The not-so-Alternative Minimum Tax, Part 1

The Alternative Minimum Tax (AMT) for individuals, enacted by Congress in 1969, is becoming less of an alternative for some taxpayers.  The AMT was originally targeted at approximately 150 taxpayers that had high adjusted gross income (AGI), but paid zero tax due to the types of income and structuring of deductions.  In effect, under the current structure the AMT almost guarantees that once taxpayers reach a certain level of income, their effective tax rate will be at least 26% or higher.

The AMT is calculated by both businesses and individuals, but under different circumstances.  This post will discuss the AMT as it applies to individuals.

Individuals subject to AMT

Individuals calculate their share of the AMT on Form 6251.  That taxpayer begins with their AGI after itemized deductions, and then adds back the following:

• Medical expenses
• State and local income, real estate, and property taxes
• Miscellaneous deductions

The taxpayer must also add back or reduce by the difference between their income tax and AMT amounts for the following:

• Investment interest expense
• Depletion
• Basis in exercised incentive stock options
• Depreciation expense

Taxpayers may also have to report AMT adjustments passed through on K-1's from their other activities (partnerships, trusts, or S-corporations).

Once all of these adjustments have been considered, the taxpayer arrives at their alternative minimum taxable income (AMTI).  Taxpayers are allowed an exemption amount, which has been indexed for inflation thanks to acts by Congress at the end of 2012.  This exemption amount is $51,900 S / $80,800 MFJ for 2013.  The exemption amount is subtracted from AMTI, and the resulting amount is multiplied by either 26% or 28% depending on whether the amount is above or below $179,500 MFJ / $89,750 S.   If income is above that amount, it is multiplied by 28%, and 26% if not.

Once the AMT is calculated, it is compared to the regular tax calculated on the taxpayer's Form 1040.  This is where the AMT earns the name "alternative": once the taxpayer compares their AMT to their regular tax, the higher amount becomes their income tax.

Why?

Why does the AMT work?  Because it attacks two types of tax situations and makes them less beneficial.

First, the AMT true's up the tax rate for taxpayers that have high incomes from sources that are not taxed at regular tax rates, such as long-term capital gains, qualified dividends, and tax-exempt interest.  If a taxpayer has $10 million in AGI, but it consists completely of long-term capital gains and qualified dividends, their tax rate is only 15% (20% in 2013) as opposed to 35% (39.6% in 2013).  The AMT would require this taxpayer to pay a higher rate due to their high income.

Second, the AMT penalizes taxpayers with certain higher-than-normal deductions.  As mentioned above, one deduction added back for AMT purposes is state and local taxes from Schedule A.  For a taxpayer living in an income tax state (a state that has their own income tax, such as Arkansas or Louisiana, but not Texas), a deduction is allowed on their Federal return for state tax payments made during the calendar year.  The difference between paying the state 4th quarter estimated tax payment on Dec 31 instead of Jan 15 of the following year is that the payment will be allowed as a deduction Schedule A in the year of payment.  However, making that payment before year-end will not matter if the taxpayer will be subject to AMT, because those amounts will be added back.

Can it be avoided?

Unfortunately, the AMT is a "do not pass go, do not collect $200" situation.  One simple way to forego the calculation is for the taxpayer's income after itemized deductions to stay below the AMT exemption amounts.  Also, if the majority of the taxpayer's income is taxed at regular rates, the AMT will not be a problem because the regular tax will most likely exceed the AMT.  If a taxpayer, because of their types of income, will be subject to the AMT, they should try to avoid certain deductions (if possible) in order to minimize their AMTI.  Simple planning maneuvers such as paying state taxes on Jan 15 of the following year and staggering the exercise of incentive stock options can minimize the amount of AMT adjustments in a given year.  Taxpayers with depreciable property can elect depreciation methods that do not create large tax to AMT differences.

In all, taxpayers that are subject to the AMT can contact their tax preparer and run a projection before year-end to see what impact the AMT could have on their situation, and what measures can be taken now in order to minimize the AMT's impact.

Stay tuned for The not-so-Alternative Minimum Tax, Part 2, which will address the AMT as it pertains to businesses.  

2013 taxes and rates

When taxpayer's see their 2013 Form 1040, they will notice a few changes to the taxes and rates from previous years.  Following is a summary of the major tax rates and taxes that will be applicable for 2013. For the purposes of this article, MFJ = married filing jointly, S = single, O = any other filing status.

Regular tax rates

Here are the tax brackets for 2013:

Tax rate	Single filers	Married filing jointly or qualifying widow/widower	Married filing separately	Head of household
10%	Up to $8,925	Up to $17,850	Up to $8,925	Up to $12,750
15%	$8,926 - $36,250	$17,851 - $72,500	$8,926- $36,250	$12,751 - $48,600
25%	$36,251 - $87,850	$72,501 - $146,400	$36,251 - $73,200	$48,601 - $125,450
28%	$87,851 - $183,250	$146,401 - $223,050	$73,201 - $111,525	$125,451 - $203,150
33%	$183,251 - $398,350	$223,051 - $398,350	$111,526 - $199,175	$203,151 - $398,350
35%	$398,351 - $400,000	$398,351 - $450,000	$199,176 - $225,000	$398,351 - $425,000
39.60%	$400,001 or more	$450,001 or more	$225,001 or more	$425,001 or more

When calculating tax using this table, taxpayers must work "up the ladder".  This means if a MFJ taxpayer has taxable income of $100,000, they will pay tax at 10% on the first $17,850, then tax at 15% on the amount between $17,851 and $72,500, and then tax at 25% on the remaining amount.  As far as water cooler conversation goes, this taxpayer is "in the 25% bracket", but that doesn't mean they pay a flat 25% on $100,000.

3.8% Medicare surtax

Taxpayers with modified adjusted gross income in excess of $250,000 MFJ / $200,000 S might find themselves completing Form 8960 with their 2013 income tax return.  Taxpayers with this level of income potentially will be subject to the 3.8% Medicare surtax on their net investment income.  Net investment income is loosely defined as all taxable interest, dividends, capital gains, rental/royalty income, and other business activities that are considered passive.  The 3.8% tax is calculated on Form 8960 and added to the taxpayer's regular tax.  For example, MFJ couple has $300,000 modified adjusted gross income that includes $1,000 of taxable dividends.  The couple will pay an additional 3.8% tax on the dividends.  The IRS has recently issued final regs on what is subject to the Medicare surtax.

Higher capital gains rates

Taxpayers with modified adjusted gross income of $400,000 S / $450,000 MFJ will see their long-term capital gains taxed at 20% instead of the 15% rate from the past several years.  This applies to both long-term capital gains and qualified dividends, but short-term capital gains will still be taxed at regular rates.

Personal exemption (PEP) and itemized deduction (Pease) phaseout

Once taxpayers reach a certain level of income, they can potentially be subject to a phaseout of allowable personal exemptions and itemized deductions, which has been discussed in a previous post.

As can be seen, there are several changes to individual tax rates, deductions, and exemptions for 2013.  With proper planning, some of these issues can be either minimized or avoided altogether.

2013 year end planning

Over the next few weeks, this publication will address several topics related to year end tax planning. With Thanksgiving coming next week, it is time for business and individual taxpayers to get their financial houses in order for the end of the year. Topics to be addressed include the following:

• New tax rates for 2013, including new capital gains rates and the Medicare surtax
• Alternative minimum tax
• Incentive stock options
• Capital gains harvesting
• Retirement contributions and other year end expenditures
• Depreciation allowances for businesses
• Considerations for cash vs. accrual basis taxpayers

If you have other topics you would like see addressed, please comment on this post or contact me below.

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Education credits

As discussed in a previous post, paying for higher education can be a stressful task for a parent and/or student.  Unfortunately, expenses for higher education cannot be claimed as deductions on a tax return outright, but there are four available deductions and credits that can help at tax time.

First, it is important to distinguish the difference between a deduction and a credit.  A deduction reduces a taxpayer's taxable income, while a credit reduces a taxpayer's tax.  Therefore a deduction does not reduce a taxpayer's tax dollar-for-dollar like a credit.  Also, some credits are refundable, meaning that if they exceed the amount of tax owed, the taxpayer can receive the difference as a refund.  In all, a credit is better because it reduces tax and could result in a refund.

The American Opportunity Credit (AOC) is a credit available for each eligible student enrolled at least half of the year for the first four years of postsecondary schooling (college).  The credit is the maximum of qualified education expenses or $2,500, and is available to taxpayer's with adjusted gross income (AGI) of $180,000 MFJ / $90,000 S or less.  On top of that, 40% of the credit can be refundable.

The Lifetime Learning Credit (LLC) is a credit available per return, not per student, up to the maximum of qualified expenses or $2,000.  This credit can be claimed for an unlimited number of years which makes it great for students attending law or medical school.  The credit is available to taxpayer's with AGI up to $127,000 MFJ / 63,000 S.  This credit is completely nonrefundable.

Taxpayer's that pay student loan interest can benefit from the Student Loan Interest Deduction (SLID).  The student loan must be taken out solely to pay qualified education expenses and the student must be the taxpayer, spouse, or a dependent.  The student must be enrolled at least half-time.  A deduction is allowed up to the maximum of $2,500 or the amount of interest paid during the year for taxpayers with AGI less than $155,000 MFJ / $75,000 S.  This deduction is an "adjustment to income" on page 1 of the 1040 and reduces AGI before other deductions.

Finally, the Tuition and Fees Deduction (TFD) is available as an "adjustment to income" up to the maximum of $4,000 or qualified tuition and fees.  Note that this deduction is available only for tuition and fees, not other expenses such as room and board, meal plans, or books.  This deduction is available to taxpayers with AGI less than $160,000 MFJ / $80,000 S.  The catch is that the tuition and fees deduction cannot be claimed if the taxpayer is already claiming the American Opportunity or Lifetime Learning credits.

These are four of the most popular education benefits offered to individual taxpayers, and their benefits are maximized in certain situations.  The AOC maximizes its benefits during the first four years of college because it has a high AGI limit and is a credit to reduce tax.  The LLC is beneficial for students that go past the first four years, but is limited in that it has a lower AGI threshold and can only be claimed per return.  The SLID removes some of the sting from paying interest on student loans, but the maximum $2,500 deduction usually pales in comparison to the total amount of interest that is paid in a year.  The TFD is beneficial for someone that goes back to school and only pays tuition, is no longer eligible for the AOC, and has a higher AGI than the threshold for the LLC.

Information from the IRS on benefits for education can be found here. Education benefits can be confusing, but seeking the advice of a professional on the best use of these credits during the college years can help reduce tax liability during years of high expenses.