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.