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Trends & Developments - June 2011 - Demystifying the Alternative Minimum Tax

AN EXPANDING CHALLENGE

Many individuals who have recently filed their 2010 income tax returns, or worked with their tax advisors to prepare projections of their 2010 tax liabilities to obtain extensions of time to file, were disturbed to learn that they were subject to the federal alternative minimum tax (the "AMT"). As originally conceived, the AMT was supposed to assure that very wealthy taxpayers did not avoid paying income tax by using certain otherwise allowable deductions and tax preferences. As a result of a variety of changes in our tax laws and the impact of inflation, taxpayers who do not consider themselves wealthy, who do not have special tax deductions or preferences, and who do not invest in tax shelters find themselves with tax liabilities under the AMT. In many cases, these taxpayers are not even aware that they have these liabilities.

The AMT has become so prevalent that the federal budget depends in large measure on the revenue the AMT produces. While many legislators acknowledge that the AMT is complex, confusing, and has broader application than originally intended, Congress has not found a way to change the system without significantly increasing an already burgeoning deficit.

What can you do to anticipate and reduce this tax liability? This article is intended to provide a few ideas.

BRIEF EXPLANATION AND SIMPLE EXAMPLE

In computing the AMT, a 28% maximum tax rate applies to ordinary AMT income in excess of $175,000 (after any allowable deductions and exclusions). AMT income of $175,000 or less is subject to a tax rate of 26%. Long-term capital gains and qualified dividends are taxed at the same rate for the AMT as for regular tax (generally 15%). There is an AMT exclusion amount of $74,450 for a married taxpayer filing jointly or $48,450 for taxpayers who are single or head of household. But a phase-out of this exemption exists based on AMT income, fully eliminating the exemption once AMT income reaches $447,800 if married filing jointly, or $306,300 if single or head of household. If the AMT computation results in a tax higher than the regular tax computation, you must pay the higher amount.

Consider the following fact pattern for a married couple, filing jointly, with two minor children, for the year 2011:

State and local tax rate:

 

8%

Source of income:

 

 

Combined salaries

 

$ 500,000

    Interest

 

10,000

    Qualified dividends
    (subject to a 15% federal rate

 

10,000

    Long-term capital gain

 

50,000

   Total Income

 

570,000

 

 

 

Itemized deductions:

 

 

    Real estate taxes

 

$ 20,000

    Charitable contributions

 

5,000

    Home mortgage interest

 

25,000

    Total itemized deductions

 

$ 50,000

 

 

 

 

Regular Computation

AMT Computation

Salaries

$ 500,000

$ 500,000

Interest

10,000

10,000

Qualified Dividends

10,000

10,000

Long-term capital gains

50,000

50,000

Adjusted gross income

570,000

570,000

Less: Deductions

 

 

State and local income taxes

(41,600)

N/A

Real estate taxes

(20,000)

N/A

Mortgage interest

(25,000)

(25,000)

Charities

(5,000)

(5,000)

Exemptions (4)

(14,800)

N/A

    Taxable Income:

$ 463,600

$ 540,000

    Tax Liability:

$ 120,132(a)

$ 139,900(b)

 

(a) * On 379,150

$ 102,574

 

(b) On 175,000

$ 45,500

      * On 24,450 (35%)

8,558

 

      On 305,000 (28%)

85,400

        On 60,000 (15%)

9,000

 

      On 60,000 (15%)

9,000

        $ 463,600

$ 120,132

 

      $ 540,000

$ 139,900

 

Since this couple's AMT liability ($139,900) is higher than their regular tax liability ($120,132), they must pay $139,900. This is $19,768 more than under their regular tax computation. In effect, the couple received no tax reduction from $56,480 of their $61,600 of state and local income taxes and real estate taxes. Put another way, if they lived in a state that imposed no income taxes and paid only $5,120 of real estate tax and sales tax, their federal tax liability would be the same $139,900. Their state and local tax burden would be reduced by $56,480 with no change in their federal tax liability – clearly a substantial federal tax incentive to move to a state and locality with much lower taxes!

PLANNING OPPORTUNITIES

If the couple could project that their income for next year will increase so that they will not be subject to the AMT in 2012, they should be able to delay until January 2012 the payment of some of their state and local income taxes and real estate taxes. They would achieve a 35% federal tax benefit for such delayed payments. However, their 2012 tax projection should take into account these delayed deductions, to make sure they are not thereby again made subject to the AMT in 2012.

The $19,768 differential between the couple's regular tax computation and AMT computation also provides a potential opportunity to accelerate certain types of income into 2011 at a 28% rate. If they could have recognized short-term capital gains, deferred income (e.g., interest on certain U.S. treasury obligations), or the ability to receive a bonus in 2011, the first $282,400 of such additional income would be taxed at 28%. This additional income would increase their regular tax computation by $98,840 (35%) and their AMT computation by $79,072 (28%). Thus, their 2011 tax computation would be:

Regular tax ($120,132 + $98,840)

$218,972

AMT liability ($139,900 + $79,072)

$218,972

 

At that point they would be getting a 35% federal benefit from all their itemized deductions, and paying $79,072 of additional federal tax on the $282,400 of additional income. This strategy would not be viable if they would be in AMT for 2012, since it would accelerate their tax payments. Accelerating income will also accelerate the state and local taxes for 2011 and possibly increase the required estimated tax payments for 2012. A reliable projection of the couple's 2012 tax configuration is necessary to ascertain whether an acceleration of income provides an overall tax savings.

MORE COMPLEX CASES

The couple in the above illustration has a relatively simple tax configurat ion, with no specially treated items, because for them the only items of income or deductions treated differently for the regular tax and the AMT are:

  • State and local income taxes.
  • Real estate taxes.
  • Personal exemptions for the taxpayers and their dependents.

Many taxpayers have additional items of income or deductions which are treated more favorably under the regular tax computation than under the AMT computation. These include:

  • Miscellaneous itemized deductions, such as investment expenses and employee business expenses.
  • Otherwise tax-exempt interest on certain municipal bonds used to finance private activities, except for such bonds issued in 2009 or 2010.
  • Medical expenses in excess of the 7.5% of adjusted gross income allowed for regular tax purposes up to 10% of adjusted gross income.
  • The difference between fair market value and exercise price upon exercise of incentive stock options.
  • Interest on a personal residence mortgage where the proceeds are not used to acquire, construct or substantially improve the residence (unless traced to business or investment uses).
  • Differences in depreciation computations.
  • Differences in the exclusion for qualified small business stock.
  • Gain or loss on the disposition of certain depreciable assets.
  • Passive activity AMT adjustments.

The existence of any of the above items are potential AMT triggers that should alert you to consider other tax planning opportunities to, in effect, increase income subject to regular tax so long as that tax in total does not exceed total AMT for the same year, and provided such planning does not produce adverse AMT effects in a subsequent year.

For planning purposes, it should also be noted that, if you pay the AMT in a particular year, you may be entitled to a tax credit against your regular tax in a subsequent year. You qualify for an AMT credit based on "deferral items" that contributed to your AMT liability. The most common deferral items are depreciation adjustments, passive activity adjustments and the tax preference on the exercise of incentive stock options. Other deductions, such as state and local income taxes and investment fees, are called "exclusion" items. You cannot get an AMT credit from these deductions. The AMT illustrated in the simple example further above would not create an AMT credit since none of the adjustments are deferral items. The reason a deduction is classified as a deferral item is because over time you will end up with the same total deductions for both regular tax and AMT purposes. As an example, a depreciation difference is a deferral item since it is often calculated using a different asset life and method for AMT purposes than for regular tax depreciation. However, over the life of the asset the total depreciation will be the same under either tax computation.

ADDITIONAL PLANNING OPPORTUNITIES

Many taxpayers are subject to the AMT every year, even without any of the special items of income and deductions. This often arises from the deductions for state and local income taxes and real estate taxes. However, some taxpayers are not subject to AMT in every year and should consider the following planning opportunities:

If you expect to be subject to the AMT for this year 2011, but don't expect to be for next year 2012 when the 35% regular tax rate will apply, then:

  • Defer until next year any deductions that are not deductible for AMT purposes. This includes not prepaying your state income taxes before the end of the year.
  • Defer until next year other deductions, even if deductible for AMT purposes, to obtain the benefit of the higher regular tax rate. The most common of these deductions is charitable contributions.
  • Accelerate ordinary income (other than qualified dividends) into this year to benefit from the lower AMT rate.
  • Realize net short-term capital gains this year to benefit from the lower AMT rate, unless these gains will be offset by short-term losses next year.
  • Delay exercising any incentive stock options. However, such an exercise next year could cause an AMT liability. If you already exercised the options, consider a disqualifying disposition to eliminate the AMT preference item.



If you do not expect to be subject to the AMT for this year 2011 and will be taxed at the regular tax rate of 35%, but expect to be subject to the AMT for next year 2012, then:

  • Prepay deductions that are not deductible for AMT purposes to get the full tax benefit this year rather than lose the tax benefit next year. These deductions include state and local income taxes and real estate taxes.
  • Prepay deductions that are deductible against the AMT, such as charitable contributions, to gain the benefit of the higher ordinary tax rate this year.
  • If possible, defer ordinary income to next year to take advantage of the lower AMT rate.
  • If you have incentive stock options that can be exercised this year, consider doing so. Such an exercise will be tax-free up to the point where the difference between the fair market value of the underlying stock over your exercise price causes your AMT computation to equal your regular tax liability.


Until such time as Congress repeals the AMT or substantially enlarges the AMT exemption amounts, taxpayers need to understand the computation and impact of the AMT. It is sometimes possible to reduce or avoid the adverse consequences. In order to accomplish this, it is necessary to prepare projections of your tax configurations for the current year and for the next year sufficiently before year-end so that appropriate action in the current year can be effectuated.


Trends & Developments – June 2011

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