Standard Deduction

Tax Court Denies Challenge to the Alternative Minimum Tax, Revealing Costly AMT Taxpayer Errors

Sunday, May 15th, 2011 | Print This Post Print This Post | Email This Post Email This Post

On occasion a frustrated taxpayer will go to Tax Court in an attempt to convince a judge that the Alternative Minimum Tax was never intended to apply to them.  As in the case of Fritz v. Commissioner, however, no sympathy is ever found there – if the calculations are done correctly the Court simply confirms that the tax is owed.  The facts in these cases present interesting lessons, however, because they reveal both the terrible feeling of frustration when getting blindsided by the AMT as well as the simple, yet missed, planning opportunities that could have allowed many of these folks to avoid paying the AMT.

 

Facts of the case

 

Mr. and Mrs. Fritz filed their tax return without attaching Form 6251, “Alternative Minimum Tax – Individuals.”  They promptly received a notice from the IRS informing them that they owed exactly $7,007 more in AMT.  The Fritz’s tax return was relatively simple – $329,000 of total income, the majority of which – $283,000 – was long-term capital gain and qualifying dividends.  The Fritzes took the standard deduction, apparently because this was greater than their itemized deductions, as well as the deduction for their personal exemptions.

 

Alternative Minimum Tax problem

 

Two AMT issues caused the Fritz’s Alternative Minimum Tax problem.

 

Loss of the standard deduction and the deduction for personal exemptions

 

As has been discussed in many previous articles, under the AMT the standard deduction is disallowed in total, as are the deductions for personal exemptions.  Because of this, Alternative Minimum Taxable Income (AMTI) is always higher than Regular Tax taxable income by these amounts.  For 2011, the standard deduction for a married couple filing jointly is $11,600, and each personal exemption is $3,700.  In a case like the Fritzes, their AMTI for the current year would be $19,000 higher.

 

Loss of the AMT Exemption due to the large capital gain

 

When a married couple’s AMTI exceeds $150,000 the AMT exemption begins to be phased out.  The exemption amount for 2011 is $74,450, but this is phased out at the rate of $1 of exemption for every $4 of AMTI in excess of $150,000.  In the Fritz’ situation, they would lose $44,672 allowing them an AMT exemption amount of only $29,778.

 

The Fritz’ argument

 

The argument made to the Tax Court by the Fritzes was that capital gains and qualifying dividends should be taxed at the 15 percent tax rate, as specified in the tax law for both the AMT as well as for the Regular Tax.  By operation of the AMT calculations, they alleged, their effective tax rate on this income actually was higher than this.

 

The Tax Court’s answer

 

The Tax Court judge was direct in his response: “Petitioner’s position in this case misses the point.  In reality, the tax on the capital gains was limited to 15 percent and the ‘additional tax’ was attributable to the elimination of preferences.”  Judgment in favor of the IRS.

 

Planning opportunities the Fritzes missed

 

There are several things the Fritzes could have done to reduce, and likely eliminate, their Alternative Minimum Tax.

 

Itemizing deductions instead of taking the standard deduction – If the Fritzes had home mortgage interest, or if they had made any charitable contributions, they could have reduced their AMT by itemizing deductions instead of taking the standard deduction.  This, unfortunately, is a common error for AMT payers.  If they had had, for example, just $1,000 in interest or contributions, they would have directly reduced their Alternative Minimum Tax by $280.  They weren’t required to take the standard deduction; they did it because it was larger than their itemized deductions, and they just didn’t think about the AMT.

 

Spread the capital gain over two or more years – The timing of when to sell securities and realize capital gains is entirely within the control of a taxpayer.  Not spreading their very large gain of $246,000 over just two years was a costly mistake on the part of the Fritzes.  If they had instead recognized half of their capital gain in the current year and pushed the other half to the following year, they would have lost over $30,000 less of their AMT exemption, most likely removing them entirely from the AMT!

 

Conclusion

 

As the Fritzes learned the hard way, paying the Alternative Minimum Tax is a penalty that often can be avoided with just a little awareness of the AMT.  Had Mr. & Mrs. Fritz done this, they would have $7,000 more in their bank account today instead of having to put this amount in the mail to the US Treasury.  Lesson learned the hard way!

 

Posted in AMT Exemption, AMT Planning in General, Calculation of the AMT, Capital gains & Dividends, Personal Exemptions, Standard Deduction | No Comments »

I Am Retired – Does the AMT Apply to Me?

Thursday, March 17th, 2011 | Print This Post Print This Post | Email This Post Email This Post

Of all the different types of AMT taxpayers, retirees typically are the most surprised when they find themselves stuck in the Alternative Minimum Tax.  Unfortunately, there is no “age exemption” for the AMT – an individual could reach 100 and still be paying it, depending on that person’s level and types of income and tax deductions.  In certain cases, the AMT may even hit a retiree harder than a person still working.  With a little understanding of the issues and some advance planning, retirees may actually be in a better position than others to do something about the AMT.

 

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.

 

Posted in AMT Exemption, AMT Planning in General, Calculation of the AMT, Capital gains & Dividends, Incentive Stock Options Exercised, Retiree, Standard Deduction, State Income & Other Taxes, Type of Taxpayer | 1 Comment »

Joint Committee on Taxation – Tax Expenditures and the Alternative Minimum Tax

Saturday, March 12th, 2011 | Print This Post Print This Post | Email This Post Email This Post

The Joint Committee on Taxation recently issued a report on tax expenditures.  “Tax expenditures” are government spending that is accomplished through the Internal Revenue Code – in effect a negative tax.  The tax expenditure term was created over 40 years ago by Stanley Surrey, then Assistant Secretary of the Treasury, as a way to describe the political use of tax breaks for means that were more typically accomplished through direct government spending.

 

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.

 

Posted in Incentive Stock Options Exercised, Legislation/tax law changes, Personal Exemptions, Standard Deduction, State Income & Other Taxes | No Comments »

Top 10 Traps Set by the AMT

Saturday, April 10th, 2010 | Print This Post Print This Post | Email This Post Email This Post

Of the nearly 30 different items that can cause taxpayers to fall into the AMT, a few are much more common than others.  Here is a quick look at the “top ten” list of those that snare the most Alternative Minimum Taxpayers.

# 1 – Personal exemptions

For the Regular Tax, every taxpayer is entitled to a personal exemption deduction for himself, and his spouse and/or other dependents.  Since the AMT denies any deduction for personal exemptions, this is the single item affecting almost every individual paying the Alternative Minimum Tax.

# 2 – State and local tax deduction

This item, which consists of property taxes, state and local income taxes, and sales taxes, is only slightly behind personal exemptions in terms of the number of AMT payers affected.  The reasons for this are the relatively heavy burden of state and local taxes as well as the fact that the AMT disallows every dollar of this deduction.

# 3 -Capital gains

This is not specifically listed as an AMT item, but the impact of capital gains on an individual’s Alternative Minimum Tax can be significant.  At levels of taxable income where most AMT payers find themselves, an additional $100 of capital gains could add up to $7 of AMT being paid on top of the $15 imposed by the Regular Tax capital gains bracket.

# 4 – Miscellaneous Itemized Deductions

A taxpayer’s employee business or investment-related expenses may be deductible under the Regular Tax, but they are not for the AMT.  This affects nearly a third of all AMT payers.

# 5 – Depreciation

Business owners and investors with rental property are allowed depreciation deductions for the property used in these activities.  The AMT disallows a portion of the depreciation deduction that otherwise may be taken.

# 6 – Passive activity losses

Many investment activities are considered “passive” for tax purposes.  An example is a taxpayer who acquires an interest in an investment partnership.  As such, losses from these investments are limited in how they may be deducted for purposes of the Regular Tax.  The AMT imposes even further limitations on the use of these losses.

# 7 – Private activity bond interest

An individual investing in tax-exempt municipal bonds may receive an unpleasant surprise when he discovers that Alternative Minimum Tax has to be paid on the interest income from a certain type of municipal bond – the so-called private activity bond.  While there may be an increase in before-tax yield from this type of bond, the after-AMT results can be very disappointing.

# 8 – Standard deduction

A taxpayer is allowed no standard deduction in computing the AMT. A valuable planning idea here could mean that an AMT taxpayer might be better off not claiming the standard deduction at all.

# 9 – Medical and dental expenses

For purposes of the Regular Tax, individuals are allowed a deduction for medical and dental expenses, to the extent these expenses exceed 7.5% of Adjusted Gross Income.  The AMT limits this deduction even further by instead imposing an excess-of-10% requirement.

#10 – Limitations on investment losses

In addition to the limitation on the use of passive activity losses as discussed above, there are other investment activities, not falling under the passive rules, the losses from which still will be limited for purposes of the Regular Tax.  Again, the AMT places even further limitations on the use of these losses.

Conclusion

In addition to this top ten list, there are nearly 20 other individual items waiting to trip up the AMT payer.  The individual items that catch any particular taxpayer are shown on that individual’s Form 6251 that is attached to his tax return.  It is important to note, however, that planning opportunities exist that can lessen the impact of each and every one of these.  Check these out at AMTIndividual.com.

Posted in Capital gains & Dividends, Depreciation & Disposition of Property, K-1 / All other AMT Items, Medical And Dental, Misc Deductions 2-percent Floor, Personal Exemptions, Private Activity Bonds, Standard Deduction, State Income & Other Taxes | No Comments »

Standard Deduction or Itemized? The AMT Requires Additional Analysis

Tuesday, April 6th, 2010 | Print This Post Print This Post | Email This Post Email This Post

A common question that arises at tax time is whether to itemize or take the standard deduction.  For individuals paying the Regular Tax the decision is easy, but when the AMT is involved there is one extra step that needs to be taken.  As will be seen in the example below, this step can save the taxpayer thousands in AMT dollars.

Annual election

The basic choice – itemizing vs. taking the standard deduction – is an election a taxpayer makes each year when the tax return is filed.  The election is binding for both the Regular Tax and the AMT; a taxpayer cannot itemize for one and take the standard deduction for the other.

Itemized deductions

The major categories of itemized deductions are Medical and Dental, Taxes, Charitable Contributions, Home Mortgage Interest, Casualty Losses, and Miscellaneous.  All of these are deductible under the Regular Tax.  Under the Alternative Minimum Tax, however, the itemized deduction categories of Taxes and Miscellaneous Itemized Deductions are disallowed in their entirety, while Charitable Contributions are fully allowed.  The categories of Medical and Dental, Home Mortgage Interest, and Casualty Losses also are allowed, at least in part.

Standard deduction

The standard deduction is a fixed dollar amount, adjusted annually for inflation.  This may be taken in lieu of itemizing deductions.  Currently this dollar amount is $11,400 for a married couple filing jointly.

Step 1 – compute the lowest Regular Tax

The Regular Tax, of course, is the starting point, and the choice here seems simple: if the standard deduction is greater than the taxpayer’s itemized deductions, then the standard deduction will result in a lower tax liability.  If the taxpayer is paying the Regular Tax, nothing more needs to be done.  If, however, the taxpayer is in the AMT, it is critical then to go to step 2 to avoid overpaying taxes.

Step 2 – recalculate the tax liability using itemized deductions

Going back to our married couple, even though their itemized deductions were less than the $11,400 standard deduction, they need to recalculate their taxes taking itemized deductions instead of the standard deduction.  Although this seemingly would increase their taxes, it may actually reduce their AMT, or even possibly even eliminate it as in the example discussed below.

Example

To illustrate how this analysis would work, assume a couple lives in Florida, a state with no income tax, and is renting their home so they have no real estate taxes or mortgage interest.  All the couple has for itemized deductions is $10,000 of charitable contributions.  They have $250,000 combined salaries and wages, and $50,000 of dividends and capital gains.

When this couple starts out with step 1, they note that their $10,000 of itemized deductions is less than the $11,400 standard deduction, so they elect to take the standard deduction.  At first blush, this seems to be the correct thing to do because their taxable income is $1,400 less by doing this than if they had itemized, but in actuality this would be a very costly mistake for them to make.

Under these facts the couple would pay $64,634 in taxes – $61,610 of Regular Tax and $3,024 of Alternative Minimum Tax.  Under the AMT, they receive no benefit from the standard deduction, and they are wasting the Alternative Minimum Tax benefit they could get from the $10,000 charitable contribution deduction.  If, instead, in this example the couple elected to itemize, their tax liability would be $62,072 – all Regular Tax, with no AMT.  Even though they gave us $1,400 in Regular Tax deductions, they saved $2,562 and completely eliminated the AMT!

Conclusion

It is critical that Alternative Minimum Taxpayers take this extra step.  At first it may seem counterintuitive to be taking the smaller of itemized deductions or the standard deduction, but thinking differently can actually end up saving significant taxes.

Posted in AMT Planning in General, Calculation of the AMT, Standard Deduction | No Comments »

It’s Fall: 10 Weeks of Alternative Minimum Tax Planning Ideas…Week 10

Tuesday, December 29th, 2009 | Print This Post Print This Post | Email This Post Email This Post

Year-End AMT Planning Wrap-Up – Part 2

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!

Posted in AMT Exemption, AMT Planning in General, Misc Deductions 2-percent Floor, Personal Exemptions, Private Activity Bonds, Standard Deduction | No Comments »

It’s Fall: 10 Weeks of Alternative Minimum Tax Planning Ideas…Week 4

Wednesday, November 18th, 2009 | Print This Post Print This Post | Email This Post Email This Post

Standard Deduction

A taxpayer has a choice of itemizing deductions or taking the Standard Deduction in computing his Regular Tax liability. The Standard Deduction is a fixed dollar amount that varies depends on filing status. In tax year 2009 it is $5,700 for Single and $11,400 for Married Filing Jointly – what we’ll call the base Standard Deduction.

State sales taxes paid in 2009 on the purchase of a qualifying new automobile can be added to the base Standard Deduction. Similarly, a limited amount of real estate taxes, and certain casualty losses, also may be added.

For purposes of the Alternative Minimum Tax, however, the base Standard Deduction is not allowed. But if the taxpayer was eligible to take a Regular Tax deduction for a casualty loss or for the new car sales tax in addition to the Standard Deduction, these items also are allowed for the AMT. The Form 6251 shows the AMT payer how to do this. Note also that if the Standard Deduction is chosen for Regular Tax purposes, it must also be used when calculating the AMT – it is a binding tax election.

The choice between itemizing and taking the Standard Deduction seems simple: if the total of a taxpayer’s itemized deductions is less than the Standard Deduction, then the Standard Deduction will result in less being paid. But this is not always the case when the Alternative Minimum Tax is involved. For AMT payers, there are certain situations where itemizing for Regular Tax purposes actually could lower the amount of AMT paid.

To illustrate, assume a taxpayer lives in Florida (no state income tax), rents instead of owns a home (no real estate taxes or mortgage interest), and didn’t make any taxable purchases this year (no sales tax deduction). But suppose this taxpayer also gave $10,000 to charity. The Standard Deduction for 2009 for joint return filers is $11,400, so this would appear to be the better choice. However, if the taxpayer were in the Alternative Minimum Tax there would be no benefit at all from the Standard Deduction, but there would be a benefit of up to $2,800 (the 28% Alternative Minimum Tax bracket times the $10,000 charitable contribution deduction) if itemizing is elected instead. Even the lower 26% tax rate would result in nearly the same benefit. So, somewhat counterintuitively, in this example opting to pay more Regular Tax will result in a lower overall tax liability.

Posted in Standard Deduction | 2 Comments »