S Corporations and the AMT Credit

Beginning in 1997, the IRS permitted financial institutions to elect S corporation status. This change initially presented many challenges to financial institutions; many of their tax advisers had little exposure to the issues affecting S corporations and were immediately expected to be fluent in these matters.

One item that became an issue for many financial institutions was the applicability of the alternative minimum tax (AMT) credit. Although this is not an issue unique to them, financial institutions typically invest in municipal securities, whose interest income is exempt from Federal income tax. In computing alternative minimum taxable income (AMTI), this interest income is added back as an adjusted current earnings (ACE) adjustment item, thus increasing AMTI relative to regular taxable income. In certain instances, this results in the payment of AMT. The taxpayer carries forward the AMT paid as a credit against tax in subsequent years, to the extent the regular tax liability exceeds the tentative minimum tax (TMT).

When a C corporation elects S status, any unused AMT credit is treated as an S carryforward item. The taxpayer can use the AMT credit carryforward to offset any built-in gains (BIG) tax that the S corporation incurs during the 10-year recognition period. For financial institutions and their tax advisers (who were not accustomed to S taxation), the issue was how to determine the usable AMT credit amount. Sec. 53(c) provides for the use of the AMT credit, to the extent the regular tax liability exceeds the TMT (as determined in Sec. 55(b)). Sec. 55, however, generally applies only to C corporations (and individuals). Thus, how do S corporations bridge the gap between Sec. 55 and the S rules?

Step 1

First, the S corporation must compute its “regular tax liability.” Regs. Sec. 1.1374-6(b) treats the tentative tax determined under Regs. Sec. 1.1374-1(a)(3) as the regular tax liability. The S corporation’s tentative tax is determined by multiplying 35% (the highest corporate tax rate) by the net recognized BIG for the tax year (Sec. 1374(d)(2)). Simply put, the BIG tax is the regular tax liability.

Example 1: Bank B elects S status, effective Jan. 1, 2000. On that date, B has a $75,000 AMT credit carryforward. In 2000, it sells various securities, resulting in a $125,000 ordinary gain, which is also a recognized BIG. B also sells a building at a $25,000 loss, which is a recognized built-in loss. In addition to these sales, B generates $150,000 of nonseparately stated income.

For purposes of determining B’s AMT credit for 2000, the regular tax liability is $35,000 ($100,000 net recognized BIG x 35%).

Step 2

The S corporation must compute its TMT by multiplying 20% (the corporate AMT rate) by its AMTI, defined in Regs. Sec. 1.1374-6(b). Under this section, AMTI is the net recognized BIG under Sec. 1374(d)(2), modified for the Secs. 56 and 58 adjustments that apply to corporations (e.g., depreciation and ACE adjustments), and Sec. 57 preferences. The Sec. 55(d) exemption amount also applies in computing the AMTI.

Example 2: The facts are the same as in Example 1. B has a $100,000 net recognized BIG for 2000. The tax basis in the building is $250,000 and the AMT basis in the building is $300,000. Therefore, the AMTI is $110,000 ($100,000 net recognized BIG + $50,000 AMT basis adjustment – $40,000 exemption amount). The TMT is $22,000 ($110,000 x 20%).

Step 3

Finally, the S corporation must determine its current-year AMT credit limit, which is used only to the extent the regular tax liability exceeds the TMT.

Example 3: Bank B has a regular tax liability of $35,000, and a TMT of $22,000. B can use $13,000 ($35,000 – $22,000) of its AMT credit carryforward for 2000, thus reducing its 2000 tax liability to $22,000. The minimum tax credit carryover to the following year is $62,000 ($75,000 – $13,000).

Other Considerations

In addition to the AMT credit, S corporations can also use Sec. 38 business credit carryovers to offset any BIG tax incurred. Sec. 38 business credits include the low-income housing credit and the empowerment zone employment credit. As with the AMT credit, an S corporation computes its regular tax liability and TMT. The Sec. 38(c) limits apply in determining the allowable credit for the current year.

The starting point in computing the TMT (as discussed in Step 2) is the net recognized BIG. In certain circumstances, the net recognized BIG is the S corporation’s “pro-forma” C corporation taxable income. Under Sec. 1374(d)(2), net recognized BIG is the lesser of (1) recognized BIGs over recognized built-in losses or (2) the S corporation’s taxable income, determined as if it were a C corporation (with modifications).

In Example 1, B’s pro-forma C taxable income is $250,000 ($100,000 net recognized BIG + $150,000 nonseparately stated income), which is greater than its $100,000 recognized BIG ($125,000) over its recognized built-in losses ($25,000). If, however, B had a nonseparately stated loss of $50,000, its pro-forma C taxable income would be $50,000 ($100,000 net recognized BIG – $50,000 nonseparately stated loss). Thus, its net recognized BIG (and starting point in computing TMT) would be $50,000.

The Taxpayer Relief Act of 1997 repealed the corporate AMT for “small corporations;” under Sec. 55(e), a corporation’s TMT is deemed to be zero if the corporation’s average annual gross receipts for all three tax-year periods ending before the current tax year do not exceed $7.5 million. Sec. 55(e)(5) limits the amount of AMT credit that small corporations can use, reducing the allowable AMT credit by 25% of the regular tax liability in excess of $25,000.

In Example 1, if B were a small corporation under Sec. 55(e), its TMT would be zero and 25% of its regular tax liability in excess of $25,000 would be $2,500 (($35,000 + $25,000) x 25%). Therefore, B would be allowed to use $32,500 ($35,000 regular tax liability – $2,500 limit) of its AMT credit carryover and reduce its current-year BIG tax to $2,500.

Planning Suggestions

Example 4: Corporation L wishes to elect S status. It has AMT credit carryovers that it does not use in its final C tax year (because it generates additional AMT credit in its final C tax year).

L should evaluate its assets and determines which assets have BIGs and which assets have built-in losses. If L intends to sell any of these assets in the near future, it would probably want to sell the assets with BIGs after the effective date of the S election. This way, L generates a BIG tax, against which it can apply the AMT credit carryover. At the same time, if L recognizes the gain in the last C tax year, the AMT credit may not be available due to the limit. In addition, L may not want to sell assets with built-in losses in the same year it sells assets with BIGs; the losses would net with the gains, possibly eliminating the BIG tax and offsetting the AMT credit. L should also determine if it is a small corporation under Sec. 55(e). If so, it can use a larger portion of its AMT credit against any BIGs, because its TMT is deemed to be zero. This could possibly affect the timing of the recognition of BIGs and built-in losses.

An S corporation can use an AMT credit carryforward for up to 10 years, which generally is the recognition period during which an S corporation could be subject to the BIG tax. After the 10-year recognition period, the S corporation may want to consider revoking its S election and converting to a C corporation. The S corporation could potentially offset any C tax liability with unused AMT (or other tax) credits. However, the S corporation would probably do this only if it had significant unused tax credits, because it could not elect S status again for five years and would end up paying corporate level taxes for an additional five years.

If L is not planning to elect S status for several years, it should consider reducing its AMTI and using existing AMT credits before making the S election. As mentioned, financial institutions are typically subject to AMT because of their investments in municipal securities. A financial institution considering S status could reduce its investments in municipal securities, thereby lowering its AMT liability and using its AMT credit carryforward. In addition, the corporation can sell appreciated assets before making the S election. By doing so, the regular tax liability (computed at 35%) would be increased relative to the AMT liability (computed at 20%), thus allowing the corporation to use additional AMT credits.

Conclusion

Most likely, a C corporation considering S status will not base its decision primarily on the existence of AMT or general business credit carryforwards. However, a basic understanding of the rules and some tax planning can prevent credits from going unused.

From Kevin F. Powers, CPA, Oak Brook, IL