Avoiding penalties for failure to pay AMT: computation's complexity may abate penalties for individuals.

In recent years, Congress has made several changes to the version of the alternative minimum tax (AMT) regime it enacted in the Tax Reform Act of 1986 (TRA).(1) The most recent changes, in the Revenue Reconciliation Act of 1993 (RRA), reduced the applicability of the corporate AMT ;primarily through changes to the depreciation computation for adjusted current earnings purposes), while increasing individuals' exposure to AMT. Under Sec. 55(b)(1)(A)(i), effective for tax years beginning after 1992, a 26% rate applies to the first $175,000 ($87,500, if married filing separately) of AMT income (after the AMT exemption); the balance is taxed at 28%. Sec. 55(d)(1) exempts the first $45,000 of AMT income in the case of a joint return or surviving spouse ($33,750 for a single taxpayer, $22,500 if married filing separately).

The increase in the AMT rate does not necessarily mean that more individuals are subject to the AMT. Because the regular tax rates were also increased by the RRA, regular tax will typically exceed tentative minimum tax (TMT).

The problem, however, is the 28% maximum capital gains rate, which equals the top individual AMT rate. When the Sec. 55(d)(3) exemption phaseout applies, a taxpayer's effective AMT rate can equal 35%, which significantly exceeds the top capital gains rate. For married taxpayers filing jointly land surviving spouses), the phaseout of the exemption results in an effective marginal AMT rate that exceeds 28% when AMT income falls between $150,000 and $330,000 2 The AMT exemption is reduced by $ 1 for every $4 by which the taxpayer's AMT income exceeds the lower figure of the range.

Example: H and W file a joint return; they have $230,000 of AMT income. Their AMT exemption is $25,000, computed as follows: AMT income $230,000 Less: Starting

phaseout amount (150,000) AMT income in excess

of starting phaseout

amount 80,000 Phaseout percentage 25% Exemption phased out 20,000

AMT income 230,000 Exemption

($45,000 - $20,000) 25,000 AMT income 205,000 AMT

$53,900(*) (*) 0.26 1$175,000) + 0.28 ($30,000).

Because of the exemption phaseout, H and W's effective marginal tax rate is 125% of the 28% rate, or 35%. If H and W have an additional $100,000 of capital gain, it will increase their regular tax liability by $28,000 (28% x $100,000), while increasing their TMT by $35,000 135% x $100,000) to $88,900.(3) The net effect is that the capital gain increases the taxpayers' likelihood of being subject to the AMT.

This result would change if the $100,000 was ordinary income, such as a compensation bonus. The ordinary income would be taxed, for regular tax purposes, at a marginal rate in excess of the 35% effective marginal AMT rate. Thus, the additional income would not increase H and W's chances of being subject to AMT.

The AMT remains a levy that few individuals think about. Since more individuals are subject to AMT following the RRA, there will probably be more instances of AMT noncompliance by individuals.

If the IRS determines that a taxpayer owed AMT, but neglected to compute and pay it, the Service will expect the taxpayer to pay the AMT due, and perhaps penalties as well. The individual taxpayer's prospects for avoiding such penalties is the focus of this article.(4) The courts have shown some sympathy for taxpayers who try to cope with the AMT's complications; to some extent, taxpayers have been helped by the Service's own difficulties with the AMT. The courts have sympathized with taxpayers trying to deal with a tax that the IRS sometimes has forgotten to apply(5) or has incorrectly computed.(6)

Typical Penalties in AMT Cases

Sec. 66621a) and 1b1 authorize the Service to impose a 20% penalty on a tax underpayment attributable to one or more of five specified transgressions, one of which is negligence or disregard of rules or regulations. Sec. 66621C) defines "negligence" as including any failure to make a reasonable attempt to comply with the provisions of the Code, and "disregard" as including any careless, reckless or intentional disregard. Regs. Sec. 1.6662-3(b)(1) is a bit more expansive, indicating that negligence includes the failure to exercise ordinary and reasonable care in the preparation of a tax return; under Regs. Sec. 1.6662-3(b)(2), a disregard of rules or regulations is "careless" if the taxpayer does not exercise reasonable diligence to determine the correctness of a return position contrary to the rule or regulation. A disregard is "reckless" if the taxpayer makes little or no effort to determine whether a rule or regulation exists, under circumstances that demonstrate a substantial deviation from the standard of conduct that a reasonable person would observe. A disregard is "intentional" if the taxpayer knows of the rule or regulation disregarded. The IRS routinely asserts the Sec. 6662(b)(1) negligence/disregard penalty when the taxpayer has neglected to compute and pay AMT.

Under Sec. 6662(b)(2), a second ground for penalty is the substantial understatement of income tax. For individuals, an understatement is "substantial" under Sec. 6662(d)(1) if it exceeds the greater of (1) 10% of the tax required to be shown on the return or (2) $5,000. The Service typically asserts this ground in AMT cases when the tax understatement is significant enough to meet one of these tests.

A taxpayer's chances for avoiding a penalty are typically tied to his ability to show that there was "reasonable cause" for failing to pay the AMT, and that he acted in "good faith." Regs. Sec. 1.6664-4(b)(1) states that the most important factor in determining whether the reasonable cause exception applies is the extent of the taxpayer's effort to assess the proper tax liability. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of the taxpayer's experience, knowledge and education. Reliance on the advice of a professional (e.g., appraiser, attorney or accountant) does not necessarily demonstrate reasonable cause and good faith. However, reliance on professional advice or other facts constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith.(7) As discussed below, different aspects of the reasonable cause test apply, depending on the lapse that creates the AMT liability.

AMT Liability Arising From Supportable Regular Tax Positions

Sometimes a taxpayer takes a return position that has reasonable prospects of prevailing in a dispute with the IRS. For example, the taxpayer may have reason to believe he is an independent contractor, rather than an employee. Thus, for regular tax purposes, he treats expenses as trade or business expenses, rather than as unreimbursed employee business expenses subject to the 2% floor.

If the taxpayer loses on this issue, the additional regular tax due may be only a nuisance; the AMT outcome, however, may be a catastrophe, because Sec. 56(b)(1)(A)(i) bars the deduction of miscellaneous itemized deductions for AMT purposes. Thus, if the taxpayer loses on the independent contractor issue, he may be pushed from a regular tax position into the AMT. Since the taxpayer is unlikely to have filed Form 6251, Alternative Minimum Tax--Individuals, to report AMT liability, the IRS will probably assess a penalty under Sec. 6662.

The Tax Court dealt with a variation on this theme in Johnson,(8) involving a couple filing a joint return. The husband was a salesman for a company manufacturing hospital equipment. In 1987, he had $95,493.84 of unreimbursed expenses related to his sales territory. The couple reported these expenses as unreimbursed employee business expenses on Schedule A of their 1987 return (just as they had done on all of their returns from 1971-1988).

After an audit, the Service issued a notice of deficiency based on the taxpayers' failure to report and pay AMT on their 1987 return. The taxpayers' fax Court petition included an amended return that incorporated an AMT calculation (prepared by their original return preparer) that listed the unreimbursed expenses as an adjustment to taxable income.

Subsequently, the taxpayers filed an amended petition and submitted a second amended tax return prepared by their counsel. This return reflected their litigating position that the husband was a self-employed independent contractor, not an employee. The return listed the former Schedule A unreimbursed employee business expenses in Schedule C. As a result, the taxpayers claimed a refund. An AMT computation was not included with this second amended return.

The court had little difficulty finding the husband to be an employee, as he had an employment agreement with his company that required him to devote all his time to his employer, taxes were withheld from his compensation and his income was reported on a W-2; thus, the taxpayers owed AMT.

The taxpayers also argued that they were not subject to the negligence penalty, because they relied on the advice of their CPA (the original preparer), who neglected to prepare Form 6251. As discussed below, this argument can work in certain circumstances. However, the court rejected this argument because, before audit, the taxpayers' CPA realized his error and forwarded to the taxpayers an amended return showing a substantial amount of AMT due. The taxpayers had chosen to disregard the return.

Nonetheless, the court concluded that although there was evidence of negligent conduct, the taxpayers' assertion of independent contractor status was reasonable, so that no negligence penalty was due. Further, the taxpayers avoided the substantial understatement penalty, because the court found substantial authority for their position. Using the standard outlined in the regulations ("the weight of authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment"(9)), the court concluded that the numerous independent contractor vs. employee cases with similar facts provided the taxpayers with substantial authority for their position.

Johnson is encouraging for a number of reasons:

[] The court refused to assess penalties, even though the taxpayers' original return was insupportable--if the taxpayers' expenses were unreimbursed employee business expenses, as they reported, they should have filed Form 6251 and paid AMT.

[] The taxpayers simply ignored the amended return sent by their CPA. They should have paid the AMT due on that amended return, or instructed the CPA to prepare an amended return showing the unreimbursed expenses as those of an independent contractor. By doing neither, the taxpayers apparently hoped to win the audit lottery. However, this lack of "clean hands" did not prevent them from avoiding penalties.

Johnson suggests that the Tax Court is disinclined to award penalties in AMT cases (at least, when its rejection of an arguably supportable regular tax position triggers AMT).(10)

Reliance on a Tax Adviser

In some cases, a return preparer may not realize that a taxpayer has an AMT liability; thus, the return may be prepared and filed without Form 6251. The taxpayer's chances of avoiding the accuracy-related penalty are fairly good in this situation. As previously discussed, under Regs. Sec. 1.6664-4(b)(1), although mere reliance on a professional does not necessarily show reasonable cause and good faith, such reliance, when coupled with other facts, can constitute reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith.(11)

Regs. Sec. 1.6664-4(b)(2), Example 1, involves a taxpayer who seeks advice from a tax professional concerning the deductibility of certain state and local taxes. The tax adviser concludes that the taxes are fully deductible and the taxpayer, in preparing his own return, takes the deduction. The example indicates that the taxpayer demonstrated reasonable cause and good faith by seeking advice from the professional, unless he "sought advice from someone that he knew, or should have known, lacked knowledge in federal income taxation."

One commentator, in reviewing the precedents in this area, noted that "[c]ases in which the taxpayer's reliance has been upheld have generally involved substantive issues or other matters beyond the knowledge of the layman."(12) It is fair to assume that the AMT falls within this class. Thus, a taxpayer should not be subject to accuracy-related penalties for failing to pay AMT if his return was prepared by a professional whom the taxpayer believed was competent.(13)

Self-Prepared Return Defenses

If a taxpayer prepares his own return and fails to file Form 62S1, different rules apply. As previously discussed, Regs. Sec. 1.6664-4(b) provides that the most important factor is the extent of the taxpayer's effort to assess the proper tax liability; circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of the taxpayer's experience, knowledge and education. At least one Tax Court case, Baker,(14) and the Service's own difficulties with the AMT, provide some support for that position.

Baker involved taxpayers with a large long-term capital gain in 1984. Under the AMT regime in effect before the TRA, the 60% net capital gain deduction (under pre-TRA Sec. 1202) was an AMT preference. The taxpayers' return did not include an AMT calculation, nor did the taxpayers pay AMT.

The Service sent the taxpayers a deficiency notice with the AMT incorrectly calculated.'5 The Service's inability to correctly compute AMT liability would appear to support the notion that AMT is beyond the "experience, knowledge and education" of most taxpayers.

Although the Tax Court recognized that the pre-TRA AMT regime was complicated, it nevertheless upheld the imposition of the AMT and negligence penalties. As the taxpayers presented no evidence to contest the conclusion that they had been negligent, the penalty stood. The court noted only that line 22 of the 1984 Schedule D stated that if that line were more than zero, the taxpayers might be liable for AMT. The taxpayers reported $193,628 on line 22, an amount considerably larger than zero. Thus, their apparent failure to take note of the line 22 language could only be due to negligence; a reasonable and ordinarily prudent person would have undertaken to determine whether any AMT liability existed, an inquiry that, in the instant case, would have produced an affirmative answer.

Baker involved a situation in which, as part of a regular tax computation, a tax form specifically drew the taxpayers' attention to the possibility of an AMT liability; the taxpayers' decision to ignore the AMT was then no longer reasonable.

At present, neither Form 1040 nor its related forms and schedules include an explicit line reference to Form 6251.(16) Thus, the Service should not be able to use the line reference argument from Baker to show that a taxpayer was negligent in failing to compute AMT on a self-prepared return. The instructions for Form 1040 and related documents, however, include repeated references to AMT. Should a taxpayer's failure to heed the instructions be grounds for a negligence penalty?

The answer should be "no." The instructions for Form 1040 and its schedules run over 100 pages; thus, it seems unreasonable to require a taxpayer to read through every page to ensure that he has properly computed his tax liability.

However, a taxpayer should have difficulty avoiding a penalty for failing to compute AMT on a self-prepared return if the taxpayer has previously paid AMT or filed Form 6251. The Service can reasonably expect in such case that the taxpayer is aware of the AMT's existence, even if a professional prepared the taxpayer's previous returns (including the AMT information). If the taxpayer did not understand the Form 6251, he should not have signed the prior return(s) before gaining at least a minimal understanding of the AMT.(17)

The "Clean Hands" Advantage

A taxpayer might prepare his own return and simply neglect to compute AMT. If the taxpayer's return is otherwise correct, he may have another argument for avoiding the negligence penalty.

This occurred in Hofstetter,(18) involving a Swiss citizen who had worked for a major New York law firm as a "trainee"/researcher and had also engaged in unpaid research at Harvard University. He filed a 1988 Form 1040-NR, U.S. Nonresident Alien Income Tax Return, without computing AMT liability.

The taxpayer left the U.S. in 1989 and returned to Switzerland. Before his departure, he was required, under Sec. 6851(d), to meet with an IRS representative to determine whether he satisfied his Federal tax obligations. An IRS agent reviewed the taxpayer's 1988 return and, as a result of the meeting, issued to him an "Annual Certificate of Compliance." In November 1989, the IRS issued a deficiency notice indicating that the taxpayer owed $4,900 of AMT for 1988, and a negligence penalty.

In response, the taxpayer first argued that, by issuing the certificate of compliance, the Service was precluded from determining a deficiency in the Federal income tax reported on his return. Second, he asserted that Secs. 55(d) (dealing with the AMT exemption) and 6013(a)(1) (precluding married couples from filing a joint return if either one is a nonresident alien) unconstitutionally discriminated against married, nonresident aliens. Third, he contended that the application of those sections violated the U.S.-Switzerland tax treaty.

The Tax Court rejected all of the taxpayer's arguments. However, the court rejected application of the negligence penalty, concluding that there had been no negligence or intentional disregard of rules and regulations. The taxpayer had otherwise completed his tax return accurately and substantiation of expenses claimed as deductions on the return was not at issue.

Although the taxpayer was not a U.S. citizen, his employment and pro se appearance before the Tax Court suggested that he had more than a minimal understanding of Federal tax law. If any individual could be said to have the experience, knowledge and education to justify the imposition of a negligence penalty for failing to file Form 6251, it would be the taxpayer in Hofstetter. Nonetheless, the court declined to impose a negligence penalty--apparently giving great weight to the fact that the taxpayer had a clean return.

However, there may have been another reason for the court's rejection of the negligence penalty: If the IRS agent who reviewed the taxpayer's return prior to his departure was unable to discern that AMT was due, how could the taxpayer be negligent in failing to report AMT liability?

Notwithstanding the special circumstances of Hofstetter, it is reasonable to assume that having a clean return increases a taxpayer's chances of avoiding accuracy-related penalties if it is determined that he incorrectly failed to file Form 6251.

Conclusion

AS the foregoing discussion indicates, taxpayers often have reasonable prospects of avoiding accuracy-related penalties when they fail to pay AMT. The value of these precedents, however, should not be overemphasized. They are primarily helpful for individuals: a large corporation would have a hard time denying knowledge of the AMT. Similarly, individuals who have been subject to the AMT in previous years will find it difficult to explain why they ignored it in a subsequent year's return.

The best approach is to keep the AMT in mind whenever a return is prepared.

Copyright [C] 1995 by Lance W. Rook. All rights reserved. Author's note: The author thanks Edward A. Sair, Partner, Washington National Tax Office, Deloitte & Touche LLP, for his insightful comments on this topic. All opinions expressed in this article, however, are the author's alone. (1) For a general discussion of the AMT, see Rook, Tax Planning For the Alternative Minimum Tax (Matthew Bender & Co., 1994). (2) For single taxpayers and heads of households, the corresponding range is $112,500 to $247,500; $75,000 to $165,000 for those married filing separately. (3) For the sake of simplicity, this example ignores any impact that the additional $100,000 of capital gain would have on adjusted gross income-based deductions (e.g., medical expenses). (4) All of the cases discussed in this article deal with individuals, as they have a better chance of avoiding penalties in AMT cases corporate taxpayers are generally more sophisticated in tax matters (and hence, more likely to be subject to penalties for noncompliance). (5) See Karl Hofstetter, 98 TC 695 (1992), discussed in the text accompanying note 18. (6) See George H. Baker, Sr., TC Memo 1990-635, aff'd without pub. Opinion, U.S. App. LEXIS 12180 (7th Cir. 1992), discussed in the text accompanying note 14. (7) See also Regs. Sec. 1.6664-4(b)(2), Example 1; Prop. Regs. Secs. 1.6662-4(g)(4) and 1.6664-4(c) (8) William O. Johnson. TC Memo 1993-530, involving pre-Revenue Reconciliation Act of 1989 (RRA '89) Sec. 6653(a)(1)(A) (the predecessor to the Sec. 6662(b)(1) negligence/intentional disregard rules), and pre-RRA '89 Sec. 6661(a) (the predecessor to the Sec. 6662(b)(2) substantial understatement rules). For purposes of this article, these pre-RRA '89 provisions are essentially the same as current law. See also 1 Kenneth Alexander, TC Memo 1995-51, and IRS Letter Rulings (TAMs) 9346001 (7/6/931 and 9342001 (4/21/931, which dealt with similar substantive law issues, but did not discuss penalties. (9) Pre-RRA '89 Regs. Sec. 1.6661-3. The same language appears in Regs. Sec 1.6662-4(d)(3). (10) This problem might also arise if a taxpayer deducts real estate taxes as a business expense, this deduction does not give rise to an AMT adjustment. However, if a court concludes that the taxes are a personal expense, under Sec.561(b)(1)(A), they become an itemized deduction for regular tax purposes that is not deductible for AMT purposes. AMT could thus be triggered. (11) See Robert W. Boyle, 469 US 241 (1985)(55 AFTR2d 85-1535, 85-1 USTC [paragraph]113,602), and George S. Mauerman 22 F3d 1001 (10th Cir. 1994)(73 AFTR2d 94-2002, 94-1 USTC [paragraph] 50,2221 which discuss the reliance defense under prior law. See also Prop. Regs. Secs. 1.6662-4(g)(4) and 1.6664-4(c). (12) Saltzman, IRS Practice and Procedure, [paragraph]17B.02[2][b] (Warren Gorham & Lamont, 1991). (13) The taxpayer has the burden of proving reliance on a professional preparer. In Baker, note 6, discussed in the text accompanying note 14, the Tax Court noted that the taxpayers presented no evidence showing that their failure to report AMT was due to the negligence of their return preparer. (14) Baker, note 6. The Seventh Circuit's affirmance discusses the substantive AMT questions, but not the penalty issue. (15) The amount of the error was relatively small. But see Hofstetter, note 5, discussed in the text following note 18, in which the IRS initially missed the AMT issue completely. (16) Form 1040 states: "Alternative minimum tax. Attach Form 6251." (See line 48 of the 1994 Form 1040.) This should not have the same effect as a specific instruction contained as part of a regular tax computation. Thus, this notation, by itself, should not allow the IRS to assess the negligence penalty. (17) But see Willard M. Christine, TC Memo 1993-473, in which the Tax Court upheld a $1,000 frivolous return position penalty under Sec. 66731a). There, the taxpayer had filed Form 6251, but did not follow the instructions. The taxpayer unsuccessfully argued that he should not be liable for AMT because Form 6251 was misleading, confusing and ambiguous. The court rejected that argument on the grounds that the ambiguity, if any, did not relieve the taxpayer from his liability under the law. (18) Hofstetter, note 5.