November, 2002 Tax Newsletter

Alternative Minimum Tax: The Silent Threat

The alternative minimum tax (AMT), created in 1969, was initially aimed at very wealthy taxpayers who were paying little or no income tax.  Over the years, it has transformed into a silent threat catching middle class taxpayers in its trap.  Among the leading targets for the AMT are employees exercising stock options, large families, small businesses, people with high medical bills, and those living in high tax states and cities.

The AMT has somewhat lower rates than the regular income tax but it covers a broader base of income with many of the "normal" deductions disallowed. You are required to calculate both the AMT and regular income tax then pay whichever is higher.  Among the disallowed normal deductions are state and local taxes and miscellaneous itemized deductions such as unreimbursed business expenses, investment expenses, and tax return fees.  Individuals with large capital gains are at risk especially if they are also taking large deductions.  Owners of partnerships, S corporations and other pass-through entities can end up with permanent AMT classification since they pass through the credits and depreciation that are disallowed or limited by the AMT. Stock options can create huge AMT liability for unsuspecting employees without careful planning. These and other scenarios can create a tax-planning nightmare.  Therefore, it is always prudent to seek professional advice prior to year-end to determine if there is a danger and to implement indicated tax strategies to mitigate it.

Some relief comes in the form of AMT credits, which are created when you actually have to pay AMT tax. You can use the AMT credits to reduce your regular tax liability in any year it exceeds your liability when calculated under the AMT. Unused credits can be carried forward if not used in a particular year.

The AMT has started to attack unsuspecting taxpayers since the 1986 tax act lowered regular rates and indexed the brackets for inflation. The AMT exemption is $49,000 per couple ($35,750 for single taxpayers) and is not is not indexed. So inflation and income growth would now push more people toward having to use the AMT. Taxpayers who have large deductions, exemptions and credits find that their regular tax falls below the AMT amount. Once you reach the AMT liability threshold it does no good to take any additional deductions.

State and local taxes can create an AMT situation if you are not aware that these are not deductible for AMT. For example, if you pay two years of state income tax or pay an additional real estate tax installment in one year it could possibly throw you into the AMT. A good general rule to follow on this issue is to match income and deductions, take large deductions when you have a lot of income.  As you might expect, there are exceptions to this rule, so, if you have a significant change in your income or deductions, I recommend that you consult a tax professional.

Capital gains can push people into the AMT.  The capital gains rate (generally 20%) is lower than the AMT rates (26%, graduating to 28%).  However, capital gains are included  in taxable income for AMT purposes. The result is that the AMT rate that you would be paying can often be much higher than the effective rate for regular tax purposes.  

If you operate a  business in which you provide services as an independent contractor, care must be taken.  If the IRS were to classify you as an employee instead of an independent contractor, you can no longer file a Schedule C as a  self-employed individual and all your deductions then become “miscellaneous” deductions, which are not allowable for AMT purposes.  If you pay your own expenses and run your own company, make sure you take the right steps to qualify as an independent contractor. Proper advice and planning is essential.

Tax credits are another area of AMT concern. Certain credits can’t be used to reduce your taxes below the AMT level, although they can be carried forward. If you have a choice between a credit and a deduction and are subject to AMT you are likely better off taking the deduction.

As mentioned at the outset, incentive stock options can also be an AMT trap. The reason is that if you exercise an ISO and do not sell the stock before the end of the calendar year, the difference between what you paid for the stock and what it was worth at the time you exercised is included in the tax base for AMT purposes..

To protect you from the risk of the silent AMT threat becoming a very noisy one, it is highly recommended that you are seek the advice of a competent tax professional.  I would welcome the opportunity to assist you in this and any other tax matter.