Corporate alternative minimum tax: ACE simplified and MTC liberalized.

Corporate Alternative Minimum Tax: ACE Simplified and MTC Liberalized

Introduction

The corporate alternative minimum tax (AMT) will be computed differently beginning with 1990 tax years as a result of the arrival of the adjusted current earnings (ACE) adjustment. Enacted as part of the Tax Reform Act of 1986, the ACE adjustment will replace the rather arbitrary book income adjustment as a means of capturing a measure of economic income within the AMT income base.

Although the overall theme for 1989's tax legislation was to raise revenue, Congress adopted some costly benefits for corporations which simplify the ACE calculation as originally enacted and modify the AMT system by liberalizing the minimum tax credit (MTC) computation.

This article discusses the newly enacted changes of the Revenue Reconciliation Act of 1989 and compares them to the ACE provisions previously scheduled to go into effect but now dropped from the AMT rules.

Background

In April 1989, Representative Dan Rostenkowski, Chairman of the House Ways and Means Committee, introduced H.R. 1761 to dramatically simplify the AMT by integrating ACE into the AMT computation. Although the Rostenkowski proposal did not survive the legislative process, a modified House version of AMT simplification is included in the 1989 Act. In general, these provisions will have a positive effect on corporate taxpayers starting with tax years beginning after December 31, 1989.

As originally enacted, the ACE computation promised to be extremely complex. For example, calculations for depreciation, depletion, intangible drilling costs (IDCs), and mineral exploration and development costs would have required (i) computing deductions over a series of years, (ii) present valuing these deduction streams, and (iii) comparing them to present valued book deduction streams prior to including the item into the ACE calculation.

Following the 1989 Act, the ACE adjustment is no longer connected to the book income adjustment and will not require present value computations. Even though the corporate AMT is simpler, corporations still must make preparations to implement the new ACE computations, as well as consider planning opportunities available during the final year of the book income adjustment to take advantage of how the different provisions affect AMT income (AMTI). In addition, corporations must focus on ACE in order to make meaningful projections of 1990 and future tax liability and FASB 96 tax accruals, as well as for 1990 estimated tax payments.

Comparison of Book Income to ACE

Under the original system, the book income adjustment under section 56(f) of the Internal Revenue Code is a corporate AMT addback equal to 50 percent of the positive excess of adjusted book income over tentative AMTI. This adjustment is based on the difference between book income and taxable income reporting. Temp. Reg. $S 1.56-1T (issued April 27, 1988) provides detailed guidance on the computation of adjusted net book income. In contrast, no regulations have been issued concerning the ACE adjustment. (1)

Beginning in 1990, adjusted current earnings will replace the book income adjustment. The ACE adjustment defined in section 56(g) equals 75 percent of the difference between tentative AMTI (before net operating losses (NOLs) or the ACE adjustment) and ACE. ACE is not based on financial statement income, but rather, the amount derived is supposed to approach economic income. This is achieved by making certain statutorily prescribed adjustments to AMTI and by borrowing some earnings and profits (E&P) adjustments. Although ACE incorporates certain E&P adjustments, it should not be confused with current E&P. In addition, the ACE adjustment, unlike the book income adjustment, can be negative (reducing AMTI), but only to the extent of prior positive ACE adjustments. These differences in the measure of book income versus ACE create meaningful planning opportunities, several of which are discussed below, and should be considered in optimizing AMT treatment under the two computations.

Computation of ACE

In order to determine ACE, corporations must prepare and maintain a separate set of records for certain types of income and expense which may be accounted for differently under section 56(g)(4) than for other purposes (e.g., regular tax, AMT, and financial accounting).

The ACE adjustment starts with AMTI before AMT NOLs or the ACE adjustment (tentative AMTI) and then a series of adjustments are made to arrive at ACE. Tentative AMTI is then subtracted from ACE and 75 percent of this difference becomes the ACE adjustment. If the adjustment is negative and there are no (or not enough) prior positive ACE adjustments, the adjustment (or excess) is lost, because prior book income is not considered and a carryforward is not available for a negative ACE adjustment.

Adjustments in Computing ACE

Depreciation

Perhaps the most complex adjustment included in section 56(g)(4) is the depreciation adjustment. As enacted in 1986, ACE depreciation was to be computed by selecting the appropriate classification among four categories for each asset, computing depreciation over the remaining life of the asset by a prescribed method, and computing the net present value (NPV) of this stream of depreciation deductions. This computation was then compared to a similar computation prepared using the book method. The slower method (the method having the lower NPV) would have been selected as the ACE method. This comparison would have been necessary for each and every asset or class of assets.

The new law simplifies this computation considerably by eliminating the book comparison and present value aspects of the depreciation adjustment. Now, in order to compute ACE depreciation, assets must be grouped into one of four classes and depreciated using the prescribed method for each group, depending on when the assets were placed in service.

a. Property placed in service in tax years beginning after 1989. The alternative depreciation system (ADS) of section 168(g) applies. This requires straight-line recovery over the property's class life, over 12 years for personal property with no class life, and over 40 years for nonresidential real or residential rental property.

b. Property to which the Modified Accelerated Cost Recovery System (MACRS) applies (generally, property placed in service after 1986) but placed in service before tax years beginning after 1989. This method of depreciation is based on the AMT adjusted basis of the property as of the close of the last tax year beginning before 1990 and follows the straight-line method over the remainder of the recovery period (generally, class life as specified in section 168(g)). (2)

c. Property to which the original Accelerated Cost Recovery System (ACRS) applies (generally, property placed in service after 1980 but before 1987). This method of depreciation is based on the regular tax adjusted basis of the property as of the close of the last tax year beginning before 1990 and follows the straight-line method over the remainder of the recovery period (generally, class life as specified in section 168(g)).

d. Other property (property placed in service before 1981 and other property to which neither MACRS nor ACRS apply). Depreciation is determined in the same manner as for regular tax purposes.

Every corporation with depreciable assets will be subject to these new rules even if the AMT does not apply for the current year, and therefore, should be prepared to implement them in 1990. A more impractical and more costly approach to follow would be to re-create historical accounts in years when the AMT actually applies. This latter approach, if followed, will prove far less effective than preparing the ACE computation on an annual basis.

E&P Adjustments

Exclusion items -- income items statutorily excluded for regualr tax or AMTI but includible for E&P computation purposes -- are included in computing ACE net of any allocable deductions. In general, the section 312 regulations require any statutorily excluded items to be included in E&P, and therefore, these items would be included in ACE.

Such items would include tax-exempt interest income (net of allocable carrying costs) and the "inside build-up" of income in life insurance contracts (net of attributable premiums). An exception to this rule is provided by section 56(g)(4)(B)(i) for discharge of indebtedness income excluded from income by section 108, which sets forth an exclusion for ACE purposes as well. (3)

Exclusion items of expense or deduction are not deductible in computing ACE unless the items relate to exclusion items of income. Exclusion item deductions are those expenses that reduce E&P but are nondeductible for regualr tax or AMTI. Therefore, items such as federal income taxes, fines, penalties, disallowed interest expense, the disallowed portion of meals and entertainment expense, and similar items probably do not reduce ACE even though they reduce E&P.

Items Not Deductible in Computing E&P

Under section 56(g)(4)(C), no deduction is allowed in computing ACE for any item that would not be deductible in any tax year for purposes of computing E&P. Generally, NOLs and dividends received are the only deductible items for regular tax or AMTI that are not deductible for E&P.

An important specific exception, however, is the corporate dividends received deduction (DRD). This deduction is generally allowable against ACE under the new law (for 20-percent-or-more corporate investors) as long as the dividends are attributable to the distributor's income that is subject to tax. (4) It should also be noted that AMT foreign tax credits are available with respect to dividends received from section 936 corporations to the extent of 75 percent of any withholding or income tax imposed by a U.S. possession on the dividend payor.

Corporations receive certain dividends for which some DRD may be available for regular tax but not under ACE. These include dividends from less-than-20 percent owned corporations; dividends allocable to tax-exempt income of the payor; and dividends subject to [section] 244 (public utility preferred stock) which are not otherwise qualifying dividends.

The IRS is required under the new rules to provide guidance, no later than March 15, 1991, as to which items are exclusion income or deduction items that should be included in the ACE computation. Although guidance is not required until March 1991, informal advice from the IRS suggests that a notice detailing E&P adjustments applicable to ACE may be released in early 1990.

Other Items

Certain other adjustments to E&P provided in section 312(n) also apply for purposes of computing ACE beginning after 1989:

* IDCs paid or incurred in tax years beginning after 1989 must be capitalized and amortized over 60 months. (5)

* Circulation and organizaational expenditures paid or incurred in tax years beginning after 1989 must be capitalized and treated as part of the basis of the assets to which they relate.

* ACE is increased or decreased by the amount of any increase or decrease in the LIFO recapture amount (excess of the FIFO inventory amount over the LIFO inventory amount).

* Installment sales treatment is allowable for ACE purposes, and therefore, no adjustment is needed provided interest is paid on the deferred tax liability in accordance with section 453a(a). (6)

* Prior to the new law, the computation of ACE would also have included mandatory percentage-of-completion accounting for long-term contracts entered into after February 1986. This provision, however, was dropped from ACE, which is consistent with the new law's repeal of the completed contract accounting method for contracts entered into after July 10, 1989.

* The new law also repealed a separate inventory capitalization method based upon E&P concepts which would have been required by ACE. Now, section 263A is available for ACE without a separate determination.

The following additional adjustments not required for E&P purposes, must be made for purposes of computing ACE:

* No loss is allowed on the exchange of pools of debt obligations having substantially the same effective interest rates and maturities. (7)

* Life insurance companies must capitalize and amortize the acquisition expenses of any policy in accordance with GAAP.

* Depletion must be determined under the cost depletion method for property placed in service in tax years beginning after 1989.

* For corporations that experience a change of ownership in tax years beginning after December 31, 1989, (within the meaning of section 382), the basis of the property of the corporation may not, for ACE purposes, exceed the allocable portion of the purchase price paid for the corporation. (8) The effective date for these transactions, where a write-down to purchase price is required, was moved by the new law from October 22, 1986, to tax years beginning after December 31, 1989.

Other AMT Legislation

Equally significant in scope to ACE simplification, Congress extended the corporate MTC to the total corporate AMT liability under the new law, effective for tax years beginning after December 31, 1989. Under the 1986 legislation, the MTC was available for AMT attributable to deferral items, preferences, or adjustments arising from temporary differences which represent the deferral rather than permanent reduction of tax liability. The MTC was created to ensure that taxpayers did not permanently lose the tax benefits associated with these deductions. Exclusion items such as certain tax-exempt interest and depletion were not eligible for the credit. Under the new law, even exclusion items will generate MTC for corporations.

Consequently, corporations subject to AMT in 1989 tax years should attempt to defer exclusion items to 1990 when these items will generate MTC. Where this is not practical, incurring AMT in 1990 by deferring other preference and adjustment items will help maximize the MTC for future use.

The 1989 Act also provided that, in limited circumstances, the corporate foreign tax credit may offset 100 percent of AMT. Only corporations meeting the following requirements can qualify:

* the foreign corporation's stock is more than 50 percent owned by U.S. persons;

* the corporation's business is conducted in one foreign country (which must have an exchange-of-information articles in its income tax treaty with the United States);

* the corporation distributes substantially all of its current E&P each year; and

* all dividends received by U.S. shareholders are utilized in a U.S. business.

Furthermore, the 1989 legislation provided that the use of percentage-of-completion accounting for home construction contracts entered into after September 30, 1989, would not be required for AMT purposes. The Act also provides that orphan drug credits currently not utilizable due to the imposition of the AMT will increase the MTC with respect to credits disallowed after December 31, 1986; this effectively creates an indefinite carryforward period for this item.

Planning Opportunities

Between now and the beginning of a corporation's first tax year subject to ACE, increased attention should be focused on how to minimize the overall tax burden in light of the elimination of the book income adjustment. Planning strategies designed to minimize book income may no longer be appropriate after 1989 tax years; corporations should seek to exploit discrepancies between book income and ACE. The discussion below addresses several of these opportunities.

Nonrecognition Transactions: Gain or loss on certain nonrecognition transactions under sections 1031 and 1033 (like-kind exchanges and involuntary conversions) or discharge-of-indebtedness income excluded under section 108 may be included in book income but are not additions to ACE. Where possible, these transactions should be deferred to 1990 tax years.

Exclusion Items: The following AMT adjustments or preferences are defined as corporate exclusion items in section 53(d)(1)(ii): depletion, private activity bond interest, appreciated property charitable contribution and health insurance organization deductions under section 833(b). These items will be eligible for MTC in tax years beginning after 1989. To the extent possible, corporations incurring AMT in 1989 tax years should defer these items.

Reduce Book Income in 1989 Tax Years: Book reserves considereed nondeductible for tax purposes, such as warranty reserves, should be accelerated when feasible for financial statement purposes by corporations subject to AMT in 1989 tax years in order to reduce the book income adjustment in 1989. These reserves are not deductible for ACE and would produce no tax benefit in post-1989 tax years.

Intercompany Dividends: Consider deferring dividend payments between affiliated group members that do not file consolidated returns, until ACE takes effect. The dividend income is incuded in separate-company book income, but deductible for ACE.

Accelerate Disallowed Expenses: Expenses that serve to nimimize the difference between book and taxable income and are unavoidable should be incurred by corporations paying AMT in a pre-1990 tax year rather than an ACE year. These expenses have no effect on ACE but will reduce the book income adjustment. Examples include fines, penalties, 20 percent of meals and entertainment expenses, and political contributions.

1990 Estimated Tax Payments

Despite the passage of simplification measures in 1989, ACE will still require a significant recordkeeping effort in that many items, most notably depreciation, are treated differently for ACE than for regular tax or AMT. Fixed asset software should be modified in time to take into account ACE depreciation for estimated payment computations. For most corporations that paid a tax liability and did not have a short tax year in 1989, the first quarter federal estimated tax payment can be based on the prior year tax liability (section6655(d)(2)(B)). Subsequent installments for large corporations, however, (those having taxable income of $1 million or moe in any of the three prior yearse must be based on current taxable income. This means large companies must compute ACE for estimated tax purposes for the second installment (due June 15, 1990, for calendar-year companies).

Conclusion

The alternative minimum tax system is changing after 1989, and many corporations whose business or investment activities create AMT issues should be aware of the benefits arising from the installation of ACE and the 1989 Act. The simplification of aCE should significantly reduce the costs associated with complying with the new rules, and the modifications to the AMT will generally benefit corporate taxpayers as compared to the current system. Companies hampered by the AMT in the past and the predictable future should consider this transition period as a unique tax planning opportunity.

(1) The IRS hs opened two regulation projects in the AMT area recently; IA-029-89 deals with ACE and IA-057-89 concerns the interaction between AMT and the consolidated return regulations.

(2) No ACE adjustment should be required for section 1250 property thata is either pre-1990 MACRS or post-1989 property. In addition, a straight-line method election for regular tax and AMT under section 168(g)(7) would eliminate any ACE adjustment on newly acquired section 1245 property.

(3) The exception for forgiveness-of-indebtedness income affords a more liberal treatment than such income receives under the book income adjustment. This raises a planning opportunity during the transition from book income to ACE if the timing of forgiveness can be deferred into an ACE year.

(4) Before the 1989 changes to the ACE provisions, any dividends received from consolidated return members would not have been eligible for an ACE deduction, presumably because these dividends would eliminate in consolidation. Only dividends received from affiliated group members that could not file consolidated returns would have been deductible for ACE.

(5) The new law repealed the present value and comparison to book requirements for IDCs, depletion, and mineral exploration and development costs. Because mineral costs are already required to be amortized over 120 months under the AMT, and ACE adjustment for these costs will be required.

(6) This is a new law change from a prior rule which would have disallowed the installation method for ACE. I.R.C. [section] 59(g)(4)(D)(iv). Apparently, Congress believed the interest charge was enacted to cause taxpayers to pay for the deferral privilege. An ACE addback would have been an additional charge for the deferral benefit.

(7) This adjustment probably was enacted at the behest of the IRS, which has been generally unsuccessful in convincing the courts that these transactions do not culminate in a realization event for regular tax purposes. See, e.g., San Antonio Savings Association, 887 F.2d 577 (5th Cir. 1989).

(8) The de minimis rule contained in section 382 also applies for ACE purposes, so that built-in losses less than $10 million or 15 percent of the fair market value of the assets of the company (whichever is lower) will not trigger an asset write-down.

Samuel P. Starr, CPA, LLM, is a partner in the National Tax Office of Coopers & Lybrand, Washington, D.C. He is a member of the AICPA Corporate AMT Task Force and has published several articles on the AMT.

David C. Green, CPA, is a tax manager in the Coopers & Lybrand, Parsippany, New Jersey, office. He has previously co-authored an article on this subject.