The AMT exemption phase-out

As taxable income increases above $150,000, the AMT exemption amount decreases.  A taxpayer loses $1 of exemption for every $4 increase in taxable income.  Thus, for example, if taxable income before exemption is $250,000 ($100,000 over the threshold), $25,000 of the AMT exemption is lost.  All other things being equal, in this example AMT taxable income would be $275,000 even though Regular Tax taxable income would be $250,000 – making it likely you would find yourself stuck in the AMT.

Note that this phase-out formula means your AMT taxable income increases at a more rapid rate – 25% faster – than any increase in your Regular Tax taxable income.  This acceleration is a significant part of what pulls individuals quickly into the AMT.

Dividends and capital gains

Under current law, dividends and long-term capital gains are taxed at a lower bracket – typically 15% – for both the Regular Tax and for the AMT.  In theory, using this same bracket prevents dividends and capital gains from triggering the AMT.

Unfortunately, however, dividends and capital gains are included as part of taxable income, so they, like all other income, have a direct impact on an individual’s AMT because of the extra 25% effect discussed above.  It’s easy to be fooled by this one.

Beyond the AMT exemption phase-out

For taxpayers who make “a lot” of money (defined below), the AMT rapidly becomes much less of a concern.  There are two forces at work here as income gets into higher levels:

First is that the AMT exemption phase-out simply stops at a certain point.  For MFJ, the phase-out stops at taxable income of $433,800.  At this point, the $283,800 of income over the initial $150,000 means (at the 4-to-1 ratio described above) the $70,950 exemption is completely gone ($70,950 times 4 equals $283,800).  After this, AMT income grows at the same rate as does Regular Tax taxable income, so the 25% penalty no longer applies.

Second is that, at this level of income, the taxpayer now is paying Regular Tax at a significantly higher bracket than the AMT bracket.  Looking at the above tax bracket schedules, one can see that the taxpayer now is well into the 35% Regular Tax bracket, leaving far behind the maximum 28% AMT bracket.  Remembering that a taxpayer pays the greater of the Alternative Minimum Tax or the Regular Tax, at these levels of income it is unlikely the taxpayer will be in the AMT.

Summary

Once a MFJ couple exceeds the $150,000 taxable income level, the sucking sound of the AMT vortex pulls them in at a rapidly-increasing rate.  But for the wealthy – ironically, those at whom the original Minimum Tax was aimed when it was first enacted over 40 years ago – they can safely sit on the sidelines and not even be concerned.  This is why, in the tax returns disclosed in the 2008 Presidential campaign, we saw that Joe Biden, John McCain and Sarah Palin – each making in the neighborhood of $250,000 – all were caught in the AMT trap, while President Obama with his millions from book royalties was not even touched by it.

Next – itemized deductions as the major difference between Regular Tax taxable income and AMT taxable income.

Through the month of May we will be publishing a series of articles explaining these themes and these calculations.  Your accountant may have closed up shop for the summer, or you simply may be tired of paying tax return preparation fees without seemingly accomplishing anything.  A little self-help on your part at this time of the year will go a long way toward understanding what happened to you in 2009 and what you can do about it for 2010.

Taxable Income, Tax Brackets and the AMT Exemption – Part I

This article and the next one will look at the basic calculations – the income tax brackets that apply for the Regular Tax, as compared to the AMT, and the AMT exemption and its phase-out and the effect this phase-out has on the computation of the Alternative Minimum Tax.

Taxable income – the starting point

While every taxpayer is different, each of us has a threshold level of income that will trigger the AMT.  What we are talking about is taxable income, which in simple terms is all of your income less all of your allowable deductions.  As a separate but parallel tax system, the Alternative Minimum Tax has different rules on what items of income must be included, and on what deductions are allowed in computing taxable income.  These differences will be explored in future articles.

Once taxable income is computed, one then looks to the tax bracket tables to compute the tax liability.

Tax brackets – the Regular Tax

Here are the 2009 Regular Tax brackets for a couple electing Married Filing Jointly (MFJ).  These and the tax brackets for the other filing statuses may be seen in the Form 1040 instructions, on page 101, found at this URL: http://www.irs.gov/pub/irs-pdf/i1040.pdf.

Tax brackets – the Alternative Minimum Tax

The AMT has one set of brackets, applying to all filing statuses.  Unlike the Regular Tax brackets, they are not indexed for inflation, so they remain constant unless Congress changes them.  These brackets can be seen on the Form 6251, found at this URL: http://www.irs.gov/pub/irs-pdf/f6251.pdf.

The AMT exemption

The AMT exemption for 2009 for MFJ is $70,950.  The exemption levels for the other filing statuses may also be found on the Form 6251 at the URL shown above.  The purpose of the exemption is to prevent taxpayers at lower levels of income from being pulled into the AMT.

For a simple example, refer in the above Regular Tax table to a couple with taxable income of $67,900.  The couple’s Regular Tax liability on this income would be $9,350, with the first $16,700 being taxed at 10% and the balance at 15%.

If there were no AMT exemption, this couple’s AMT would be $17,654 because the full $67,900 of taxable income would be taxed at the AMT’s 26% bracket – far in excess of the 10% and 15% Regular Tax brackets.  With the AMT exemption, however, this couple’s taxable income for Alternative Minimum Tax purposes is zero, so they have no concerns about the AMT.

Summary

The above illustrates the basic calculations behind the Alternative Minimum Tax and the importance of the AMT exemption.  But a provision that affects the amount of the exemption as a taxpayer’s income increases – the “phase-out” of the exemption – will be explored in the next article – Part II.

The AMT issue

The AMT side of this issue stems from the impact that capital gains have on an individual taxpayer’s AMT. While long-term capital gains are taxed at the same tax rates for both the Regular Tax as well as the AMT, an increase in an individual’s taxable income, whether from ordinary income or from capital gains, in many cases means a decrease in the individual’s AMT exemption amount.

Here is how this works: once a certain level of Alternative Minimum Taxable Income (AMTI) is reached, every dollar of additional income will reduce the taxpayer’s exemption by 25 cents. The threshold level for a married couple filing jointly is $150,000; it is lower for singles and marrieds filing separately. These thresholds, as well as the mechanics of the AMT exemption phaseout, are explained in the lower part of the IRS Form 6251.

The estate tax issue

Here is the estate tax issue: capital gains are the excess of the selling price of a capital asset, such as a security, over the taxpayer’s basis in that security. The most common concept of basis is what the taxpayer paid for the security when he bought it. For example, a share of stock purchased for $100 will have a tax basis of $100; if it is later sold for $120, the taxpayer has a capital gain of $20 on which he will pay tax. But in the case of inherited securities the determination of basis is very different.

So long as the estate tax is in effect, a beneficiary receives a tax basis in any inherited property equal to its fair market value on the date of death. In the vast majority of cases, this is a “stepped-up” basis because, over time, stocks generally appreciate. This is especially the case for senior citizens because they generally have a long-term hold strategy. All of this means that a decedent’s tax basis typically is well below a stock’s current price. In the above example, that share of stock worth $120 may have been acquired by the decedent for $50, or even less.

The two rules together

With the estate tax in place, if the decedent passes away when that stock is worth $120, that amount is now the tax basis for the heir when the shares are distributed to him. Thus, if the heir sells it for $120, he has zero gain to pay tax on, and this has zero effect on his AMT exemption amount.

Suppose, however, the estate tax is not put back in place. In this case the heir’s tax basis in the above example is $50 because he receives a “carryover” basis instead of a stepped-up basis, and a sale at $120 would result in a $70 capital gain. If the individual has AMTI over the specified threshold, this $70 gain on each share of stock sold would decrease his AMT exemption by $17.50 (25% of the gain). If enough shares are sold, this could have a significant and direct impact on the individual’s Alternative Minimum Tax liability.

Summary

Warren Buffet and Bill Gates are long-standing advocates for the estate tax. While these two probably are not AMT payers, every one of the 4.3 million individuals currently subject to the Alternative Minimum Tax, as well as all other taxpayers who are at risk of being drawn into the AMT, should be right there joining these two in advocating reinstatement of the estate tax!

The AMT items that were talked about in Part 1 of this wrap-up generally were the bigger ones that can, depending on a taxpayer’s situation, present immediate year-end Alternative Minimum Tax savings opportunities. But the other items that were discussed in this 10-week series also are important in making sure the least amount of AMT is paid. Here is a brief recap of these other items, with references to the amtblog.com articles in which each appeared.

Investments: Private Activity Bonds – an individual investing in tax-exempt municipal bonds can receive an unpleasant surprise when he discovers that AMT has to be paid on the interest income from a certain type of municipal bond. See the December 18th article posted on amtblog.com.

Miscellaneous Itemized Deductions – business or investment-related expenses may be deductible under the Regular Tax, but they are not for the AMT. Several planning ideas on how to minimize this impact are presented. See the November 14th article posted on amtblog.com.

Limitation on Itemized Deductions: AMT Adjustment – when a taxpayer is in the AMT, the limitations that apply to itemized deductions are calculated differently from the limitations that apply for the Regular Tax. See the November 25th article posted on amtblog.com.

State Income Tax Refunds: AMT Adjustment – because of the different AMT treatment of state and local tax deductions, any adjustment to these deductions – for example, a refund of overpaid state taxes which generally is treated as income when received – is itself then given different treatment for the AMT. See the November 29th article posted on amtblog.com.

Standard Deduction – a taxpayer is allowed no standard deduction in calculating the AMT. An interesting planning idea here could mean that an AMT taxpayer might be better off not claiming the standard deduction at all. For a discussion of this opportunity see the November 18th article posted on amtblog.com.

Personal Exemptions – similar to the standard deduction, a taxpayer is allowed no deduction for personal exemptions in calculating the AMT. Not a whole lot can be done here, but there always are at least a few planning ideas. See the November 22nd article posted on amtblog.com.

The AMT Exemption, also known as “the annual patch” – the AMT Exemption amount is set annually by Congress. This is a prescribed amount by which a taxpayer’s Alternative Minimum Taxable Income must exceed his Regular Tax taxable income before the AMT itself is triggered. If Congress were to fail to adjust this exemption amount, 24 million new taxpayers would be pulled into the AMT, in addition to the four-plus million already stuck there. See the December 21st article posted on amtblog.com. Also, pay careful attention to the news we will be seeing on this in the near future as we anxiously await Congress’ fix on this again for 2010.

Good luck with your AMT planning. Hopefully each of these articles provided a simplified explanation along with a few 2009 Alternative Minimum Tax savings ideas. Soon we’ll be working on 2010!

The House has adjourned for the year, and the Senate is putting all of its energies into the massive health care reform effort. Left behind – far behind in fact – is any thought of relief for the 24 million taxpayers who will become subject to the Alternative Minimum Tax for the first time on January 1, nor for the significant increase in the amount of AMT paid by each of the four million-plus already enveloped by it.

The issue? The AMT exemption level and the so-called annual “patch.” Below is a reprint of two articles that appeared on amtblog.com earlier in the year, after President Obama signed the 2009 Stimulus Act into law.

The AMT “patch”

Once again we read that Congress has fixed the AMT problem by enacting a temporary “patch” in the recent stimulus bill. With this, 24 million taxpayers who otherwise would be in the AMT in 2009 are spared – but only for one year. Come January 1 these 24 million people again risk falling into the AMT.

What is this all about? It’s simply another example of the law of unintended consequences. When the first minimum tax was enacted back in 1969, it seemed like a good idea – 155 taxpayers making over $200,000 were paying no taxes at all under the regular income tax, so a “minimum” tax would make sure that they did. But today that 155 has exploded to over 4 million who are paying the AMT. Unfortunately, this patch does nothing for these 4 million – it just keeps the other 24 million from joining this exclusive club.

Why is this happening? The principal reason for this kudzu vine-like growth in the number of AMT victims is the failure to index the AMT for inflation, while the Regular Tax is so indexed. The annual patch fixes this with a catch-up AMT indexing adjustment. In our next article we will explain indexing and this annual adjustment.

Why just a one-year patch and not a permanent fix? The answer is simple economics – the revenue loss for the 2009 fix alone is 70 billion dollars. A permanent fix, using Congress’ 10-year forecasting model, could approach a cost of nearly 1 trillion dollars. Now you’re starting to talk about real dollars.

Indexing

The AMT “patch” that Congress passed in the recent stimulus bill saved 24 million taxpayers from falling into the AMT in 2009. As mentioned in the last article, this temporarily fixed the problem caused by Congress’ original failure to index the AMT for inflation.

What is indexing? Under our system, tax brackets are progressive – i.e., the more you make, the higher your tax bracket. Some time ago Congress decided it wasn’t fair to have taxpayers fall into a higher tax bracket if the only increase in income simply reflected inflation. For example, in 2008 a single taxpayer hit the 33% bracket when taxable income reached $164,550. In 2009, that same taxpayer will be able to earn $171,550 before hitting 33% – a 4.3% increase. Presumably the CPI increased by 4.3% during this period. (Economists reading this are welcome to write in and explain how all this actually works).

For the AMT, the level at which an AMT payer goes from the 26% bracket to 28% ($175,000) has not changed. Instead, the Congressional fix is to index the AMT “exemption amount.” For a single taxpayer, in 2008 the exemption amount was $46,200. This is an increase of 4.2% over what it was the previous year, because of Congress’ 2008 patch. If the patch is not enacted, however, the exemption amount reverts all the way back to what it was in 1993 – $33,750 for singles. This is the reason such a large number of taxpayers – 24 million – are left hanging out there every year!

Keep an eye on this issue – the so-called AMT “patch.” It will be in the news, as it is every year.

Capital gains are income derived from the sale of property, most typically investment property. While capital gains are not directly an AMT preference item, they do have an impact on a taxpayer’s Alternative Minimum Tax, and, therefore, are an essential element of AMT planning. One real-life scenario with which the writer is familiar involved a retiree with what one would call a typical investment portfolio, including mutual funds, and it was solely a larger-than-usual year-end capital gain distribution from one mutual fund that threw that individual into the AMT.

For a little review, capital gain income historically has been taxed at a rate lower than the rate that applies to other, “ordinary,” income such as salaries and wages and interest income. This lower rate applies only to “long-term” capital gain (LTCG), which means the taxpayer must hold the property for over one year before selling it. Under current law, most dividend income also receives this favorable LTCG treatment.

In general, the tax rates that apply in computing the Alternative Minimum Tax are different from the rates that apply in computing the Regular Tax. However, LTCG is taxed at the same rate for both computations – typically 15%. Thus, a LTCG by itself is not an AMT item. Despite this treatment, however, a LTCG definitely can be a factor that triggers the AMT.

Here’s what happens. First, every taxpayer is entitled to an AMT Exemption amount. This Exemption is designed to prevent taxpayers with only small AMT items from paying the AMT. For example, a couple filing a joint return for 2009 is entitled to an Exemption of $70,950. Unfortunately, however, this Exemption is phased out as the taxpayer’s income increases. The actual phase-out is the loss of $1 of Exemption for every $4 of additional income (i.e., at a 25% rate). So even though LTCG is not a preference item, the more capital gain a taxpayer has the more of his Exemption is phased out and, thus, the more likely he is to pay the AMT. This is exactly what happened to the retiree mentioned above, who, by the way, also happened to be 90 years old at the time. While it may not seem right, there certainly is no AMT forgiveness even for old age!

To illustrate how this works, assume a taxpayer realizes an additional $10,000 of LTCG. In comparing the tax rate schedules for the AMT and the Regular Tax, one would conclude that this capital gain income would have no impact on the taxpayer’s AMT because it is taxed at the same rate under both computations. But here’s what actually happens by adding $10,000 to taxable income:

Income increase
(a) AMT Exemption Phase-out (25%)
(b) Increase in AMT Income (a)+(b)
$10,000 $2,500 $12,500

This increase in AMT income at a rate 25% greater than Regular taxable income is the problem. It is simple math – the more AMT income taxed, the greater the chance of being pulled into the AMT.

In summary, an AMT payer definitely needs to factor capital gains into the equation when doing any tax planning. With year-end now only a little more than two weeks away, anyone thinking of recognizing gains this year had better take this into account.

By way of background, PAYGO refers to a method of financing changes to the law that result in Federal monies being spent, by demanding that offsetting funds also are made available at the same time. In other words, to spend a dollar Congress must find a way either to increase revenues by a dollar, or to make a dollar of spending cuts somewhere else. The obvious goal of this is to put a brake on deficit spending.

PAYGO was first enacted into law in 1990, and it remained in effect until 2001 when it was allowed to lapse. At that point the discipline of fiscal restraint was gone, and the annual budget deficits began to grow again.

In 2007 the PAYGO system was reestablished as a rule of the House of Representatives, although the Senate did nothing. Less than one year later, however, due to taxpayer outcries to do something about the ever-growing Alternative Minimum Tax burden, Congress completely abandoned its PAYGO pledge, allowing it to pass the series of “patches” we have seen in recent years.

Yesterday’s White House press release read as follows:

“The President will discuss his plan to ensure that the federal government lives within its means and will lay out his commitment to:
• Return to an era of responsible government spending, the President is asking Congress to approve legislation requiring that any new tax cut or entitlement program be paid for.
• Put PAYGO back into law, with automatic cuts in mandatory programs as penalties for violations.
• Return to the rules of the 1990s when statutory PAYGO enforced the tough choices that moved the budget from large deficits to surpluses.”

With all that great-sounding language, however, the President admitted that he did have to make a few exceptions, including dealing with our favorite little monster – the Alternative Minimum Tax:

“There would be exceptions in four areas where current policy differs substantially from current law: (1) Medicare payments to physicians; (2) the estate and gift tax; (3) the AMT; and (4) tax cuts enacted in 2001 and 2003.”

So while the President acknowledges that he must continue with the annual fixing of the AMT problem, he’s also recognizing that the cost is so great that there simply is no way to pay for it. The old adage repeats itself again – you just can’t have your cake and eat it too!

What is indexing? Under our system, tax brackets are progressive – i.e., the more you make, the higher your tax bracket. Some time ago Congress decided it wasn’t fair to have you fall into a higher tax bracket if your only increase in income simply reflected inflation. For example, in 2008 a single taxpayer hit the 33% bracket when taxable income reached $164,550. In 2009, that same taxpayer will be able to earn $171,550 before hitting 33% – a 4.3% increase. Presumably the CPI increased by 4.3% during this period. (Economists reading this are welcome to write in and explain how all this actually works).

For the AMT, the level at which an AMT payer goes from the 26% bracket to 28% ($175,000) has not changed. Instead, the Congressional fix is to index the AMT “exemption amount.” For a single taxpayer, in 2008 the exemption amount was $46,200. This is an increase of 4.2% over what it was the previous year, because of Congress’ 2008 patch. If the patch is not enacted, however, the exemption amount reverts all the way back to what it was in 1993 – $33,750 for singles. This is the reason such a large number of you – 24 million – are left hanging out there every year.

What is this all about? It’s simply another example of the law of unintended consequences. When the first minimum tax was enacted back in 1969, it seemed like a good idea – 155 taxpayers making over $200,000 were paying no taxes at all under the regular income tax, so a “minimum” tax would make sure that they did. But today that 155 has exploded to over 4 million who are paying the AMT. Unfortunately, this patch does nothing for you 4 million – it just keeps the other 24 million from joining your exclusive club.

Why is this happening? The principal reason for this kudzu vine-like growth in the number of AMT victims is the failure to index the AMT for inflation, while the Regular Tax is so indexed. The annual patch fixes this with a catch-up AMT indexing adjustment. In our next article we will explain indexing and this annual adjustment.

Why just a one-year patch and not a permanent fix? The answer is simple economics – the revenue loss for the 2009 fix alone is 70 billion dollars. A permanent fix, using Congress’ 10-year forecasting model, could approach a cost of nearly 1 trillion dollars. Now you’re starting to talk about real dollars.