Conjuring up AMT income from thin air

Technical topics regarding tax preparation.
#1
makbo  
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While the tax code does not define "income" (rather, it defines "gross income" circularly in terms of "income"), there is a general notion of income as "instances of [1] undeniable accessions to wealth, [2] clearly realized, and [3] over which the taxpayers have complete dominion." [Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955)]

For example, Cancellation of Debt (COD) is recognized as gross income if not explicitly excluded under law. Even imputed income is based on accession to wealth. I cannot think of any instances where gross income, for tax purposes, is not at least marginally based on some event or transaction that occurs outside of the tax law.

Except one.

In §55(b)(2) it states "The term "alternative minimum taxable income" means the taxable income of the taxpayer for the taxable year-
(A) determined with the adjustments provided in section 56 and section 58, and
(B) increased by the amount of the items of tax preference described in section 57."


But then, in complete disregard of the definition in (b)(2), (d)(2) states "In the case of a taxpayer described in paragraph (1)(C) [MFS taxpayer], alternative minimum taxable income shall be increased by the lesser of (i) 25 percent of the excess of alternative minimum taxable income (determined without regard to this sentence) over the minimum amount of such income (as so determined) for which the exemption amount under paragraph (1)(C) is zero, or (ii) such exemption amount (determined without regard to this paragraph)."

In short, a MFS taxpayer may under certain circumstances have up to $42,250 (2017 amount) of completely arbitrary and fictitious income, not based on anything, added to AMT income and then taxed.

It is very hard to find any reference or explanation of this in any professional reference materials. The only place I found an attempt to explain it is here:

"The married-filing-separately (MFS) phase-out does not stop when the exemption reaches zero[...] This is because the MFS exemption is half of the joint exemption, but the phase-out is the full amount, so for MFS filers the phase-out amount can be up to twice the exemption amount, resulting in a 'negative exemption'.

[...] This prevents a married couple with dissimilar incomes from benefiting by filing separate returns so that the lower earner gets the benefit of some exemption amount that would be phased out if they filed jointly. When filing separately, each spouse in effect not only has their own exemption phased out, but is also taxed on a second exemption too, on the presumption that the other spouse could be claiming that on their own separate MFS return. "


If true, this "presumption" is absurd, as it is quite likely the other spouse also has the AMT exemption phased out (especially in a community property state, which I'm guessing represents about one-third of the taxpaying population). In other words, not only is the $84,500 AMT exemption (2017 amount) completely phased out at high incomes for the two married taxpayers filing separately, but an additional $84,500 of income is added to the combined incomes of the married taxpayers - "income" that is not an accession to wealth or even remotely related to any event or transaction outside of the tax law.

If the concern was indeed this presumption that a MFS spouse might not have the exemption phased out sufficiently, why not just require that for MFS filers, the AMT exemption can be no larger than the spouse's exemption? This would be similar to the rule that the standard deduction for a MFS filer whose spouse elects to itemize is zero.

I wonder if this law could be realistically challenged in court, due to

1) contradictory definition of AMT income in §55 as described above -- (b)(2) vs. (d)(2), and

2) no constitutional authority to arbitrarily create taxable income for a taxpayer when it is derived from no source whatsoever and is not an accession to wealth.
 

#2
makbo  
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^ bump
 

#3
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Anybody can realistically challenge anything in court. Saddle up Rosenante, have Sancho fetch your lance, and go teach that windmill a lesson. But what is your motive?

If you had a client who was both subject to this tax on phantom income and willing to spend the time and money it would take to pursue the issue, you might be able to construct a good argument but a lot of tax laws seem capricious and yet they are not considered invalid and your chances would be pretty slim.
Because on T.A. ten was the most you were allowed
 

#4
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It is very hard to find any reference or explanation of this in any professional reference materials.


Here’s from the committee report (HR 100-795; Technical and Miscellaneous Revenue Act of 1988):

In order to prevent an incentive for separate filing by married persons, the bill provides, in effect, that the maximum amount of the exemption phase-out will for married individuals filing separately be the same as for married taxpayers filing jointly. 46 More specifically, the bill provides that for taxable years ending after the date of enactment of the bill, alternative minimum taxable income of a married person filing a separate return is increased by the lesser of (1) 25 percent of the excess of alternative minimum taxable income (determined without regard to this adjustment) over $155,000 (i.e., the amount at which the exemption phase-out ends on a separate return) or (2) $20,000 (i.e., the maximum exemption amount of the taxpayer's spouse).

And from TenLetters:

If you had a client who was both subject to this tax on phantom income and willing to spend the time and money it would take to pursue the issue, you might be able to construct a good argument but a lot of tax laws seem capricious and yet they are not considered invalid and your chances would be pretty slim.


I don’t know which (other) laws are capricious, you’d have to let us know. But where Makbo’s point might differ from these other capracious laws is that Makbo’s point is based on the fundamental concept of income and accession to wealth. If muni bond income kicks up your SS benefits such that you end up paying more federal tax because of it, courts have held that the additional tax is nonetheless a tax on the SS benefits themselves, and, therefore, such a provision is constitutional. The additional tax is not a tax on your tax-exempt income.

If we were to construct a similarly-reasoned IRS argument in the MFS case, IRS might say something like, “You are not being taxed on phantom income for AMT purposes. You are being taxed on a negative AMT exemption amount.” I myself think it falls pretty flat. The entire passage in the committee report is suspect. The first sentence explains the purpose of the provision. The first sentence will not comport with the second sentence if the calculation outlined in the second sentence produces a number greater than $0 [which gets added back to AMTI]. In that case, the first sentence, will not hold true, since the provision, “in effect” (their words), will do more than ensure equality of phase-out between MFS and MFJ filers: It actually adds an amount to the MFS taxpayer’s AMTI. This is unlike other AMT adjustments/preferences, where claimed deductions are disallowed for AMT purposes altogether, or where things that aren’t taxable for regular tax purposes are taxable for AMT purposes, or where we have timing differences. Congress has the right to tax these things.

The presumption Makbo is talking about is being based on a purely hypothetical MFJ taxpayer that does not have his exemption phased out. It’s a one size fits all type of formula, when one size doesn’t fit all.

I’ve heard complaints about this provision a few times over the years. If Makbo really does have a client affected by this, consider taking the case to a law school, maybe one with a tax clinic. They might be interested in taking this on as a learning tool for the law students.
 

#5
Nilodop  
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It was a learning tool for this old retired guy, for sure.
 

#6
LW25  
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makbo wrote:[ . . . ] I wonder if this law could be realistically challenged in court, due to

1) contradictory definition of AMT income in §55 as described above -- (b)(2) vs. (d)(2), and

2) no constitutional authority to arbitrarily create taxable income for a taxpayer when it is derived from no source whatsoever and is not an accession to wealth.


Interesting argument.

The other side might argue that the U.S. Constitution contains no express limitation on the power of taxation of this kind.

This brings to mind the following issue: For a Federal income tax to be constitutional, does the tax actually have to be imposed on true, economic income? Must the tax itself bear an accurate label -- as an income tax -- to be constitutional? Can a Federal tax be labeled as an income tax and yet validly tax something that is not income?

Here's a quote from a case from the Court of Appeals for the Third Circuit, not involving the AMT issue raised here, and thus perhaps not directly on point, but troubling nonetheless:

It is not necessary to uphold the validity of the tax imposed by the United States that the tax itself bear an accurate label [ . . . ]It could well be argued that the tax involved here [a U.S. federal income tax] is an "excise tax" based upon the receipt of money by the taxpayer. It certainly is not a tax on property and it certainly is not a capitation tax; therefore, it need not be apportioned. [ . . . ] Congress has the power to impose taxes generally, and if the particular imposition does not run afoul of any constitutional restrictions then the tax is lawful, call it what you will.


--Penn Mutual Indemnity Co. v. Commissioner, 277 F.2d 16 (3d Cir. 1960) (footnotes omitted; emphasis added).

And, in Murphy v. Internal Revenue Service, the United States Court of Appeals for the District of Columbia Circuit ruled that a personal injury award received by a taxpayer was "within the reach of the congressional power to tax under Article I, Section 8 of the Constitution" — even if the award was "not income within the meaning of the Sixteenth Amendment." Murphy v. Internal Revenue Serv., 493 F.3d 170 (D.C. Cir. 2007).

Again, these cases arguably are not directly on point. However, the general thrust of case law -- especially modern case law -- is that there are very few constitutional restrictions on the Federal taxation power.

If a fact pattern implicating Eisner v. Macomber, 252 U.S. 189 (1920), were presented to the U.S. Supreme Court today, would the Supreme Court overrule that case? To hold that the Federal income tax is not required to be imposed on economic income to be valid, would the Supreme Court even need to overrule Macomber? In that case, the taxpayer and the government were arguing over whether a true stock dividend -- where the taxpayer received no actual cash or other property -- was "income". The Court ruled that it was not income. But, if I recall correctly, what the parties did not litigate was the more basic question: Is there any constitutional requirement that a federal income tax actually be imposed on INCOME to be valid? And if so, in exactly what clause in the Constitution would that requirement be found?
 

#7
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It is not necessary to uphold the validity of the tax imposed by the United States that the tax itself bear an accurate label [ . . . ]It could well be argued that the tax involved here [a U.S. federal income tax] is an "excise tax" based upon the receipt of money by the taxpayer.


It could well be argued, in Makbo’s MFS case, that there is no receipt of anything by the taxpayer.

I think we’ll find that a statutory provision is okay as long as it bears a rational relationship to a legitimate government purpose. The legitimate government purpose is explained in the first sentence of the committee report excerpt. The second sentence might or might not support that purpose. To that point, the Murphy court would say:

Further, the legislature “is not bound to tax every member of a class or none. It may make distinctions of degree having a rational basis, and when subjected to judicial scrutiny they must be presumed to rest on that basis if there is any conceivable state of facts which would support it.” Carmichael v. Southern Coal & Coke Co., 301 U.S. 495, 509 (1937)
.

This is where the debate lies, it seems to me.
 

#8
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LW25 wrote:For a Federal income tax to be constitutional, does the tax actually have to be imposed on true, economic income? Must the tax itself bear an accurate label -- as an income tax -- to be constitutional? Can a Federal tax be labeled as an income tax and yet validly tax something that is not income?


The income tax has never been assessed on true, economic income, so I'd guess the simple answer is that something can in fact be labelled an income tax and validly tax something that is not income.
 


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