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Structuring an installment sale of depreciable property to mitigate the corporate AMT.

The Tax Reform Act of 1986 (TRA) increased the corporate tax rate on net capital gains to 34%, the highest nominal rate applicable to the ordinary income of a C corporation. This change eliminated most tax advantages of realizing a long-term capital gain in corporate solution(1) Since most recognized corporate income is now taxed at the same rate, despite its character, the ability to defer the recognition of income takes on added significance.

The installment sale is a time-tested technique for deferring income in certain situations. For example, the deferral possibilities of a casual sale of less than $5 million of real property on the installment basis was relatively unaffected by the many tax changes of the 1980s.(2) However, the advent of the corporate alternative minimum tax (AMT) and the more recent introduction of adjusted current earnings (ACE) significantly complicate the tax landscape and the planning horizon.

The preamble to Regs. Sec. 1.56(g)-1 stated:

[E]xcept as otherwise provided by regulations or other guidance issued by the Internal Revenue Service, all Internal Revenue Code provisions that apply in determining the regular taxable income of a taxpayer also apply in determining adjusted current earnings (ACE) .... [Regs. Sec,] 1.56(g)-1(a)(5) provides that ACE is a separate tax system except to the extent the Service provides otherwise. The Service has not expanded [Regs. Sec,] 1.56(g)-1(a)(5) to include any exceptions .... (3) (Emphasis added.)

This "separate tax system" concept provides many planning opportunities. All C corporations with depreciable property will have multiple depreciation computations and thus multiple bases for the same asset. This article will focus on planning for dispositions of certain depreciable property and the numerous options for reducing tax liability through the judicious use of installment reporting. However, taxpayers must recognize that, because of Sec. 453(i) as the depreciation recapture potential under Sees. 291, 1245 and 1250 increases, the possibility of deferring a regular income tax (RIT)gain through an installment sale is usually diminished.

Adjusted Bases o[ Corporate Assets

Most depreciable corporate assets have a unique basis for each tax computation (i.e., one basis for the RIT, a second basis for preadjustment alternative minimum taxable income (PA-AMTI), a third basis for ACE and, in some cases, a fourth basis for earnings and profits (E&P) purposes).(4) Numerous tax traps and planning opportunities exist because of these separate basis computations.

For RIT purposes, Sees. 1011, 1012 and 1016 set out the basis computation for depreciable assets.

For PA-AMTI purposes, Sec. 56(a)(7)provides a distinct basis for modified accelerated cost recovery system (MACRS) property, but not for accelerated cost recovery system (ACRS) property. In general, the PA-AMTI basis of MACRS property is determined in the same manner as the RIT basis, except that PA-AMTI depreciation (rather than RIT depreciation) is subtracted from the initial depreciable basis to compute the PA-AMTI basis.

The TRA Senate Report explained Sec. 56(a)(7) as follows.

For all depreciable property to which minimum tax adjustments apply, adjusted basis is determined for minimum tax purposes with reference to the amount of depreciation allowed for minimum tax purposes under the alternative system [i.e., the alternative depreciation system (ADS)]. Thus, the amount of gain on the disposition of such property will differ for regular and minimum tax purposes(5) (Emphasis added.)

The Technical and Miscellaneous Revenue Act of 1988 (TAMRA) added Sec. 56(g)(4)(I), an imprecise provision that requires that the adjusted basis of property for ACE purposes be determined in the same manner as the RIT basis, except that depreciation computed for ACE purposes is substituted for RIT depreciation.(6) Sec. 56(g)(4)(I) does not distinguish between ACRS and MACRS property. Thus, ACRS property will have a distinct ACE basis but a PA-AMTI basis equal to its RIT basis. MACRS property will have one basis for RIT purposes, another basis for PA-AMTI purposes and yet another basis for ACE purposes. See Example 1 above.

Installment Sales

Sec. 56(a)(6), ,as amended by the Revenue Act of 1987, deleted a TRA provision that prohibited the use of the installment method in computing PAAMTI. The Conference Report to the 1987 Act explained Sec. 56(a)(6) by stating that "the installment method may be used in determining alternative minimum taxable income for all nondealer dispositions of property."(7)

It is interesting to note that the Conference Report stated that the installment method "may be used" to compute PA-AMTI. This suggests that the taxpayer could employ the installment method for KIT purposes but "elect out" for PAAMTI purposes. The following logic supports this interpretation.

1. The amendments to Sec. 56(a)(6) deleted a proscription against using the installment method to determine PA-AMTI. However, there is no mandate that the installment method must be used to determine PA-AMTI. If that had been its intent, the Conference Committee could have stipulated that the installment method, if employed for KIT purposes, would also be required for PA-AMTI purposes.

2. The preamble to the Sec. 56 regulations stated that the IRS views the KIT, the AMT and the ACE as "separate tax systems" and that the Code generally applies to each separate system.

3. As there are three "separate tax systems," should not taxpayers be allowed, absent a clear prohibition, the elections provided in the Code for each system, including the "election out" of the installment method under Sec. 453(d)?

Because of the different basis computations, illustrated in Example 1, adoption of the installment method for both RIT and PA-AMTI purposes rarely yields the same gain or loss for the respective tax computations.

Example 2: Assume the same bases computed in Example 1. The building is sold, before allowing for any depreciation in the year of sale, for its original cost of $1,200,000. In this case, a gain of $144,456 ($1,200,000 - $1,055,5441 is included in regular taxable income. However, in calculating PA-AMTI, the includible gain is $113,748 ($1,200,000 - $1,086,252). Because of the difference in the respective gain amounts, a downward adjustment of $30,708 ($113,748 - $144,4561 is required to arrive at PA-AMTI.

Example 2 highlights a significant shortcoming in the instructions to Form 4626, Alternative Minimum Tax-Corporations (including environmental tax). The 1991 instructions for line 2g state: 121 Nondealer dispositions: For nondealer dispositions occurring after March 1, 1986 but before the first day of your tax year that began in 1987, you will have adjustments if you used the installment method for regular tax purposes but were required for AMT purposes to report the entire gain in the year of disposition. In such cases, enter the income you reported for regular tax purposes for the current year with respect to those dispositions on line 2g as a negative amount.

For nondealer dispositions occurring on or after the first day of your tax year that began in 1987, generally no adjustments are necessary since you are allowed to use the installment method of accounting for both regular tax purposes and AMT purposes. (Emphasis added.)

While taxpayers may use the installment method to compute both RIT and PA-AMTI, the basis of MACRS assets will rarely be the same for both purposes. Thus, an adjustment in the computation of PA-AMTI almost inevitably results. The Form 4626 instructions are very misleading in this respect.

A significant question arises with respect to the disposition of certain depreciable assets. What if there is a gain for RIT purposes, but a loss for PAAMTI purposes? Referring to Example 2, if the asset were sold for $1,075,000, a $19,456 gain ($1,075,000 - $1,055,544) results for RIT purposes, but a $11,252 loss ($1,075,000 -$1,086,252) results for PA-AMTI purposes. The Code allows the use of the installment method for PA-AMTI purposes when it is used for RIT purposes, but does not appear to require it. Can taxpayers report a PA-AMTI loss on the installment method when the gain for RIT purposes is reported on the installment basis?(8)

This observation represents another argument in favor of the "separate tax system" concept. Temp. Regs. Sec. 15A.453-1(a) provides that [u]nless the taxpayer otherwise elects ..., income from a sale of real property or a casual sale of personal property, where any payment is to be received in a taxable year after the year of sale, is to be reported on the installment method. (Emphasis added.) Allowing installment reporting for RIT purposes, but prohibiting its use for PA-AMTI, is a logical approach in cases in which there is a RIT gain but a PA-AMTI loss.

Regs. Sec. 1.56(g)-1(f)(4)(i) provides that ACE is generally computed without regard to the installment method. For C corporations with nondealer installment sales of less than $5 million, the entire gain (loss)must be reported in the year of sale for ACE purposes(9). Thus, C corporations may use the installment method of reporting for PA-AMTI purposes regardless of the method employed for RIT purposes, but generally may not use the installment method of reporting for ACE purposes. Assuming the taxpayer realizes a gain for all three tax computations (RIT, PA-AMTI and ACE), reporting is rather straightforward, although both a PA-AMTI gain adjustment and an ACE gain adjustment are usually required. See Example 3 on page 39.

Current Tax Savings

While an installment sale for RIT purposes presents an obvious opportunity to defer, if not reduce, a RIT liability, there are at least three benefits of the PA-AMTI and ACE depreciation adjustments resulting from an installment sale.

1. Almost without exception, the adjustment to regular taxable income for PA-AMTI will be a negative adjustment {generally the PA-AMTI basis exceeds the RIT basis). For C corporations subject to a current AMT liability or approaching the threshold of an AMT liability, negative adjustments can reduce or eliminate a current AMT liability. The PA-AMTI adjustments required by Sec. 56(a) including the AMTI gain or loss adjustment) are allowed without reference to prior-year adjustments and may even reduce PA-AMTI below regular taxable income.

2. The smaller a corporation's ACE, up to 75% of which increases (decreases) the taxpayer's AMTI, the less AMT a corporation must pay. Negative ACE adjustments reduce the size of the taxpayer's ACE but are limited to prior-year positive adjustments by Sec. 56(g)(2).

3. As a result of the adjustments necessary to convert regular taxable income to PA-AMTI and PAAMTI to ACE, the C corporation may avoid or minimize a current AMT liability, and also reduce its current RIT liability. Sec. 53 allows a taxpayer to reduce a current RIT liability through a credit based on a prior-year AMT liability. If the taxpayer's RIT liability exceeds its AMT liability, the Sec. 53 credit for prior-year minimum tax liability may produce significant tax savings. See Example 4 on page 40.

Additional Installment Sale Considerations

The availability of installment reporting for both RIT and A-AMTI purposes and the resulting PAAMTI and ACE gain (loss)adjustments suggest numerous reporting combinations. The possibility of modifying the taxpayer's regular taxable income, PA-AMTI and ACE over the installment period presents significant planning opportunities. While there are a number of possible combinations, the simplified illustration in Example 5, on pages 42-43, is limited to three possibilities.

As Example 5 suggests, the adjustments for each tax system (RIT, PA-AMTI and ACE) over the installment period are significantly affected by the taxpayer's initial election (or nonelection). For example, a taxpayer with significant year 1 regular taxable income but small positive adjustments for PA-AMTI, before considering the installment sale, might be able to elect option No. 3 without increasing its tentative AMT to the point at which it exceeds its RIT. By so electing, there are no AMT tax consequences in year 1. However, the corporation has assured itself of $270,000 in negative adjustments in adjusting its regular taxable income to PA-AMTI in each of the next two years. This could significantly reduce year 2 and year 3 AMTI without increasing its year 1 tax liability. The sale of MACRS real property requires other considerations as the RIT basis and the PA-AMTI basis of MACRS assets will usually differ. However, the PA-AMTI and ACE basis of MACRS real property will usually be identical (see Example 1).

For ACRS real property sold at a gain for RIT purposes (which results in a gain for PA-AMTI due to the identical bases) but at a loss for ACE purposes, careful planning is required. See Example 6 on page 44.

Once again, the sale of MACRS real property at a gain for RIT purposes but at a loss for PA-AMTI and ACE purposes (due to identical bases for both computations) may suggest other planning possibilities.

Conclusion

The concept of separate tax systems provides C corporations with many planning opportunities for the disposition of depreciable property and numerous options for reducing tax liability through the judicious use of installment reporting.

The possibilities seem to be almost unlimited. For example, a C corporation having no need or desire to dispose of a particular property might consider an installment sale of the property to reduce its total tax liability and then lease the property back. As long as the installment saleleaseback arrangement is entered into with an unrelated party and there is a genuine shifting of some economic or financial risk between the seller-lessee and the buyer-lessor, it should be respected for tax purposes.

In any event, one observation is obvious. Considering the complexity inherent in the current multiple tax system, perhaps it is time for some bona fide tax simplification. Many of the proposed tax changes (vetoed by President Bush in 1992) would merely reduce the ACE depreciation adjustment for assets placed in service after 1991. Who knows how many corporate dollars are lost through excessive compliance costs and the resulting efforts at tax minimization?

(1) A capital gain might still be preferred by C corporations with unused capital losses.

Copyright [C] 1993 by Brian L. Laverty and Dennis J. Gaffney. All rights reserved.

(2) Secs. 291(a) and 453(i) are notable exceptions if the property is depreciable.

(3) TD 8340 (3/14/91).

(4) preadjustment AMTI is defined in Regs. Sec. 1.56(g)-1(a)(6)(i) as "the alternative minimum taxable income of the taxpayer/or the taxable year, determined under section 55(b)(2), but without the adjustment for adjusted current earnings and without the alternative tax net operating loss deduction under section 56(a)(4)."

(5) S. Rep. No. 99-313, 99th Cong. 2d Sess. 524 (1986).

(6) The "Adjusted Current Earnings Adjustment Worksheet" released by the IRS with the 1991 Form 4626, Alternative Minimum Tax-Corporations (including environmental tax), provides for this basis adjustment on line 9.

(7) H. Rep. No. 100-495, 100th Cong., 1st Sess. 931 (1987).

(8) It is well established that losses may not be reported on the installment method for RIT purposes.

(9) See Regs. Sec. 1.56(g)-1(f)(4)(iii) and Sec. 453A(c)(4) for the possibility of partially reporting sales in excess of $5 million on the installment method for ACE purposes.
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Title Annotation:alternative minimum tax
Author:Gaffney, Dennis J.
Publication:The Tax Adviser
Date:Jan 1, 1993
Words:2537
Previous Article:IRS takes position that GRATs cannot be zeroed out.
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