Sec. 58(c)(1) creates potential future AMT from PAL carryforwards.

Due to the current economic climate, taxpayers and practitioners are becoming more adept in dealing with the tax aspects of discharge of indebtedness (DOI) income for insolvent or bankrupt taxpayers under Sec. 108. However, often overlooked is Sec. 58(c)(1), which deals with insolvent taxpayers and the alternative minimum tax (AMT) treatment of their passive activity loss (PAL) carryforwards.

The PAL rules for AMT purposes are generally the same as for regular tax purposes. Two major differences are addressed in Sec. 58(b). Sec. 58(b)(1) requires minimum tax rules to be used for measuring and allowing income and deductions in applying any limitations for passive activities. Also, Sec. 58(b)(2) disallows the phase-in rules of Sec. 469(m) for AMT purposes. The other main difference, described under Sec. 58(c)(1), applies only to insolvent taxpayers. Insolvent taxpayers' disallowed passive losses must be reduced by the amount the taxpayer is insolvent. In other words, PALS must be included for AMT purposes without any Sec. 469(m) limitations to the extent the taxpayer is insolvent, essentially converting PALs to active losses for purposes of calculating AMT in the year of insolvency. There are no regulations explaining this provision, nor is there any indication from the committee reports as to the intent behind it.

It appears that Sec. 58(c) was intended to provide tax relief to the insolvent taxpayer under the AMT system. However, by allowing the insolvent taxpayer to take PALs for AMT purposes to the extent of insolvency, Sec. 58(c)(1) may actually increase an individual's alternative minimum taxable income (AMTI).

Example 1: An insolvent taxpayer, T, files a joint return with 1989 regular taxable income of $50,000 and PALs of $300,000. Under Sec. 58(b)(2), T has an AMT adjustment of $60,000 for the phase-in allowed for regular tax purposes under Sec. 469(m). Without the relief allowed under Sec. 58(c), T would pay AMT of $4,723. If T is insolvent in excess of $300,000, the application of Sec. 58(c) reduces his AMTI to zero, therefore eliminating the $4,723 AMT.

Because the allowance of PALs is a timing difference between regular tax and AMT, the application of Sec. 58(c)(1) can cause the opposite effect (i.e., increasing an individual's AMTI) in future years.

Example 2: Assume the same regular taxable income and passive losses as in Example 1, with two differences: (1) T has a net operating loss (NOL) carryover of $125,000 for both regular and AMT purposes and (2) he has Sec. 108 income of $500,000, which is excluded from taxable income due to insolvency.

In 1989, for both regular tax and AMT purposes, T has zero taxable income and AMTI. Therefore, applying Sec. 58(c) has no effect on the 1989 tax due. Accordingly, the only result is to increase the AMT NOL by $300,000. Because of the Sec. 108(a) exclusion from income, both the regular NOL and, arguably, the AMT NOL are reduced to zero.

It is not certain how Sec. 108(b) applies to AMT attributes since such attributes are not specifically listed in Sec. 108(b). However, many practitioners believe that Sec. 108(b) applies separately to AMT attributes under a parallel system concept.

Example 3: In 1990, T again has $50,000 of taxable income and is still insolvent. Included in this amount is net gain from the entire disposition of his passive activity; therefore, the PAL carryover fully reduces taxable income. For AMT purposes, without the prior year application of Sec. 58(c)(1), there would have been a negative adjustment in the amount of $60,000, resulting in no AMT. But after the application of Sec. 58(c)(1), there is a positive adjustment in the amount of $240,000. T will be subject to AMT for 1990 with an additional tax liability in the amount of $50,068. In this instance, T was required in 1989 to use passive losses for AMT, thereby converting them to an AMT NOL. Because he was insolvent and had discharge of indebtedness income in 1989, both the regular tax and AMT operating losses were reduced pursuant to Sec. 108(b). In the year in which the passive activity is disposed, T is required to pay AMT. (Note that this adjustment will become part of the minimum tax credit under Sec. 53 and will ultimately be refunded to T, depending on his future tax situation.)

Obviously, practitioners and taxpayers have little control over when a taxpayer become insolvent. It is important to realize that the taxpayer need not have DOI income in order for the required recalculation of allowed passive losses for AMT purposes. The very fact of taxpayer insolvency mandates the application of Sec. 58(c)(1). However, practitioners can attempt to minimize the section's negative effects. In planning dispositions of activities that will create passive income, it may be necessary to coordinate the timing with the year in which the taxpayer is insolvent and the PALs are allowed for AMT. Another alternative is to ensure that the taxpayer will not be subject to AMT in the year in which the taxpayer has excess passive activity income, either through dispositions or otherwise.

How this section is applied for PAL carryovers into the year the taxpayer is insolvent, and ascertaining which PALs are converted to active losses, is not certain. But whatever the tax consequences of applying Sec. 58(c)(1) may be, taxpayers and practitioners must be aware of the fact that PALs are treated differently for insolvent taxpayers under AMT.