A Guide to the Alternative Minimum Tax (AMT)

Thursday, 20 November 2008

The purpose of the alternative minimum tax is to ensure that everyone pays a fair share of tax. Essentially, a flat tax rate is applied on alternative minimum taxable income in excess of an exemption amount.

The alternative minimum tax (AMT), the government’s attempt to keep people from taking too many tax breaks, went into effect in 1983 and with TRA 1986 the rules were tightened. The alternative minimum tax concept was developed out of the favored or preferred status Congress gave to certain types of income, so-called preference items. To prevent some individuals with large incomes from paying little or no tax, the AMT was introduced. The Tax Reform Act of 1986 made the alternative minimum tax tougher and extended its provisions to thousands of additional taxpayers. Subsequently the Revenue Reconciliation Act of 1993 increased the rates still further.

What constitutes “alternative minimum taxable income?” Generally, it is your adjusted gross income as determined for regular income tax purposes increased by certain tax preference items and decreased by certain itemized deductions.

After taking into account certain tax credits and adjustments, the alternative minimum tax is then computed.

However, the alternative minimum tax is payable only if it exceeds the taxpayers regular tax. Because regular taxes were generally lowered by TRA ‘86 and because the new laws tighten up the alternative minimum tax, many more taxpayers are now subject to the AMT’s bite.

AMT Formula

Basically, the tax is equal to the excess of a percentage of Alternative Minimum Income (less exemption) over the regular tax. The AMT exemption was increased by the Economic Growth and Tax Reconciliation Act. The Working Families Tax Relief Act of 2004 extended the relief and further fine-tuned the law. Most recently, the Tax Increase Prevention and Reconciliation Act of 2005, that became law in May 2006, extended the exemptions and raised the caps.

Exemption amounts of $45,000 (after 2007) on a joint return (or for a surviving spouse), $33,750 (after 2007) on a single return, $22,500 (after 2007) on a married filing separate return, and $22,500 on an estate or trust return, are available in calculating the taxable excess. These exemption amounts are reduced by 25% of the amount by which the AMTI exceeds $150,000 on a joint return, $112,500 on a single return and $75,000 on a separate return or in the case of an estate or trust.

For children subject to the “kiddie tax” the exemption is the lesser of the above amounts or the child’s earned income plus $6,400 (as indexed for 2008).

Alternative Minimum Income consists of one’s adjusted gross income; to which is added back many of the so-called tax preference items that were deducted in arriving at Adjusted Gross Income (AGI).

The Alternative Minimum Taxable Income definition is the AGI less alternative tax Net Operating Loss (NOL) less alternative tax itemized deductions less income from accumulated income distribution plus tax preferences.

To determine what, if any, one’s alternative minimum tax may be is an assignment for a tax professional, for there are many different additions, subtractions, deductions and adjustments to be made in computing the tax.

Triggering Events

Because of the effect on tax planning, you should be aware of what items might lead to the imposition of the alternative minimum tax. Understanding them might assist you in postponing or offsetting them whenever possible. These include:

1. Deducting net operating losses.
2. The excess of accelerated over straight-line depreciation of real estate or leased equipment.
3. Percentage depletion on oil and gas wells and similar projects.
4. Intangible drilling costs.
5. Exercising incentive stock options.
6. Deducting large amounts of non-refundable credits.
7. Deducting large amounts of state and local taxes.
8. Tax-exempt interest on nonessential function bonds.
9. Deductible passive losses.

You should get to know the alternative tax deductions. The 1986 changes were meant to tighten the deduction rules, not to simplify them.

Under these rules, you can deduct qualifying charitable contributions, casualty and theft losses and medical expenses that exceed 10 percent of your adjusted gross income and personal and estate taxes.

However, as mentioned above, you cannot deduct state and local taxes payable. However, Foreign Tax Credits are deductible against the alternative minimum tax after certain modifications. That is an important change to people in states with high taxes, such as California or New York. Until now, tax advisors have commonly told their clients to prepay state taxes to get a deduction.

Nor can you keep deducting certain kinds of interest. There are limits on the amount you can deduct for interest incurred in financing investments - stock purchases on margin, for instance, or limited partnership interests.

For more information on the alternative minimum tax and other year-end tax planning topics, download your free copy of the 2008-2009 Tax Planning Guide (a 36-page guide).

Brock and Associates, LLC is a fee-based financial planning firm specializing in asset protection and wealth preservation. Contact us for more information on how to avoid the alternative minimum tax and for other tax planning strategies.

 

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