The Small Business AMT Exception.

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The small business AMT exception. The Taxpayer Relief Act of 1997 simplified corporate taxpaying and reporting for small businesses by exempting them from alternative minimum tax (AMT) if the new rules are met. These rules include an average annual gross receipts test that seems straightforward on its face. However, on closer inspection, the new rules are fraught with problems, such as when the "lookback period" begins for tallying average gross receipts. This article explains the new provisions and offers examples for corporations seeking to qualify for the AMT exemption. The Taxpayer Relief Act of 1997 (TRA '97), Section 401(a), enacted a significant change to the corporate alternative minimum tax (AMT) system as it affects small businesses. Under new Sec. 55(e), effective for tax years beginning after 1997, the AMT is repealed for "small business corporations." According to Sec. 448(c) (1), a C corporation that had average gross receipts of less than $5 million for the prior three years is a small business corporation for this purpose. Further, a corporation that meets the $5 million gross receipts test will continue to be exempt from AMT as long as its average gross receipts do not exceed $7.5 million. A corporation that fails to meet the $7.5 million gross receipts test will be subject to AMT prospectively only. This article discusses three major aspects of the new law: (1) the entities to be aggregated in determining gross receipts (including use of a short tax year and/or predecessor companies); (2) use of the minimum tax credit (MTC) in a year in which tentative minimum tax (TMT) is zero; and (3) the fresh-start provisions that apply when average gross receipts exceed $7.5 million. Sec. 448(c) Issues Gross Receipts Test New Sec. 55(e)(1)(A) provides an AMT exemption for corporations that meet the Sec. 448(c) $5 million average gross receipts test. The first issue is when the three-year lookback period for the test begins. Start of lookback period: According to the TRA '97 Conference Committee Report, 1 the three-year lookback period for the $5 million average gross receipts test is tax years after 1994 (i.e., tax years 1995, 1996 and 1997); however, the General Explanation of Legislation Enacted in 19972 (Blue Book), states that that is erroneous and that the three-year lookback period includes tax years beginning after 1993 (i.e., tax years 1994, 1995 and 1996). This in itself is an issue that, without resolution, could trigger much litigation. New entity: A newly formed corporation in 1998 or thereafter not deemed to stem from a predecessor corporation is automatically exempt from AMT for its first tax year. If in the first tax  year, the corporation's gross receipts exceed $7.5 million, the corporation will lose its AMT exemption starting in its second tax year. The exemption continues to apply only as long as average gross receipts remain at $7.5 million or less. What happens if a new entity results from a tax-free spinoff of a division, branch or single-member limited liability company (LLC) in a D reorganization or Sec. 355 corporate division? If' it is not  viewed as stemming from a predecessor company or being part of an affiliated group, it would be  AMT-exempt in at least its first year of operation. Sec. 381 does not apply to the spinoff of a controlled corporation (because the distributing parent keeps all tax attributes, except earnings and


profits and accumulated adjustments account); thus, the predecessor company rule should not apply. If the corporate division was non-pro rata, the controlled group rules of Secs. 52(a) and 1563(a) would likely not apply. If the new entity were to lose its AMT exemption in the future, the new Sec. 55(e)(3) anti-abuse rule (discussed below) would need to be considered. If' the distributing parent were exempt from AMT, the AMT and adjusted current earnings (ACE) rules (discussed below) would apply prospectively. Short tax year: Sec. 448(c)(3)(B) and Temp. Regs. Sec. 1.448-1T(f)(2)(iii) require gross receipts for a short tax year to be annualized in computing gross receipts. Example 1: X Corp., formed in 1998, had the following gross receipts:  Year Gross receipts 1998 (six-month tax year) $3,000,000 1999 $3,000,000 2000 $4,000,000 2001 $17,000,000 For 2001, X meets the $5,000,000 average gross receipts test, because the average gross receipts in 1998-2000 were only $4,333,333 (($6,000,000 + $3,000,000 + $4,000,000)/3). However, the average gross receipts test is not met for 2002, because average gross receipts for 1999-2001 exceed $7,500,000 (($3,000,000 + $4,000,000 + $17,000,000)/3). Thus, X is AMT-exempt in 1998, 1999, 2000 and 200l, and not AMT-exempt starting in 2002. Example 2: The facts are the same as in Example 1, except that X's gross receipts are only $1,000,000 in 2002. Is X AMT-exempt for 2003, because average gross receipts were under $7,500,000 in 2000-2002 (($4,000,000 + $17,000,000 + $1,000,000)/3)? According to Sec. S ec. 55(e)(1)(B), X is once again not exempt; thus, the AMT exemption is lost starting in 2002 and cannot be reacquired. Example 3: Q Corp.'s gross receipts were $6,000,000 in 1995 (its first year of existence), $5,000,000 in 1996, $8,000,000 in 1997 and $3,000,000 in 1998. Q is not AMT-exempt starting in 1998, because its average gross receipts in 1995-1997 exceeded $5,000,000 (($6,000,000 + $5,000,000 + $8,000,000)/3).


Other questions: What if a corporation was a large corporation in the late 1980s and early 1990s, but downsized and averaged less than $5 million for the lookback period? Such a corporation would seem to be eligible for the AMT exemption. If a personal service corporation (PSC) had more than $5 million of average gross receipts for the prior three years, it would still be able to use the cash method of accounting, but would not be exempt from AMT, under Sec. 448(b)(2). The Small Business Job Protection Act of 1996, Section 1308(a), allowed an S corporation to own 80% or more or a C corporation. If an S parent created a C subsidiary, would the parent's gross receipts be counted in determining whether the subsidiary was AMT-exempt? The answer should be "yes," because Sec. 1563(a)(1) would apply. Controlled and Affiliated Groups Sec. 448(c)(2) requires all persons treated as a single employer under Sec. 52(a) or (b) or Sec. 414(m) or (o) to aggregate gross receipts for purposes of the $5 million gross receipts test. Sec. 52(a) uses the controlled group definition under Sec. 1563(a) (with modifications) to determine whether receipts have to be aggregated. Under Sec. 1563(a), controlled groups are affiliated companies in either a parent-subsidiary relationship (Sec. 1563(a)(1), with the parent owning more than 50% of the subsidiary's vote and  value), or a brother-sister corporation relationship (Sec. 1563 (a) (2)). Letter Ruling (TAM) 9809001(3) is a recent example of an affiliated service group. In the ruling, an architectural S corporation was owned by a father and son. An unrelated engineering PSC was owned by two other individuals. The two companies marketed their architectural-related services to the public. The IRS held that these companies' gross receipts had to be aggregated under Secs. 414(m) and 448(c)(2). The new AMT exemption provides another motive to use multiple entities that avoid Sec. 1563(a)(2) (brother-sister) status. If gross receipts can be spread among various unrelated entities, it is more likely that each entity will qualify for the AMT exemption.  Avoiding aggregation: Basically, the paired corporations must fail either of the following tests under Sec. 1563(a) (2) to avoid brother-sister status: five or fewer shareholders (e.g., individuals, estates or trusts) (1) own at least 80% of the vote or value of each company; and (2) own more than 50% of  the vote or value by taking into account identical stock ownership in each corporation. For this


purpose, if a taxpayer owns 5% of A Corp. and 55% of B Corp., his identical ownership is 5% (the lowest common denominator). If either test is failed and the companies are not deemed to be an affiliated group, the AMT exemption will be more readily available, because the gross receipts of the  various companies will not be aggregated. Example 4: M, T and C are a family consisting Or a mother and two adult sons. They are planning to establish a business projected to generate approximately $16,000,000 in revenue and $400,000 in taxable income in the first year. If they create one corporation and it performs as projected, it will be subject to AMT and its Federal tax liability will be $136,000 ($400,000 x 0.34). However, if M, T and C establish four roughly equally profitable corporations that are not part of a controlled group, the corporations will be exempt from AMT and pay a total Federal income tax of $89,000 ($22,250 x 4), a savings of $47,000. How can this be accomplished? If M owns 100% of A Corp.; Towns 100% of B Corp.; C owns 100% old Corp.; and M and T each own 50% of E Corp., none of these companies are brother-sister corporations under Sec. 1563(a)(2); see Exhibit 1 on page 483. If each company has less than $5,000,000 in gross receipts beginning in 1998, none would be subject to AMT.  Alternatively, if more companies were desired, T and C could also own 50% each of F Corp., and M and C could each own 50% of G Corp., without triggering the brother-sister rules; see Exhibit 2 on page 483. What Are Gross Receipts? Temp. Regs. Sec. 1.4481T(f) (2)(iv)(A) defines gross receipts as total sales (net of returns and allowances) and all amounts received for services, plus any income from investments (e.g., interest, dividends, rents, royalties and annuities) and from incidental or outside sources; it also includes original issue discount and tax-exempt income. Gross receipts are reduced by the taxpayer's adjusted basis in capital assets and Sec. 1231 assets sold. Gross receipts do not include the repayment of loans or sales tax collected from the consumer. Under Temp. Regs. Sec. 1.4481T(f) (2) (i), only the unrelated business income of a tax-exempt organization is counted as gross receipts. Thus, contributions and donations are excluded. Presumably, the same logic would apply to a foreign corporation doing business in the U.S.--i.e., only effectively connected income would be counted towards the $5 million gross receipts test. Thus, if a foreign company with $100 million of overseas receipts provided services to international clients that yielded $3 million of domestic revenue, it would be exempt from AMT. Under Temp. Regs. Sec. 1.4481 T(f)(2) (ii), if a group of companies is required to aggregate its gross receipts, intercompany sales are eliminated before determining the aggregate gross receipts. Predecessor entities: According to Temp. Regs. Sec 1.448-1T (f)(3), Example (5), when computing the three prior-years' average gross receipts, the receipts of any predecessor entity have to be included. Under that example, a sole proprietor's trade or business receipts were included when the business was incorporated in a Sec. 351 transaction. Unfortunately, it is unclear when the tax adviser may encounter other "predecessor entity" situations. For example, is the incorporation of a partnership or an LLC with multiple owners subject to the predecessor rule? When multiple owners are present, attribution may be more difficult. For instance, if three corporate partners incorporate a joint venture, does predecessor status result; if  so, to or from which entity?  According to Temp. Regs. Sec. 1.448-IT(f)(3), Example (3), a corporate partner's gross receipts are are not attributed to the partnership. No guidance is given as to whether the aggregate or entity


concept applies to the partnership gross receipts attributed to the corporate partner. If the entity theory applies, dropping businesses into a partnership would become an easy way to qualify for Sec. 55(e). Sec. 702(c), however, requires a partner to include in gross income his pro rata share of  partnership gross income; presumably, gross receipts would also be passed through to the corporate partner.(4) MTC Use If a small corporation was in business prior to 1998, it may have MTC carry-forwards. MTCs are created when a taxpayer's TMT exceeds the regular tax for that year. MTCs may be used in a subsequent year to reduce regular tax (after credits), but not below that year's TMT. Under Sec. 55(e),TMT is zero each year the AMT exemption applies; how much of the MTC can be used in the  years the exemption applies? Sec. 55(e)(5) provides that MTCs offset a company's regular tax up to $25,000, plus 75% of the regular tax liability in excess of $25,000. Thus, if a company's regular tax liability for an AMT-exempt year is less than $25,000, the MTC may offset all of it. Example 5: W Corp. is a small business corporation exempt from AMT with an MTC carryover to 1998 of $40,000. Its 1998 regular tax liability is $22,000. The MTC will offset $22,000 of regular tax liability (resulting in no tax liability for 1998); $18,000 of MTC will be carried forward. If, in 1998, W had a research and development credit available, the regular tax liability would first be reduced by that credit before the MTCs were used. Example 6: K Corp. has a $105,000 regular tax liability in 1998 and a $130,000 MTC carryover to that year. The MTC will offset the first $85,000 of regular tax ($25,000 + $60,000 [75% of $80,000 ($105,000 - $25,000)]), reducing the 1998 regular tax liability to $20,000; $45,000 of MTC will be carried to 1999. Example 7: B Corp. has a $125,000 tax liability in 1998 and an MTC carryover of $60,000 to that  year. B may offset a maximum of $100,000 ($25,000 ($25,000 + [0.75($125,000 - $25,00 $25,000)]) 0)]) of MTCs against regular tax; because B has only $60,000 of MTCs, it can use them to bring regular tax liability down to $65,000. There is no MTC carryforward to 1999. Sec. 55(e)(5) dictates that the $25,000 minimum allowance must be allocated among members of a controlled group. Thus, the master allocation schedule of various tax limits among brother-sister or parent-subsidiary companies should be modified. Losing the AMT Exemption Fresh-Start Provisions If a corporation was exempt from AMT and subsequently lost the exemption due to growth in gross receipts, it gets a "fresh start" as to AMT and ACE adjustments. Sec. 55(e)(2) applies most of the  AMT rules on a prospective basis; under Sec. 55 (e) (4), only transactions occurring on or after the change date result in AMT adjustments, preferences and ACE adjustments. Thus, the AMT system can be viewed as newly enacted for the formerly exempt company on the change date. For example, a corporation is nonexempt from AMT for calendar years 1987-1997, exempt under Sec. 55(e) from 1998-2000 inclusive, and in 2001, the prior three-years' average gross receipts exceed $7.5 million; thus, the corporation is again subject to AMT in 2001. The change date is Jan. 1, 2001, under Sec. 55(e)(4). In computing AMT for 2001, the company needs to consider the following issues on a prospective basis.


Depreciation: Sec. 55(e)(2)(A) does not mandate depreciation adjustments under Sec. 56(a)(1). Thus, no ACE adjustment is required for 1987-1997 or 1998-2000, under Sec. 56(g)(4)(A); only an AMT adjustment is required, for assets placed in service after 2000. This is a significant relief provision. The logical extension of this rule would be that, except for tangible personal property placed m service after 2000, the adjusted basis for AMT and ACE purposes is the regular tax basis. NOLs: Under Sec. 56(a)(4), any prior-year alternative minimum tax net operating loss (AMTNOL) under Sec. 56(d)(2) will be ignored; instead, any regular tax NOL on Jan. 1, 2001 will become the  AMTNOL. This could be disadvantageous, because 100% of past-year regular tax NOLs NOLs offset taxable income, while only 90% of alternative minimum taxable income (AMTI) can be offset by  AMTNOLs. Also, regular NOLs could have offset taxable income during the exempt period.

Installment sales: Under Sec. 56(g) (4)(D) (iv), if an installment sale occurred in the corporation's  AMT-exempt period but was recognized in a nonexempt period, no downward adjustment to ACE is available. Any installment sale occurring on or after the change date, and not covered by the interest charge rules, is subject to an ACE adjustment. Negative ACE adjustments: From 1990 on, tax advisers have had to monitor closely the amount and order of positive and negative ACE adjustments. Under Sec. 56(g)(2)(B), any pre-change-year accumulated positive ACE adjustments are eliminated under the fresh-start rule. A negative ACE adjustment arising in 2001 would be lost forever, because no positive prior-year ACE adjustments exist. Long-term contracts: According to Sees. 56(a)(3) and 55(e)(2)(C), only contracts entered into on or after the change date are subject to the ACE adjustment. Thus, residential construction contracts entered into before the change date are no longer subject to ACE. LIFO inventory: Under Sec. 56(g) (4)(D)(iii), the difference between LIFO and FIFO must normally be added back to tentative AMTI to compute ACE. During the exempt period, no such adjustments have to be made. When the exemption is no longer available, the question becomes whether the negative adjustment applies to post-1983 positive LIFO adjustments or only to post-change positive LIFO adjustments. Given the final LIFO and ACE regulations, the answer would seem to be the former. Private activity bond and exempt interest income: Under Sec. 57(a)(5), the acquisition date of the underlying bonds is not important; the nonexempt corporation includes the interest income as an  AMT or ACE adjustment beginning in 2001.


Organization costs: Under Sec. 56(g)(4)(D)(ii), the Sec. 248 five-year amortization of organization costs allowed for regular tax is not allowed for ACE purposes. However, if the corporation is AMTexempt in the year the organization costs are incurred, no ACE adjustment will be required. Because a corporation's first year is almost always AMT-exempt, the effect of Sec. 56(g)(4)(D)(ii) is significantly diluted.

Key person life insurance: In the case of whole-life key person insurance policies, increases in cash surrender values increase ACE, while premium payments decrease ACE. When the insured dies, the adjusted basis in the policy is netted against the proceeds for ACE purposes. It is unclear whether an  AMT-exempt company would increase its policy's adjusted basis by cash-surrender value increases during its exempt period; guidance from Treasury would clarify this issue.  Anti-abuse rule: Sec. 55(e)(3) was enacted to prevent the AMT exemption from being abused. If  property is transferred to an AMT-exempt company in a Sec. 381 transaction or in a transaction in which the transferee takes a carryover basis in the assets, the prospective application rule does not apply. However, the treatment is prospective only if, in the merger, tax-free liquidation or formation, the transferor was not subject to AMT or ACE adjustments. Other Issues Relationship Between Secs. 55(e) and 1374 When a corporation switches from C to S status, the Sec. 1374 built-in gains tax is triggered. Among other issues, the tax may be reduced by the former C corporation's MTCs. If the C corporation was eligible to be AMT-exempt, it is unclear whether Sec. 55(e)(5) limits carryover; Treasury needs to address this issue. Investments If a corporation is exempt from AMT, its investment strategy might change. For example, private activity bond and exempt interest are more favorably treated than taxable bond interest. Also, dividends from less-than-20%-owned domestic corporations have a higher after-tax yield if AMT does not apply. Conclusion The TRA '97 enacted Sec. 55(e), which significantly reduces the compliance costs and complexity for


eligible small businesses, starting in 1998. If a corporation meets the $5 million gross receipts test, it will be exempt from AMT and able to use MTCs against regular tax. If the company's gross receipts later render it ineligible for exempt status, it will apply the AMT and ACE rules prospectively. Despite this good news, there are still many unanswered questions. RELATED ARTICLE: EXECUTIVE SUMMARY  * When does the three-year lookback period start? The Conference Committee Report says 1995, while the Blue Book says 1994. * A corporation that loses the exemption is liable for AMT prospectively only. * Gross receipts for a short tax year have to be annualized in applying the test. (1) The Taxpayer Relief Act of 1997, Statement of the Managers (8/1/97), p. 73. (2) General Explanation of Tax Legislation Enacted in 1997 (JCS-23-97), the Taxpayer Relief Act of  1997, p. 60. For a discussion of whether a Blue Book is part of the legislative history and, therefore, authority, see, e.g., Karlinsky and Burton, "Can an Individual Deduct Interest Paid on a BusinessRelated Tax Deficiency?," 27 The Tax Adviser 430 (July 1996). (3) IRS Letter Ruling (TAM) 9809001 (10/24/97). (4) See Rev. Rul. 71-455, 1971-2 CB 318. Editor's note: Stewart S. Karlinsky is a member of the AICPA Tax Division's Corporations and Shareholders Taxation Committee.

COPYRIGHT 1998 American Institute of CPA's No portion of this article can be reproduced without the express written permission from the copyright holder. Copyright 1998, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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