BUSINESS TAX CHANGES

Thomas P. Langdon

Small Corporation Alternative Minimum Tax Exemption

Prior Law: For taxable years beginning before December 31, 1997, a C corporation is subject to the alternative minimum tax (AMT) regardless of gross receipts.

New Law: "Small corporations" are exempt from the corporate alternative minimum tax. A small corporation is defined as a corporation that has average gross receipts of $5 million or less for the 3 taxable years that ended with its first taxable year beginning after December 31, 1996. For purposes of meeting the qualification tests, the new law refers to existing Code Sec. 448(3), which applies the $5 million test on the basis of the period during which the corporation was in existence, in the event the corporation had not been in existence for 3 years.

In order to qualify for the AMT exemption, the corporation must qualify as a small corporation for 1997 (or its tax year beginning after December 31, 1996). If the company is not qualified as a small corporation in that tax year (or its first tax year for corporations formed after 1996), it will never be eligible for the AMT exemption. Proper planning should be conducted for businesses that anticipate 3-year average gross receipts at or near $5 million. If possible, a corporation on the verge of exceeding this threshold should consider delaying receipts in order to meet the definition of a small corporation for AMT purposes.

Once a business is qualified as a small corporation, it continues to be a small corporation as long as its 3-year average gross receipts do not exceed $7,500,000. Therefore if the corporation meets the $5 million test in its 1997 tax year, in following tax years it can earn significantly more yet still qualify as a small corporation.

If a business entity loses its qualification as a small corporation for failure to comply with the $7,500,000 test in future years, its AMT liability will be based on preferences and adjustments only on transactions the corporation entered into after losing its status as a small corporation. For purposes of calculating AMT liability, the "change date" is the first day of the first taxable year for which the taxpayer ceases to be qualified as a small corporation. The preferences and adjustments for determining AMT liability are the following:

• depreciation and pollution control facility preferences on property placed in service on or after the date the company loses its status as a small corporation
• mining and exploration development and costs paid or incurred after the change date
• long-term contracts entered into after the change date
• alternative net operating loss deductions after the change date
• limitations on the allowance of negative adjustments based on adjusted current earnings apply only to prior taxable years beginning on or after the change date
• adjustments for depreciation to adjusted current earnings under Sec. 56(g)(4)(A) shall not apply
• ACE earnings and profits adjustment and ACE depletion adjustment of Sec. 56(g)(4) shall apply in the same manner as if the day before the change date were substituted for "December 31, 1989," each place it appears

Because the AMT will only apply to transactions entered into after the loss of small corporation qualification, a company that can qualify for small corporation status in 1997 will be better off when compared to a company that does not qualify and is subject to the existing AMT provisions.

Commentary: One issue often faced by small business and family business owners is how to effectively structure a buy-sell agreement for the corporate shares. While entity type buy-sell agreements between two or more shareholders is usually the simplest to design and requires a minimum number of insurance policies when compared to a cross-purchase agreement, certain corporate tax issues used to weigh against the use of the entity approach. One tax issue dealt with the alternative minimum tax, which treats as a preference item both the increase in the cash surrender value over the premiums paid each year and the death benefit over the corporation’s AMT basis in the life insurance policy when a shareholder dies. Particularly with smaller corporations, receipt of a large death benefit to execute the buy-sell agreement would often trigger the alternative minimum tax, subjecting part of the death benefit to taxation. Since part of the death benefit was taxed under the AMT system, the corporation would have to make up the taxes paid on the death benefit in order to fully comply with its obligations under the buy-sell agreement. To make matters worse, a full AMT credit for the taxes paid on the life insurance death benefit was not available to the corporation.

The new law protects small corporation shareholders from the imposition of the AMT when funding entity buy-sell agreements. As long as the company qualifies as a small corporation, the AMT does not apply and will not subject insurance proceeds (or increases in cash value) to taxation.

In fact, this new provision in the law will actually encourage the use of Sec. 303 Redemptions. Sec. 303 of the Code allows a corporation to redeem corporate shares from the estate of a deceased shareholder, in a sale or exchange, enough stock to pay for death taxes and administration expenses of the estate. "Wait and see" or "hybrid" buy-sell agreements often use Sec. 303 as the proxy for the amount of the redemption that will be executed by the corporation.

Corporate ownership of life insurance for key employee, deferred compensation, and other purposes will likely become more popular as a result of this provision.

Net Operating Loss Carry Modifications

Prior Law: Businesses that experienced a net operating loss in their business year could carry that loss back 3 years, and forward 15 years. The carryback provision allowed the business to receive an income tax refund for the prior years, based on the lower income for those years after adjustment for the carried-back loss.

New Law: Businesses are permitted to carry back a net operating loss 2 years (one year shorter than prior law allowed), and carry forward a loss for 20 years (5 years longer than prior law allowed). The 3-year look-back rule still applies in two situations:

• when an individual suffers losses of property arising from fire, storm, shipwreck, or other casualty, or from theft
• when small businesses (as defined in the gross receipts test of Sec. 448(c)) and taxpayers engaged in the business of farming experience net operating losses attributable to presidentially declared disasters

The new law does not apply to net operating losses carried forward from prior tax years.

Commentary: The new carryback period, 2 years, limits the ability of a business to get a tax refund from prior years. Originally, the 3-year look-back period was put in place to allow businesses the opportunity to get a tax refund, which could be used in the business to generate future earnings. The President proposed changing the 3-year look-back rule to one year. The 2-year rule, as enacted, was the result of a compromise with Congress. Because the 2-year rule is effective for tax years beginning after August 5, 1997, it may be advisable to accelerate losses into the current tax year (provided it began before August 5, 1997) in order to take advantage of the 3-year look-back period.

The extension of the carryforward period will yield little if any benefit to business owners. The present value of tax deductions from years 15 to 20 is marginal, at best.

Modification of Carry for Business Credits

Prior Law: Under prior law, unused business tax credits (including investment credits, targeted jobs credits, alcohol fuel credits, research credits, low-income housing credits, enhanced oil recovery credits, disabled access credits, renewable electricity production credits, empowerment zone credits, Indian employment credits, and employer social security credits) could be carried back 3 years and carried forward for 15 years.

New Law: Effective for credits arising in tax years beginning after December 31, 1997, the carryback period is modified to one year (from 3 years), and the carryforward period is modified to 20 years (from 15 years).

Commentary: By shortening the carryback period, Congress has decreased the dollars available to businesses in the form of current tax credits that can be reinvested in the business for future growth.

Involuntary Conversions

Prior Law: When property of a taxpayer is involuntarily converted, the taxpayer could defer taxation on the gain realized if the taxpayer purchased a similar replacement property within 2 years of the earlier of the date of the disposition of the property or the earliest date of the threat or imminence of condemnation of the property. If the taxpayer was a C corporation or a partnership with corporate partners, however, deferral on the gain was not allowed if the replacement property was purchased from a related person. All other taxpayers were allowed to defer the gain regardless of the source of the replacement property.

New Law: The new law extends the rules applicable to C corporations and partnerships with corporate partners to other taxpayers. If the taxpayer is one of the following, replacement property in an involuntary conversion must be obtained from an unrelated person:

• C corporation
• a partnership in which one or more C corporations own, directly or indirectly, more than 50 percent of the capital interest, or profits interest, in the partnership at the time of the involuntary conversion
• any other taxpayer, if, with respect to property involuntarily converted during the taxable year, the aggregate of the amount of realized gain on such property on which there is realized gain exceeds $100,000 (In the case of a partnership, this provision applies with respect to the partnership and with respect to each partner.)

Related persons, for purposes of this section, are those defined in Sec. 267(b):

• brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants
• an individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual
• two corporations that are members of the same controlled group
• a grantor and a fiduciary of any trust
• a fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts
• a fiduciary of a trust and a beneficiary of such trust
• a fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts
• a fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust
• a person and an organization to which Sec. 501 (relating to certain educational and charitable organizations that are exempt from tax) applies and which is controlled, directly or indirectly, by such person or (if such person is an individual and not a corporation) by members of the family of such individual
• a corporation and a partnership, if the same persons own more than 50 percent in value of the outstanding stock of the corporation, and more than 50 percent of the capital interest, or the profits interest, in the partnership
• an S corporation and another S corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation
• an S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation

Commentary: While the new provisions regarding involuntary conversions will not likely affect many individuals, businesses must be careful to avoid the related party rules if deferral of income tax on the gain of involuntarily converted property is their goal.

Previous

Top