To pay or not to pay, that is the question

For taxpayers that make estimated tax payments throughout the year, the payment for the fourth quarter is due on January 15 of the next year. Even though this payment is made in the following year, it is still credited as a payment for the tax year in which it applies. But, if the taxpayer lives in an "income tax state" (a state with its own income tax, like Arkansas or Louisiana, but not Texas) and makes estimated tax payments to the state, there is a catch to when these payments are deductible on a Federal return.

Allowable itemized deductions for individuals on a Federal 1040 include state and local taxes paid. These taxes include income, real estate, and personal property taxes as well as some other taxes paid to a state or local government. The deductible portion of these taxes is the amount actually paid during the year, not amounts assessed or paid in other years. Here are a few examples:

Bob, who does not live in an income tax state, pays his personal property taxes for 2012 in October of 2013 for $500. At the same time, he receives his assessment for 2013 of $600 which will be due in October 2014. Bob's deduction for personal property taxes in 2013 is $500, because that is what he actually paid even though it was related to the previous year.  The $600 will be deductible to him in 2014 when it is paid.

Peggy lives in an income tax state and makes state estimated tax payments quarterly. In January 2013, she made her 4th quarter payment for 2012 for $500. Then, in April, June, and September of 2013 and in January 2014 she made quarterly payments of $600 each for her 2013 state taxes. Peggy's state tax deduction on her Federal return for 2013 is $2,300 ($500 + 3 $600 payments) which is the total of the payments made during 2013, even though one of them was related to a previous year.

This example leads us to the point of this article. If Peggy makes her state fourth quarter payment for 2013 in December 2013 instead of January 2014, her state tax deduction on her Federal return will be $2,900 instead of $2,300. As a result, her Federal tax liability would be decreased slightly because of the added deduction. It is for this reason that taxpayers living in income tax states should always consider paying their final estimated tax payment before the end of the year.

But, as is usually the case, there are caveats with this plan - the Alternative Minimum Tax and the time value of money.

Taxpayers subject to the Alternative Minimum Tax (AMT) will not realize the benefit of paying their state estimated tax payment early because those payments will be added back as a preference item on Form 6251.  Therefore if taxpayers are close to or already subject to the AMT, they should make their payments as scheduled (not early).

Taxpayers must also consider the time value of money when paying estimated tax payments early.  For example, if the funds needed to make the estimated tax payment will be accessed by selling investments at a gain, then the net effect of the transaction might be zero because the additional benefit from the payment could be offset by the additional income recognized from selling the investments in the same year.  Furthermore, the funds used to pay taxes earlier by 15-30 days may lose investment earnings which could be large if the estimated tax payment is large.

In closing, taxpayers should consider making their 4th quarter state estimated tax payment in December (now!) as long as they are not subject to the AMT and they have liquid funds to make the payment without creating additional income.

The not-so-Alternative Minimum Tax, Part 2

A few days ago, this blog addressed the Alternative Minimum Tax (AMT) as it applies to individuals.  A little known fact is that businesses, like individuals, can be subject to the AMT.  Although the purpose is the same - assure that taxpayers with certain types of income and deduction structures pay at least a minimum amount of tax - the way in arriving at the AMT is slightly different.  This article addresses AMT as it applies to tax-paying corporations (C Corps).  It does not apply to passthrough entities such as S Corps or Partnerships, because AMT is calculated at the individual level.

Not all businesses are alike

Unlike individuals, some corporations are exempt from the AMT.  A corporation that qualifies as a "small corporation" is exempt from the AMT.  To be classified as a small corporation, the entity must:

• Be in its first year of existence, i.e. the current tax year is the year the entity began operations, or
• The company was treated as a small corporation for all prior tax years beginning after 1997, and
• The company's gross receipts did not exceed an average of $7.5 million for the preceding 3 tax years ($5 million if the entity has been in existence for 3 years or less)

After determining that the corporation is subject to the AMT, the taxpayer will complete Form 4626 with the Form 1120.  Form 4626 is organized similar to Form 6251 for individuals.  It begins with the corporation's taxable income, and then adds back / takes away various adjustments and preferences, such as:

• Differences in depreciation
• Differences in gains and losses
• Depletion
• Intangible drilling costs
• Adjusted Current Earnings adjustments (ACE)

After the corporation accounts for these adjustments and preferences, they arrive at their alternative minimum taxable income (AMTI).  Corporations are afforded an exemption if their income falls in a certain range, typically $40,000.  The AMTI is then multiplied by 20% to arrive at the AMT.

Just like individuals, if the AMT exceeds the corporation's regular tax, then they must pay the higher amount.

Because corporation's do not receive the same preferential treatment of gains being taxed at a lower rate like individuals, the biggest factor in a corporation's AMT calculation is depreciation.  A corporation needs to be mindful when capitalizing depreciable property that a large difference between the tax and AMT depreciation methods could subject the corporation to a higher tax rate.  Some assets, when capitalized using the 200% double-declining method of depreciation can only be depreciated using the 150% MACRS method for AMT purposes.  This will cause the AMT depreciation expense to be lower than the tax depreciation, resulting in an addition to taxable income in arriving at AMTI.

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.