Strategies for Dealing with the Alternative Minimum Tax
Introduction
Every taxpayer must compute his tax liability two ways: the regular way using tax tables or rate schedules and the alternative way. The higher of the two taxes is the final liability. The alternative minimum tax (hereinafter referred to as the AMT) came into being in 1969. It was designed to extract some minimum amount of tax from wealth taxpayers with large deductions.
As personal income tends to rise each and every year, more and more taxpayers are becoming subject to the AMT. There are numerous reasons. AMT rates and exemptions have not been indexed for inflation while regular tax rates and exemptions have been. The difference between the value of stock options exercised and the option price produces income for AMT but not for regular tax. Large amounts of capital gains frequently cause AMT tax.
There are a number of permanent adjustments and deductions not allowed in computing alternative minimum taxable income. These do not give rise to a future AMT credit The more common ones are as follows:
► state taxes,
► miscellaneous itemized deductions,
► medical expenses below 10% of adjusted gross income,
► personal exemptions,
► the standard deduction,
► residential interest in excess of “qualified housing interest” which is debt used to purchase construct or substantially improve a qualified personal residence. i.e. refinancing to take out equity will cause an AMT disallowance of the interest on that portion of debt in excess of the qualified indebtedness,
► percentage depletion in excess of year-end property basis
► interest from private activity bonds issued after August 7, 1986
► 7% of the excluded gain under Section 1202 for small business stock sales
In computing alternative minimum taxable income, there are a number of temporary adjustment and preference items that must be added to taxable income. These are temporary preference items that do give rise to a future AMT credit. The more common ones are as follows:
► depreciation in excess of that allowed for AMT purposes,
► circulation expenses in excess of 3 year amortization allowed for AMT purposes,
► research and experimental expense in excess of 10 year amortization allowed for AMT,
► mining development costs in excess of 10 year amortization allowed for AMT purposes,
► excess of value of stock options exercised over the option price unless stock is sold in the same year as the exercise
► intangible drilling costs in excess of 120 month amortization or if elected, cost depletion,
► Pre-1987 depreciation, generally excess depreciation over straight-line for real property
In computing alternative minimum taxable income, there are exemptions allowed so that taxpayers in lower tax brackets are not affected by the AMT. Remember that the AMT was originally designed to catch only the rich taxpayers. Not any more. Nevertheless, the exemptions do provide some relief although Congress has neglected over the years to properly adjust them for inflation so that now it finds itself unable or unwilling to make major adjustments to get back to the original intent of the law.
AMT Exemption Phase-Outs
The AMT exemption phases out at a rate of 25 cents for every dollar of alternative minimum taxable income over the phase-out amounts listed in the table below. For 2008, the exemption and AMTI phase-out amounts are as follows:
Filing Status
| AMT
Exemption
| Phase-out
Begins | Completely
Phased out | | | | | | Married filing separately
| $34,975
| $75,000 | $214,900 | Married filing jointly
| $69,950 | $150,000 | $429,800 | Single or head of household
| $46,200
| $112,500 | $297,300 |
As stated before, the exemption amounts and phaseout ranges are not adjusted for inflation; thus, AMT may affect taxpayers who in the past have not had exposure to AMT if their income is steadly increasing each year. The exemption when combined with the computational mechanics of AMT will not necessarily protect against imposition of the AMT. Taxpayers who have a large number of exemptions may find themselves in AMT (personal exemptions are not allowed in computing AMT).
How Large Capital Gains Can Throw a Taxpayer Into AMT
AMT is computed at a rate of 26% on the first $175,000 of alternative minimum taxable income and 28% on any excess over $175,000. As indicated above, the AMT exemptions are phased out when certain alternative minimum taxable income levels are reached. Even though dividends and capital gains enjoy preferential tax rates in 2008 for both regular tax and AMTI, once the phase out amount is reached, all of the non dividend and non capital gain income is subject to the AMT rates with no exemption, no itemized or standard deduction, no personal exemptions…..in other words, no tax break or protection from the flat 26% and 28% tax rates.
Refundable Minimum Tax Credit
In past years, the tax credit allowed for past AMT has been little or nothing. As amended by the 2008 Extender’s Act, if a taxpayer has an used minimum tax credit (hereinafter referred to as MTC), the new MTC limitation cannot be less than the new AMT refundable credit amount. How does this new general rule work? The definition of the AMT refundable credit amount is the amount equal to the greater of 1) 50% of the long-term unused MTC for the current tax year, or 2) the amount of AMT refundable credit amount for the preceding year determined without regard to the new rules.
The long-term unused MTC is defined as MTC carried over from prior years that is attributable to tax years before the third tax year immediately preceding the current tax year. For 2008, the MTC would be credits from the year 2004 or prior. It is important to note that the new MTC credit is refundable, meaning even if there is no tax liability for the current year, the taxpayer will get the MTC refundable credit.
The MTC is generated only if the preferences are timing or temporary ones, such as incentive stock option AMT income which “turnaround” when the stock is sold, or differences in depreciation lives and methods. Therefore, permanent differences will not generate MTC. Examples of differences that will not generate MTCs:
► State taxes
► Medical expenses in excess of 10% of AGI
► Home equity interest expense
► Residential interest expense after July 1, 1982 and before October 13, 1987 not traceable to acquisition, improvements to a qualified residence
► Miscellaneous itemized deductions in excess of the 2% AGI limitation
► Standard deduction
► Personal exemptions
► Excess depletion
► Interest from private activity bonds issued after August 7, 1986
► 7% of the Section 1202 exclusion of gain from sale of small business stock
Example:
John Doe has a 2008 return showing a regular tax of $70,000. He has MTCs of $100,000 from prior years, of which $20,000 is the computed AMT refundable amount on the 2007 tax return, and $80,000 is from 2004 and prior years due to incentive stock option exercises. John’s AMT refundable credit is the greater of 50% of $80,000 or $40,000 or $20,000, or $40,000. If John’s MTC of $100,000 had been generated all from the year 2005, his refundable MTC would have been zero.
Strategies for Minimizing AMT
What are some of the strategies that can used to deal with the AMT problem? Let’s look at the common ones.
Increase Ordinary Income
Taxpayers may benefit by shifting bonuses, pay increases, short-term capital gains, and any other ordinary income into the AMT year. Why, since deferral is usually the best tax strategy? Maybe it still is. You have to “run” the numbers. What accelerating income into a current year does is to have the income taxed at an AMT rate of 26% or 28%, whereas the taxpayer may have been in the top regular tax bracket. You have to be sure there is enough tax saved to justify paying a tax one year or more early. As the saying goes, don’t try this at home alone…if you don’t have a computer and a tax software program.
Deferring Itemized Deductions
Certain itemized deductions are not deductible when computing the AMT. These are all state taxes, home equity interest or interest on loan balances above acquisition debt (see below), all miscellaneous itemized deductions over the 2% adjusted gross income threshold, and medical expenses to the extent they exceed the 7.5% threshold but not in excess of 10% of adjusted gross income. To the extent possible, payment of these expenses may be deferred until the following year, if there is a benefit to doing so. In a year in which capital gains are anticipated to be realized, deferring the payment of state taxes can reduce AMT in the year the gains are realized. But you must check how the extra state tax payments in the following year affect AMT. It is also possible that the AMT in the following year will be higher than if the state taxes were paid in the year the gains are realized.
Electing Out of the Standard Deduction
If a taxpayer is in AMT but does not itemize because the standard deduction is greater than itemized deductions, the taxpayer may want to consider itemizing, even though lower than the standard deduction, if it results in a lower AMT tax.
Alternate Year State Tax Payments
Since state taxes are not deductible, the question arises whether the payment of them can be timed so as to fall in every second year. State taxes include real estate taxes, income taxes (withholding and estimated), car excise taxes, and personal property taxes. If the taxpayer files quarterly state income tax estimates, could they be curtailed every other year and would there be any tax savings resulting from that strategy? To answer that question, estimates of tax liability must be made…the numbers must be run…on the two years involved. As to wage withholdings, if a taxpayer has some control over his or her state income tax withholdings, by virtue of being an owner of a business, could those withholdings be timed so as to fall in every second year, and what is the benefit? Remember that the effect of underpayment of state estimated tax penalties must be taken into account. This strategy may continue to be an alternative only so long as interest rates remain relatively low.
Table Sales Tax Election
A taxpayer may elect the sales tax method for the state tax deduction, despite the fact that the state of residence imposes an income tax and/or a real estate tax. To what extent this may reduce overall tax liability, including the AMT, can only be determined by trying it in specific situations. Generally, you would think that it wouldn’t help at all because regular tax is being reduced as well as the AMT, and AMT is the difference between the AMT computed tax and the regular computed tax. They both are affected.
Renting of the Home
Renting part of the home results in moving real estate taxes from Schedule A – Itemized Deductions where they are nondeductible for AMT purposes onto Schedule E – Rental Income where they are fully deductible for AMT purposes. Renting of a home can occur if the home is owned entirely by one spouse as beneficiary of a trust while the other spouse who uses space for a home office pays rent to the trust. Real estate taxes would be paid by the trust and wind up in Schedule E – Rental Income where they are fully deductible for AMT purposes. Rental of a house to trust-worthy friends while away for an extended period moves the real estate taxes off Schedule A and onto Schedule E – Rental Income.
Investing In Muncipal Bonds
As everyone knows, interest on municipal bonds is exempt from regular income tax. However, interest on municipal bonds which fund a private activity…say for example an industrial park…are taxable for AMT purposes. In other words, the interest on those bonds must be added to regular taxable income specifically for the purpose of computing alternative minimum taxable income (AMTI). If a taxpayer is in an AMT situation, he or she must now consider the after-tax return alternative between taxable bonds, exempt municipal bonds, and private activity muncipal bonds. The often overlooked fact is that for taxpayers in the highest regular marginal tax brackets who now find themselves subject to AMT, the highest AMT tax rate is “only” 28%. It may be that a taxable bond will yield the highest rate of after-tax return.
Avoid Remortgaging The First Or Second Home in Order to Take Out Equity
Only interest paid on a loan used to purchase, build or substantially improve a taxpayer’s principal residence and one other residence is deductible for the specific purpose of computing both regular tax and AMT. That means that the interest on most home equity loans (not used to build or substantially improve a residence) or on any loan balance in excess of the original acquisition loan must be added to alternative minimum taxable income in computing the AMT.
The strategy to avoid this result may be to borrow on stocks or other investment property. However, the problem with this strategy is that there is a limit on the amount of deduction for investment interest expense. It is limited to the net investment income. Net investment income is the excess of investment income over the actual deduction from investment expense, ie. the amount in excess of the 2% miscellaneous itemized deduction adjusted gross income limitation. Investment income includes gross interest, dividends, annuity income, royalties not from a business, gains from assets producing these types of income, short-term capital gains, working oil and gas interests treated as nonpassive, and net long-term capital gain gains to the extent elected to be treated as such. The penalty for making that election is a give-up of the favorable capital gain rates.
The definition of a second home includes a house, condominimum, or mobile home. It does not include a boat or a motor home such as an RV.
Exercise Incentive Stock Options in Same Year As Sale
The excess of the fair market value over the strike price or exercise price of an incentive stock option is an AMT taxable item. It is not taxable for regular tax purposes. There are several strategies to eliminate or minimize this type of AMT preference income. The first one is to simply “run the numbers” or project what the tax situation will be, given exercise of a certain number of options. Exercise only
that number of shares which will keep the AMT at bay. Continue to stagger exercises over a number of years, all avoiding an AMT situation. The second strategy is to exercise the option at a point in time when the stock price is likely to be at its lowest level. The third strategy is to sell the options in the year of exercise. This is a strategy that must be validated by “running the numbers” to be sure that there is not too much of a “give-up” of tax savings from long-term capital gain rates.
A caveat to any option tax strategy is to put the investment fundamentals first and foremost. More money can be lost by ignoring the investment aspects then by losing a few tax dollars.
Use Longer Depreciation Lives
Believe or not, just so Congress is assured the tax code remains complicated, depreciation is computed one way for regular tax purposes and another way for AMT purposes. For AMT, depreciation is computed using longer lives and either straight-line or 150% declining balance methods. For regular tax depreciation can and usually is computed using the 200% declining balance method with the shorter MACRS recovery periods. The Internal Revenue Code Section 168 (b)(2) and (3) allows the taxpayer to elect the same depreciation method and life for regular tax as for the AMT computation. Therefore strategy is to simply use that election and use the same lives and method for regular tax purposes as for AMT. That will completely eliminate this AMT preference addback adjustment.
Also, be aware that the 100% writeoff under IRC Section 179 is not allowed for AMT purposes and will become an addback adjustment. However, there is no AMT adjustment for the 50% bonus depreciation deduction. Be aware that Massachusetts does not allow the 50% bonus depreciation deducton, but they do allow the IRC Section 179 deduction.
Minimize or Eliminate Passive Activity Losses
Losses from rental real estate, tax-shelter farm activities, and similar passive activities are not deductible in computing AMT income. For certain taxpayers, this is a problem if the passive activity loss is deductible for regular tax purposes. The strategy to avoid this preference item is to adopt one or more of the strategies for eliminating or minimizing passive activity losses.
Long-Term Contracts
Taxpayers must use the percentage of completion method of computing profit on contracts lasting more than two taxable years when computing AMT. Taxpayers may use a simplified method for small contracts, but that essentially measures profit as work progresses.
The taxpayer does not have to use the percentage of completion method if:
1) the contract was a home construction contract, or
2) the contract is a small contract that can be completed in two years, the taxpayer had no more than $10 million in average annual gross receipts in the three years prior to the year in which the contract was entered into, and the contract can be completed within two years.
One strategy might be to limit contract periods to less than two years. In addition, if the contract is complete within one year, AMT is essentially eliminated in any case.
Circulation and Research and Experimental Costs
For regular tax purposes, these costs are expensed in most instances. R&D costs have some applicable elections, but generally the costs are expensed. However, just to keep things complicated, the Internal Revenue Code says that in computing AMT, circulation expenses must be spread evenly over three years and R&D costs must be spread evenly over ten years. An election can be made to use the three-year and ten-year lives and completely eliminate this AMT item.
Contingent Fee Arrangements
A lot of taxpayers receive legal settlements and awards for damages, which in many instances must be reported as gross income. The contingent legal fee can only be deducted as a miscellaneous itemized deduction for employment-related (discrimination and wrongful termination for example) and nonbusiness lawsuits. Since miscellaneous itemized deductions are not allowed in computing AMT, the AMT can apply. In effect, the taxpayer is penalized for winning in court.
This is a much litigated issue. Taxpayers with this issue may wish to seek professional help.
AMT Capital Losses
Generally, the net capital loss of up to $3,000 allowed against ordinary income in computing regular tax should be the same amount allowable in computing the AMT. However, not all software picks up the capital loss from the regular tax computation and copies it into the AMT software calculation. You have to double-check to be sure the AMT computation picks it up. An AMT capital loss can be different, however. The difference usually occurs when incentive stock options are present.
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