What happens with the AMT calculation when one’s income level changes?

Tax brackets for the Alternative Minimum Tax are progressive, as are those of the Regular Tax.  What this means in simple terms is that additional amounts of income are taxed at a higher rate than the tax rates that apply to the lower levels of income.  The Regular Tax has six brackets, ranging from 10% to 35%, while the AMT has just two – 26% and 28%.  As will be explained below, however, there are other adjustments in computing taxable income that actually can make these stated tax brackets significantly higher.

What are the real AMT brackets?

In calculating the Alternative Minimum Tax, an individual is allowed to subtract an exemption amount from what otherwise would be taxable income.  This exemption amount is $74,450 for a married couple in 2011.  As has been discussed in previous articles, however, the exemption is phased out as a taxpayer’s income increases.  This phaseout has the direct  effect, therefore, of increasing the effective AMT tax rates for individuals who find themselves in this phaseout range.

For 2011, for the married couple, the phaseout begins at $150,000 and doesn’t stop until their income exceeds $440,000.  Within this range, each incremental $100 of income will result in a loss of $25 of the AMT exemption.  The result is that a 28% Alternative Minimum Tax bracket is increased by a factor of 25%, resulting in an effective AMT tax bracket of 35%!

What does all this mean for planning?

Knowing one’s effective tax bracket is the only way to do proper AMT planning.  It can be a costly mistake to deliberately accelerating income, thinking one is in an Alternative Minimum Tax bracket lower than the Regular Tax bracket, only to find out this actually is not the case.  Many year-end tax planning articles routinely suggest that people in the AMT do exactly this, but without knowing what your effective AMT tax rate is it could instead turn out to be a costly mistake.

What types of income can be accelerated or deferred?

The answer to this question will depend on each individual’s situation- i.e., whether the person is employed or self-employed, what kind of investments the person has, etc.  Discussed below is a brief overview of some of the types of income that an individual may be able to accelerate or defer at year-end.

-  Employee compensation such as bonuses and stock options

Some employers allow employees the choice of taking their bonuses currently or deferring them to a future year.  In addition, employees may be granted stock options, and the timing of when these options are exercised is entirely up to the employee – they can be exercised just as easily in December as they can in January.  If the employee has what are known as nonqualified stock options, taxable income will be recognized immediately on the date of exercise – both for the AMT as well as Regular Tax purposes.  If the options are qualified options (these are more commonly known as incentive stock options, or ISOs), there is no taxable income on the date of exercise for Regular Tax purposes, but there is for the Alternative Minimum Tax.

-  Business income from self-employment, LLCs or partnerships

A business usually has some degree of control at year-end over its net income for that last month of the tax year.  For example, a cash-method business could pay outstanding bills in December to reduce income, or wait to pay them in January, which would directly affect the amount of income reported on the business owner’s tax return.  The business also could hold off from sending out certain bills out towards the end of the year, thus postponing income into the following year.

-  Investment income

Here are some acceleration or deferral thoughts on a few types of investments:

Capital gains – an individual has complete control over the timing of any sales of investments, so capital gains easily could be recognized this year or next.

Rental income – a landlord might ask for the rent check that is due on January 1^st to be paid a few days early.

Interest and dividends – as a longer-term strategy, an individual could shift in or out of bonds and/or dividend-paying stocks to affect the amount of interest and dividend income received on a current basis.

Conclusion

Knowing what tax bracket the taxpayer is in is critical to any tax planning, but especially so for individuals in the Alternative Minimum Tax.  The only way to minimize the AMT is to take a little time as we approach year-end to look at the options available in terms of what income might be moved between 2011 and 2012, and then to figure out which of these choices will result in the lowest tax burden.  With the holiday season keeping everybody pretty busy, it’s never too soon to start doing at this!

Types of stock options

For tax purposes there are two types of stock options – “qualified” and “nonqualified.”  The official term for a qualified option is Incentive Stock Option, commonly referred to as an “ISO.”  Each employer has the discretion, through the design of its plan, as to which type of option it grants to the employee, and it is not uncommon for some employees to have both types.  It is important to note here that it is the responsibility of the individual to understand what he has.

Stock option essentials

A stock option, like any other option, is a contract giving one person the right to buy property from another person at a predetermined price.  If the underlying property (stock) increases in value, the value of the option correspondingly increases.  If the value of the stock decreases, the option has no value.  Options generally have a fixed term – five to ten years for stock options is common, so the employee must act within this period or the option will lapse.

Example – an employee is granted an option to buy 1,000 shares of his employer’s stock at today’s value of $50.  If the stock increases to $60 before the option lapses, the employee can exercise the option, effectively buying the shares from the employer at a discount and, in this example, realizing a $10,000 gain.  To alleviate the hardship of asking the employee to write a check for the $50,000 exercise price, employers commonly arrange with a broker to allow what is referred to as a “cashless” exercise involving a same day sale.  In this situation, on the date of exercise the broker sells an equivalent number of shares, and then sends the employer the $50,000 along with enough to cover the tax withholding requirements.  Then, at the close of the market’s three-day settlement period, the net amount ($10,000 less taxes) is credited to the employee’s account.

Tax results from option exercise

Nonqualified option – on the date of exercise the $10,000 in the above example is taxable income.  This is ordinary income, not capital gain, just as if it were part of the employee’s salaries and wages.  The $10,000 will be included in taxable income reported in the employee’s W-2 at the end of the year.

ISO (qualified option) – The $10,000 will not be taxed as income on the date of exercise.  Instead, it is a tax preference item for purposes of the AMT, meaning that Alternative Minimum Taxable Income will be higher than the employee’s Regular Tax taxable income by $10,000.  The number in this example is relatively small, but if the preference item from an ISO exercise is large enough the employee easily can find himself stuck in the AMT.  If the individual already is in the AMT, the hit from an ISO exercise will make it just that much more painful.

Tax planning for option exercises

The exercise of a nonqualified option does not have any direct AMT consequences.  As an individual’s taxable income increases, however, the Alternative Minimum Tax exemption is phased out, so testing for the impact of this is important before exercising even a nonqualified option.

Especially critical, however, is tax planning before doing an ISO exercise.  In order to exercise an ISO without triggering the Alternative Minimum Tax, the individual has to do the tax calculation under alternative assumptions as to the size of the exercise, as well as consider doing the exercise partially in one year and partially in the next.  By doing this it certainly is possible to minimize the impact of an ISO exercise.  Note also that the employee has a period of time after the exercise within which a sale of the stock will constitute a “disqualifying disposition,” thus negating the AMT effect and retroactively treating the transaction as if it were instead a nonqualifying option.

Summary

The underlying investment decision as to the right time to cash out of employee stock options must, of course, must be the individual’s primary focus, but if that exercise will bring along with it a big AMT hit taxes need to be considered in deciding how many options to exercise and in what year they are exercised.  That nice chunk of extra income the employee thinks he is getting can be seriously eroded by improper tax planning.

There’s a great story that Eric Solomon, Assistant Secretary of the U.S. Treasury for Tax Policy during the Bush administration, used to tell.  His father had received a letter from the IRS stating that his 2004 tax return could not be processed because he had not computed his Alternative Minimum Tax. “My dad said, ‘I’m 82. I don’t pay the AMT,’” Solomon would recall. Unfortunately, no such octogenarian exemption exists, but Solomon said he had to spend three hours on the phone with his dad working through the Form 6251.

This article will address both income issues associated with retirees and the AMT as well as deduction issues.

Income issues

Retirement plan distributions

Individuals have many choices as to how they can take distributions from their retirement plans, whether these plans are in the form of pensions or 401(k)-type plans.  A lump-sum distribution, or some other accelerated form of distribution, more likely would trigger the AMT than choosing a lifetime annuity.  This is because the higher one’s income is in any one year the more likely the AMT exemption is phased out, in turn meaning the more likely the individual is to be in the Alternative Minimum Tax.

Stock options- nonqualified

Many mid- to upper-level employees who work for a corporation, typically a publicly-traded corporation, receive “nonqualified” stock options as part of their compensation packages.  Many of these option plans allow the individual a certain period of time after retirement to exercise these options.  Similar to the point made above with respect to retirement plans, a retiree must consider the AMT impact when deciding when to exercise these options and how much income will be generated.

Stock options – Incentive Stock Options

If an individual has Incentive Stock Options, the exercise of these in one year can almost guarantee paying the Alternative Minimum Tax.  This is because the difference between the value of the stock on the date of exercise and the option price is a direct AMT preference item – unlike the indirect effect the exercise of nonqualified stock options can have as discussed above.

Capital gains

Retirees on occasion may have capital gains that are disproportionately large in comparison to the rest of their income.  These gains may result from distributions from mutual funds, over which the individual has no direct control, or from an effort to diversify an investment that is too concentrated in one stock, or from any number of reasons.  These sudden bumps in income can cause the retiree to lose a portion of his AMT exemption, resulting in a problem similar to those discussed above.

Deduction issues

Standard deduction

A taxpayer may elect to take the “standard deduction” in lieu of itemizing deductions.  The amount of the deduction varies by filing status, but for a couple filing jointly it is $11,600 for 2011.  Since no standard deduction is allowed for the AMT, Alternative Minimum Taxable income – the amount on which the AMT is calculated – will be $11,600 higher than Regular Tax taxable income.  Add to this the extra $2,300 exemption for folks age 65 and over and one can see why more and more retirees are being pulled into the AMT.  Note that an extra amount also is allowed in cases of blindness, further exacerbating the problem for these individuals.

Property taxes and state income taxes – changes in state of residence

An individual who itemizes deductions generally will get a Regular Tax benefit for property taxes and state income taxes, as well as certain other state and local taxes.  None of these taxes is allowable as a deduction in computing the Alternative Minimum Tax.  Accordingly, like the standard deduction issue discussed above, taxable income on which the AMT is calculated will be higher than Regular Tax taxable income.  If a change in state of residence at retirement is contemplated, it is important to plan for the AMT effects.  Moving from a high state and local tax jurisdiction to a state without income tax like Florida, for example, could mean falling out of the AMT along with a corresponding opportunity to move income, or deductions, from one year to the other to minimize the AMT.

Summary

A sudden change in one’s income position, as typically happens in the case of retirement, can present significant Alternative Minimum Tax planning opportunities.  Deductions that would be lost in an AMT year may be shifted to a Regular Tax year, and income might be taxed at a lower rate in one year versus the other.  These principles apply to all future retirement years; not just the year of transition from employment to retirement.  While often overlooked, taxes, especially the Alternative Minimum Tax, are a very important part of planning for retirement.

Set forth below is an excerpt from this recent report – the part addressing the Alternative Minimum Tax.  It makes for interesting reading, especially when one finds such comments as “the AMT is not viewed as part of normal income tax law.”

The report:

Under the Joint Committee staff view of normal tax law, compensatory stock options would be subject to regular income tax at the time the options are exercised and employers would receive a corresponding tax deduction.  If the option has a readily ascertainable fair market value, normal law would tax the option at the time it is granted and the employer would be entitled to a deduction at that time. The employee’s income would be equal to the difference between the purchase price of the stock and the market price on the day the option is exercised.

Present law provides for special tax treatment for incentive stock options and options acquired under employee stock purchase plans.  When certain requirements are satisfied, then: (1) the income that is received at the time the option is exercised is excluded for purposes of the regular income tax but, in the case of an incentive stock option, included for purposes of the alternative minimum tax (“AMT”); (2) the gain from any subsequent sale of the stock is taxed as a capital gain; and (3) the employer does not receive a tax deduction with respect to the option.  The special tax treatment provided to the employee is viewed as a tax expenditure by the Joint Committee staff.  However, it should be noted that the revenue loss from the special tax treatment provided to the employee is accompanied by a significant revenue gain from the denial of the deduction to the employer.  The negative tax expenditure created by the denial of the deduction for employers is incorporated in the calculation of the tax expenditure.

The individual AMT and the passive activity loss rules are not viewed by the Joint Committee staff as a part of normal income tax law. Instead, they are viewed as provisions that reduce the magnitude of the tax expenditures to which they apply. For example, the AMT reduces the value of the deduction for State and local income taxes (for those taxpayers subject to the AMT) by not allowing the deductions to be claimed in the calculation of AMT liability.  Similarly, the passive loss rules defer otherwise allowable deductions and credits from passive activities until a time when the taxpayer has passive income or disposes of the assets associated with the passive activity. Exceptions to the individual AMT and the passive loss rules are not classified as tax expenditures by the Joint Committee staff because the effects of the exceptions already are incorporated in the estimates of related tax expenditures. In one case the restrictive effects of the AMT are presented separately because there are no underlying positive taxexpenditures reflecting these effects: the negative tax expenditures for the AMT’s disallowance of personal exemptions and the standard deduction.

In our 10-week series of articles on tax planning for the Alternative Minimum Tax, we have looked at many things a taxpayer can do to reduce his AMT liability. With only four days left in which to act in order to reduce 2009’s taxes, here is a summary of these items, with reference to the date each article appeared on amtblog.com. Please refer back to the article for the specific tax-saving steps that still may be taken before year end.

State and local taxes

This item affects 94% of all AMT payers, yet it is one of the easiest to plan for and it can have the most direct impact on a taxpayer’s Alternative Minimum Tax. There are three types of taxes here:

1. Property taxes – by weighing the relative factors of property tax burden, percentage of AMT payers, and size of population, here is a ranking of the top 10 states that are hit the hardest by this item. Residents of these states really do need to focus on this one in particular. See the November 8th article posted on amtblog.com, “Property Taxes.”

#1 – New York
#2 – New Jersey
#3 – California
#4 – Illinois
#5 – Massachusetts
#6 – Connecticut
#7 – Maryland
#8 – Pennsylvania
#9 – Virginia
#10 – Ohio

2. Income taxes – the tax dollars here are larger, on a per-taxpayer basis, than property taxes. While the AMT planning takes a little more work than property taxes, the potential savings still are there. See the amtblog.com article posted on November 2nd, “State Income Taxes.”

3. Sales tax on new cars – this is easy money for those who bought a new car this year, or still are contemplating buying one. See the amtblog.com article posted on November 11th, “Sales Tax on New Cars.”

Stock options, in particular Incentive Stock Options (ISOs)

A large number of corporate employees, generally ranging from the mid-management level up to the “C Suite” folks, have stock options granted to them by their employers. If these options are ISOs, AMT planning is critical because of the major impact the exercise of these options can have on an individual’s Alternative Minimum Tax. Our two-part series of articles appearing on amtblog.com on December 3rd and December 6th, “Incentive Stock Options – Parts 1 and 2,” go through the basic steps in determining whether a taxpayer does in fact have an ISO – often confused with the other types of stock options and equity grants an employer may offer – and then explains how these ISO exercises trigger the AMT. This is a very important read for all those who either have exercised stock options or are contemplating exercising stock options.

Capital gains

The impact of capital gains on a taxpayer’s Alternative Minimum Tax can be a real surprise – and, unfortunately, not a pleasant surprise At first blush capital gains appear to be AMT-neutral, but this is far from the case. The December 13th article on amtblog.com, “Investments – Capital Gains,” explains this issue. To the extent a taxpayer has recognized capital gains in 2009, and/or “harvested” capital losses to offset capital gains, there can be a direct AMT impact. Any capital gain or loss activity between now and December 31 also will have this impact.

Summary

It is not too late to take action on any of the above items for 2009, but time is short. Once the ball drops in Times Square, you’ll be planning for 2010!

An individual holding an Incentive Stock Option to acquire his employer’s stock, and considering taking advantage of this fall’s run-up in the price of that stock, needs to be planning for the potential Alternative Minimum Tax impact. Time is important – Dec. 31 is fast approaching, and after that it is too late to do any AMT planning for a 2009 ISO exercise.

Why does an ISO exercise trigger the Alternative Minimum Tax? Let’s first summarize and compare the Regular Tax and the Alternative Minimum Tax impact:

- Regular Tax – When an ISO is exercised, the taxpayer does not have any taxable income at that point. Later, when the stock is sold, there will be capital gain income, taxed at the favorable capital gain rates. Note that this is the big tax advantage to ISOs over nonqualified options, which are taxed at ordinary tax rates on the date of exercise.

- AMT – When an ISO is exercised, an AMT item is generated and must be reported on the Form 6251. The amount of this item is the income the taxpayer otherwise would have paid Regular Tax on if the stock option were not an ISO. Depending on the size of the exercise in relation to the taxpayer’s other income, this ISO exercise AMT item can be the single thing that pushes the taxpayer into having to pay the AMT.

Here is how an individual planning to exercise an ISO computes the amount of the AMT item:

The “spread,” or difference, between what the taxpayer pays for the stock (the “exercise price”) and the value of the stock on the date of exercise (the “fair market value” or “FMV”) is the dollar amount of the AMT item. As an example, assume the following:

$20 – the exercise price, or the amount the employee must pay his employer to acquire each share of stock.

$50 – the FMV of each share on the date of exercise. For a publicly-traded company, this is the average of the high and the low trading prices on that day.

5,000 – the number of shares the employee can acquire through the exercise of the option.

The “spread” per share is $30 and the number of shares is 5,000, so the total dollar amount of the spread is $150,000. This is the amount of the AMT item to report on the Form 6251. As mentioned above, if this were not an ISO, but a regular “nonqualified” option, this amount would be income, taxed immediately at up to 35% plus any related payroll taxes, and reported in the employee’s W-2. But because in our example we are assuming that we do have an ISO, the $150,000 is not subject to tax at this point. Caution, however: as an AMT item, without advance tax planning this amount easily could be enough to trigger the AMT for any particular taxpayer.

Assuming the taxpayer does his tax planning and avoids triggering the AMT, the tax savings in this example is as much as $30,000 or even more – not an insignificant sum for a taxpayer to keep in his pocket rather than turn it over to Uncle Sam. The $30,000 is the difference between the top Regular Tax bracket of 35% and the current capital gains rate of 15%, multiplied by the amount of income.

There are a number of technical rules that must be met for a stock option to qualify as an ISO. The employee must consult with his company’s HR and/or Law Departments to confirm that these rules have been met.

Remember – December 31 is only 3-1/2 weeks away!

There are many different ways an employer can award an employee with equity, or stock ownership, in the company. Briefly explained below are the ones commonly used for this purpose. Critical to planning for the Alternative Minimum Tax, the employee must first know exactly what form of equity he holds, because only one has direct AMT implications.

Incentive Stock Option – also known by its acronym, “ISO,” or as a “Qualified Stock Option,” this one is an AMT preference item. If the employee holds an ISO, tax planning is critical – significant Alternative Minimum Tax dollars can be involved.

None of the other forms of employer equity ownership listed below has direct AMT implications. General tax planning always is advisable, of course, but these are not AMT concerns.

Non-Qualified Stock Option – the majority of stock options that employees are given are this type. Acronyms used are “N-Q,” “NQ,” or “NSO.” Caution here is appropriate – these commonly are mistaken for the ISO form of stock option.

Restricted Stock or Restricted Stock Unit – this is not a stock option; it is direct ownership, or a direct ownership derivative, of the employer’s stock. Also referred to as “RS” or “RSU.” Restricted Stock itself is sometimes distinguished from an RSU by calling it a Restricted Stock Award, or “RSA.”

Stock Appreciation Right, or “SAR” – this is a bonus agreement between the employer and the employee whereby the employee will be paid an amount equal to any appreciation in the employer’s stock over a set period of time. Also known as “Phantom Stock,” this simply is a cash bonus plan that is based on an increase in the stock’s value.

Employee Stock Purchase Plan, or “ESSP” – these plans allow employees to purchase actual shares of stock from the employer, usually at a discount.

Employee Stock Ownership Plan, or “ESOP” – this is a qualified retirement plan that invests in the employer’s stock. It is similar to a 401(k) plan, but without the investment diversification typically found in a 401(k).

An individual with an equity award received from his employer simply needs to review the above list and make sure he knows exactly what he has. If, and only if, he has an Incentive Stock Option – an ISO – does he need to worry about the AMT impact. But the time to worry is now – Dec. 31 is fast approaching. Come Jan. 1 it is too late to do anything about 2009′s taxes.

Next – understanding why an ISO triggers the Alternative Minimum Tax.