deductible under 10-year amortization.

Tax Consequences

When qualified expenditures are not capitalized by the corporation, there is an adjustment that produces a difference between regular tax and AMT basis. This difference will equalize over time, but can produce potentially unexpected results, depending on interim events. These particular adjustments have great potential to cause overpayment of AMT. It is perhaps too easy for a practitioner to input information from Form K-1, Shareholder’s Share of Income, Deductions, Credits, etc., and do no further work. If a K-1 shows an adjustment passthrough deduction section (box 12c of 2005 1120-S Form K-1), the uninformed preparer may subject the taxpayer to an increase in alternative minimum taxable income (AMTI) in the current year, without noting that the taxpayer is entitled to a negative adjustment to AMTI in succeeding years.

If a shareholder is allocated a portion of the qualified expenditures enumerated above, he or she can take into account only that portion of the allocable expenditure for which he or she has basis, in computing current-year tax. If the shareholder were to elect to capitalize the expenditure under Sec. 59(e), he or she would only be allowed to do so as to the amount for which he or she has basis. The balance of the allocated expenditure could be taken into account in any future year in which the shareholder has basis. Thus, he or she may have a basis for regular tax purposes that differs from the basis for AMT purposes.

Example 2: T, an S shareholder, invests part of the corporation’s assets in a gold-mining venture in Alaska. T has a $10,000 basis in his S stock for regular tax purposes and $12,000 for AMT purposes. In the venture’s first year, T’s corporation is allocated $15,000 of mining exploration expenses, which it passes to T. There are no other items of income or expense for the year. For regular tax purposes, T may deduct only up to $10,000 of mining exploration expenses. If he deducts the $10,000, his adjustment in computing AMT would be $9,000, the amount by which his deduction exceeds 10-year amortization, under Sec. 56(a)(2)(A). T could, as an alternative, elect to capitalize and amortize the amount of expense for which he has basis. His current deduction would be $1,000; he would continue to take a $1,000 deduction in each of the succeeding nine years. There would be no AMT adjustment.

If T receives a distribution from the corporation during the period in which his AMT basis exceeds his regular tax basis, the distribution’s taxation will differ under the regular tax and AMT systems. The fact that T has more basis for AMT purposes than for regular tax purposes does not affect his regular tax computation; his adjustment for AMT purposes is computed by reference to his regular tax deduction. His basis for regular tax purposes would be reduced from $10,000 to zero. It is not clear whether his basis for AMT purposes would be reduced by $10,000 or $12,000—equity would seem to indicate that the reduction would be only $10,000. The Allen case rationale might lead to the conclusion, in the absence of a specific instruction to the contrary, that the AMT basis is reduced by $12,000. Additional IRS guidance is needed in this area.

If T obtained additional basis in subsequent periods, he would be able to take the remainder of the allocated qualified expenditure into account as a deduction, subject to his election to capitalize and amortize the costs instead.

This illustrates why tax advisers preparing S returns should have some knowledge of the shareholders’ sensitivity to AMT items. This knowledge could affect the corporate-level decision to capitalize R&D or mining development costs.

If a taxpayer elects, under Sec. 59(e), to capitalize and amortize any portion of his or her allocated share of an expense under Sec. 173, 174, 616 or 617, it appears that a separate item of property would be created, under Regs. Sec. 1.59-1(b)(2). Further, the basis of the S stock would be reduced, for both regular tax and AMT purposes, by the qualified expenditure for which a Sec. 59(e) election was made. If the item of property referred to in Regs. Sec. 1.59-1(b)(2) is the S stock, the stock basis would be adjusted, for regular tax and AMT purposes, by the differing amounts deducted over the three-, five- or 10-year period called for in Sec. 59(e)(1). Service guidance on whether the S stock basis is adjusted, or whether a separate item of property is created, would be very helpful.

If the S stock basis is not affected by the Sec. 59(e) election, it is not clear what happens to any remaining unamortized qualified expenditure when the stock is disposed of by gift, testamentary transfer or sale. Sec. 59(e)(5) discusses the effect when the property associated with the deduction is disposed of, but it does not refer to a transfer of an interest in the entity. Regs. Sec. 1.59-1, the only regulation under Sec. 59, states that the amount elected under Sec. 59(e) is properly chargeable to a capital account under Sec. 1016(a)(20), relating to adjustments to basis of property. However, it does not indicate which property. Again, IRS guidance would be helpful.

Acquisition of S Stock

When S stock is purchased, the basis is initially the same for regular tax and AMT purposes. If, at the time of an ownership change, the S corporation has any timing differences inherent in assets or attributes (such as depreciable assets or contract-income recognition) the reversal of the timing difference will positively or negatively affect the new owner. 

Example 3: B forms a new S corporation, capitalizes it with $1 million and purchases $1 million of equipment. He depreciates the equipment using normal accelerated depreciation. After one year, he has claimed $200,000 in depreciation for regular tax purposes and $150,000 for AMT purposes. At the beginning of year two, B then sells one-half of his stock to R for $500,000. If income equaled all other expenses except depreciation, B’s gain on the sale would be $100,000 for regular tax purposes and only $75,000 for AMT purposes. Although R’s basis for regular tax and AMT purposes is identical to start, in the future R will receive $25,000 more in AMT depreciation than in regular depreciation (50% of the $50,000 difference in remaining depreciation). Again, if that income equaled all other expenses except depreciation, at the end of the useful life of the equipment for regular tax purposes, R would still have a $25,000 basis in her stock for AMT purposes.

Incorporation transactions under Sec. 351 will produce differing S stock basis for regular tax and AMT purposes when the contributed assets have a basis that differs for regular tax and AMT purposes. If the property transferred is subject to debt in an amount that lies between regular tax and AMT adjusted basis, a basis difference will occur.

Example 4: J’s small construction company owns equipment with an original cost of $100,000. The company has taken $15,000 regular depreciation and $10,000 of AMT depreciation. J’s adjusted tax basis in the equipment is $85,000 for regular tax purposes and $90,000 for AMT purposes. On his attorney’s advice, he incorporates the construction business, transfers the equipment to the corporation and elects S status. His stock basis is $85,000 for regular tax purposes and $90,000 for AMT purposes, under Sec. 358(a).

Example 5: The facts are the same as Example 4, except the equipment is subject to $87,000 acquisition debt when J incorporates. Because he has transferred property to his corporation with debt in excess of his $85,000 regular tax basis, J will recognize $2,000 ordinary income for regular tax purposes under Sec. 357(c), and his stock basis will be zero. For AMT purposes, he does not recognize the $2,000 gain, because his AMT basis in the equipment exceeds the debt transferred. On his return for the year of incorporation, the $2,000 recognized gain for regular tax purposes will be a negative adjustment to gain or loss for AMT purposes. His stock basis for AMT purposes will be $3,000.

Contractors who use the cash, accrual or completed-contract method must use the percentage-of-completion method for AMT purposes, under Sec. 56(a)(3). This can result in significant differences between basis for regular tax and AMT purposes. These differences, in turn, can cause cascading complications for purposes of debt basis and taxability of distributions.

Example 6: The facts are the same as in Example 4; J ends year one with $85,000 regular tax basis and $90,000 AMT basis. J decides to use the completed-contract method of accounting for his corporation, under Sec. 460(e). In year two, he is successful in obtaining a contract on which he has estimated a total profit of $200,000. At the end of year two, J’s contract is 50% complete. For regular tax purposes, J does not recognize any income under the completed-contract method. However, he is required to use the percentage-of-completion method for AMT purposes and must report $100,000 income as an AMT adjustment. For regular tax purposes, J’s stock basis remains at $85,000; for AMT purposes, his stock basis has become $190,000.

The corporation distributes $100,000 by year-end. For regular tax purposes, the distribution exceeds J’s $85,000 basis; thus, J will recognize $15,000 capital gain under Sec. 301(c). His stock basis for regular tax purposes is reduced to zero. For AMT purposes, J reduces his basis ($190,000) by the distribution ($100,000), for a $90,000 ending AMT basis; he recognizes no gain in excess of basis for AMT purposes. To accomplish this, J would report a $15,000 negative AMT adjustment on Form 6251, Alternative Minimum Tax—Individuals.

The contract is finished the following year and, under the completed-contract method, J will recognize $200,000 ordinary income for regular tax purposes and $100,000 income for AMT purposes, using the percentage-of-completion method. By the end of year 3, the corporation will distribute $100,000. Over the course of the contract, the entity earned $200,000 and distributed $200,000. Note: J’s initial AMT basis was $5,000 higher than his regular tax basis, but ended up $10,000 lower than his regular tax basis, due to the interaction of the different recognition rules under the two systems. J ends up with the basis shown in Exhibit 1 above under each system.

Although basis has shifted only slightly in this example, the amount of income reported for regular tax and AMT purposes has varied widely between years. This leads to drastically different basis for regular tax and AMT purposes as of the end of year two. Many clients will attempt to undertake transactions not when their regular tax and AMT basis is similar (i.e., end of year three), but when it most disparate (i.e., end of year two). Only by having accurate knowledge of the differing basis can a practitioner hope to help a client avoid a nasty tax bill.

Debt Basis

Frequently, debt basis will also vary for regular tax and AMT tax purposes. These variations will, in turn, lead to interesting situations on repayment and distributions. While debt basis can be used to deduct losses, it cannot be used to provide basis for distributions.

Example 7: The facts are the same as in Example 6, except that J decided to use the cash method of accounting for his contracting business. He received the same contract that will produce a $200,000 profit over two years. At the end of year one, J’s regular tax basis is $85,000 and his AMT basis is $90,000. In year two, J loans the corporation $120,000 in exchange for a written note and incurs $120,000 expenses in excess of billings, to bring the job to 50% complete. For regular tax purposes, the contract will show a $120,000 loss while, for AMT purposes, the corporation will have $100,000 income. J also takes $100,000 distribution at year-end. Because distributions reduce basis before taking losses into account, J reduces his regular tax basis from $85,000 to zero and reports a $15,000 gain for the excess of the distribution over his basis. J can deduct the entire loss for regular tax purposes, by using his $120,000 regular tax loan basis. This reduces his regular tax loan basis to zero. For AMT purposes, the corporation reports $100,000 profit under the percentage-of-completion method. This increases basis for AMT purposes from $90,000 to $190,000. The $100,000 distribution then reduces his stock basis back to $90,000. J’s AMT loan basis remains unchanged at $120,000. At the end of year two, J has zero regular tax basis in both his stock and his loan. His AMT basis, however, is $90,000 for stock and $120,000 for debt. If J were to sell any portion of his stock, his regular tax gain or loss would be substantially different from his AMT tax gain or loss.

In year three, billings and collections exceed expenses by $320,000 and J repays the loan. For regular tax purposes, J will report $320,000, which will restore his debt basis to $120,000 and his stock basis to $200,000. For AMT purposes, J will report $100,000 profit in year three. Note: J’s AMT debt basis is still $120,000. The $100,000 distribution will reduce both his regular tax and AMT basis by the full amount of the distribution. Again, in a two-year time period, the corporation earned $200,000 and distributed $200,000. J started the two-year period with his AMT basis $5,000 higher than his regular tax basis. At the end of year two, his basis varies by $210,000 under the two systems; he ends the two-year period with his regular tax basis $10,000 higher than his AMT basis, as shown in Exhibit 2. 

Example 8: X forms S corporation Y and capitalizes it with $20,000 and a $100,000 shareholder loan. Y incurs a loss from operations. The loss is $60,000 for regular tax purposes, but only $40,000 for AMT purposes. X’s stock basis is reduced to zero. The loan basis will be reduced to $60,000 for regular tax purposes, but will be $80,000 for AMT purposes. If the loan is repaid at this point, there is $40,000 gain for regular tax purposes, but only $20,000 for AMT purposes. On repayment of the reduced-basis note, the gain recognized will be capital if the loan is evidenced by a written note and will be taxed as ordinary income if it is an open-account loan.⁸ If only part of the loan is repaid, the gain must be computed in the same manner as an installment sale; part of the repayment is return of capital and the rest is gain; see Exhibit 3.

If more than one loan is made to the corporation by the same shareholder, the basis reduction due to losses is allocated among the various loans. The allocation must be made in proportion to the varying amounts of basis remaining in the loans.⁹ 

Example 9: The facts are the same as in Example 8, except the loan was not repaid; instead, another $100,000 loan was made in the following year, for $200,000 total debt. If losses of $32,000 for regular tax purposes and $63,000 for AMT purposes were to be allocated to debt, they would be allocated between the two loans using the proportion of the varying basis amounts. For regular tax purposes, the loss allocated to the old loan would be $12,000 ($32,000 × ($60,000/$160,000)), for a remaining basis of $48,000. The new loan would be allocated $20,000 ($32,000 × ($100,000/$160,000)), for a remaining basis of $80,000. For AMT purposes, the old loan would be allocated $28,000 ($63,000 × ($80,000/$180,000)), for a remaining basis of $52,000, while the new loan would be allocated $35,000 ($63,000 × ($100,000/$180,000)), for a remaining basis of $65,000; see Exhibit 4.

When debt basis is restored through income recognition, the basis restoration is allocated first to loans repaid during the year and, to the extent of debt basis restoration, allocated among any other remaining reduced-basis debts in proportion to the total basis reductions made in prior years.¹⁰

It is not uncommon to see commercial tax preparation software that tracks debt basis. It is less common to see software that tracks basis for multiple loans and correctly allocates basis reduction and restoration.  Practitioners are well-advised to determine their software’s capabilities and devise alternatives if needed.

These calculations are not just a meaningless exercise. Advising a client on the pros and cons of taking cash from an S corporation requires knowledge of both the client’s regular tax and AMT situations, including these basis calculations. Taking cash distributions, compensation or loan repayments could produce significant tax differences, depending on a client’s tax situation.

Exactly what constitutes a loan for purposes of deducting S losses has been one of the most frequently litigated aspects of S taxation. Tax advisers need to realize the effect of the correct characterization of debt. If debt is to be used as part of basis to deduct losses and it is later determined that the debt was not qualifying, the revision of numerous years of tax returns for both the S corporation and all affected shareholders could become a daunting task.

Transactions involving loans that the taxpayer and practitioner considered to be in closed years may be effectively reopened through basis adjustment in later years. In a recent pronouncement,¹¹ the Service set forth the rationale for making changes in open years related directly to errors made in using debt as part of the basis for claiming losses in closed years. It is beyond this article’s scope to consider the pros and cons of the “annual accounting period–closed year” versus “open forever through basis adjustments” arguments, but the tax adviser should be aware that the IRS believes that basis schedules can serve as entry into closed years.

Conclusion

Part II, in the February 2007 issue, will discuss the effect of the AMT rules on ordering rules, gift and estate transactions, compensation-related transactions, C-to-S conversions, distributions and suspended carryovers.