Alternative Minimum Tax (AMT)

by Jim Stephens, CPA Elliot & Warren, PLLC

The Alternative Minimum Tax (AMT) was created in 1969 as an "add-on" tax to correct a problem revealed in a Treasury Department report that in 1966, 155 taxpayers with adjusted gross income of $200,000 (about $1 million in today's dollars) did not pay any U.S. income tax. It was originally designed as a 10% add-on tax applied to nine tax preference items when the total of those preference items exceeded a $30,000 exemption. The Tax Reform Act of 1986 expanded the list of preferences and adjustments, with the result being a tax that affected more middle class taxpayers.

AMT is separate system from regular income tax, and it is reported on Form 6251. The tax rates have increased from the original 10% to 26% on Alternative Minimum Taxable Income (AMTI), less applicable exemption, up to $175,000 and 28% on AMTI, less applicable exemption, in excess of $175,000. The current exemption amounts for 2005 are $58,000 (married filing jointly) and $40,250 (single). The AMT exemption begins to phase out at a rate of 25% of the AMTI over $150,000 (Married filing joint) and $112,500 (Single). The exemption is completely eliminated when AMTI reaches $382,000 (Married filing joint) and $273,500 (Single).

The starting point for computing AMTI is regular taxable income. From there, add back your personal and dependent exemptions and the standard deduction (if taken) or preferences and adjustments (if you itemize). For taxpayers that itemize deductions, the following are the most common adjustments that are made when calculating Alternative Minimum Taxable Income (AMTI):

• Medical deductions from Schedule A are allowed to the extent they exceed 10% of AGI (as opposed to 7.5% for regular income tax).
• Taxes from Schedule A, line 9 are not deductible for AMT, and must be added back. These include state income taxes, real estate taxes and personal property taxes.
• Home equity interest that is not used for acquiring or remodeling (improving) a principal or second residence is not deducted, and must be added back.
• Miscellaneous itemized deductions subject to the 2% of AGI rule are not allowed for AMT purposes. These can include, but are not limited to, tax preparation fees, safe deposit box rental, unreimbursed employee business expenses and legal fees. Legal fees paid under a contingent fee agreement can pose a serious problem when contemplating AMT.
• State income tax refunds are not taxable for AMT purposes, and should be deducted to arrive at AMTI.
• Interest income on tax-exempt bonds classified as "private activity bonds" is taxable for AMT, but not for regular income tax. On the same note, investment interest expense paid to carry those bonds is deductible for AMT, though not for regular income tax.
• Incentive Stock Options (ISO's) can cause large adjustments in deriving AMTI. You are required to adjust for the difference in the fair market value and the strike price of the ISO's at the date of exercise. If the options are acquired and disposed in the same tax year, there will be no adjustment for AMT. However, if the income is significant, it could drive up your AMTI, and reduce your AMT exemption through phase out. If the options are acquired, but not sold, the adjustment for AMT will increase your basis in the shares for AMT purposes. When the options are disposed of, there will be another adjustment on form 6251 to show the difference in the cost basis of the options for regular income tax and AMT.

Capital gains are taxed at the same rate for AMT purposes as they are for regular tax purposes. However, large capital gains may increase your AMTI and begin to phase out your AMT exemption. The same result occurs for ISO's that are acquired and disposed of during the same year. Be sure to consider AMT when the time comes to exercise ISO's and when selling investments that may cause large capital gains. With proper planning, you may be able to lessen your risk on being in AMT by timing these events to occur at an advantageous time.

Be careful not to accelerate deductions that could be add backs for AMT, thereby giving you no significant tax savings. These can include state income taxes, real estate taxes and personal property taxes.

This is designed to give you an overall idea of the common pitfalls of the AMT and to highlight areas where proper planning may be used to minimize or eliminate the AMT and should not be considered definitive advice on avoiding the AMT altogether. Please contact Jim Stephens, CPA at (704) 333-8881 to discuss your current situation and areas where we may be able to help you.

Elliot & Warren P.L.L.C.