Capital gains & Dividends

Employee Stock Options: New Government Report Highlights Alternative Minimum Tax Issues

Saturday, July 7th, 2012 | Print This Post | Email This Post

The Congressional Research Service recently released its report on the tax issues surrounding employee stock options, including the impact of the Alternative Minimum Tax. As noted in the report, over 10 million employees currently receive stock options as a form of compensation from their employers. With this significant a portion of the U.S. population being faced with the complexities of the taxation of stock options, a review of the Regular Tax and Alternative Minimum Tax treatment is essential to basic tax planning for those affected.

Congressional Research Service (CRS)

The CRS is an agency of the U.S. Government, located within the Library of Congress. Its purpose is to provide politically neutral legal and policy analysis to Members of both the House and the Senate. Its reports provide straightforward and objective analyses of important legal issues.

What is a stock option?

A stock option simply is a right, granted by an employer to an employee, to buy a certain number of shares of the employer’s stock at a set price. If the stock goes up in value the employee receives additional compensation in the form of the appreciation in the stock’s price. For example, if Employer A grants Employee X the right to buy 1,000 shares of stock at $10 per share, and the stock price goes to $15 when the employee exercises the option, the individual will have received additional compensation, over and above his or her base salary, in the amount of $5,000.

Two types of employee stock options

There are only two basic types of employee stock options – “qualified” and “nonqualified.” Because qualified options must meet certain requirements in order to be labeled as such, and they have less favorable tax results for the issuing employers, these are less frequently encountered. Nonqualified options, on the other hand, are easier to issue because of the lack of these requirements, and along with the more favorable tax treatment to the employer, are more commonly found. The Alternative Minimum Tax treatment is significantly different between these two types of options, so it is very important as a first step that the employee know which type of option he or she has received.

Qualified stock options

Qualified stock options are also known by their Internal Revenue Code label “Incentive Stock Options,” or “ISOs.” Employees prefer receiving these because there is no tax due on the date of exercise for Regular Tax purposes. So long as certain holding period requirements are met, the employee will have long-term capital gain treatment on subsequent sale of these shares, resulting in a significant tax savings because the capital gains tax rate is much lower than the tax rate on ordinary income.

Nonqualified stock options

The Regular Tax treatment of nonqualified stock options is much different than it is for ISOs. For this type of option, on the date of exercise the employee will have compensation income, reported on his or her W-2, for the increase in the value of the stock. In addition to the Regular Tax rates applying (currently as high as 35%), FICA taxes also will be due.

Example – comparison of Regular Tax treatment

Using the above example of $5 of appreciation on 1,000 options, the tax savings alone from exercising an ISO as compared to a nonqualifed option could be nearly $1,400, a very significant part of the total $5,000 gain. This represents the difference between a capital gains rate of 15% applying and an ordinary income rate of as high as 42.65% (35% income tax and 7.65% FICA tax).

Alternative Minimum Tax

Because the AMT was designed to put a damper on some of the favorable Regular Tax treatments found in the tax law, there is a price to be paid by those exercising ISOs. While there is no Regular Tax to be paid on exercise of an ISO, the “spread” (the $5 in our example) per share is a tax preference item, and must be included in the employee’s AMT income (“AMTI”). By including this amount, the employee’s AMTI will be higher than his or her Regular Tax, thus potentially triggering the AMT in the year of exercise.

AMT planning for ISOs

The planning to minimize – and in many cases to completely eliminate – the AMT impact from exercise of ISOs is fairly easy. All one has to do is a little planning before the exercise, testing for the AMT using alternative amounts of ISO shares. For example, it could be that the $5,000 in our example is not enough of a tax preference item to trigger the AMT, while exercising several years’ worth of options at once would trigger the AMT. In this case, the employee is better off spreading the exercise over several years instead of doing them all in one year.

Conclusion

There are 10 million people out there who can do just two simple things to avoid unnecessarily paying the Alternative Minimum Tax. The first is to understand what kind of option – ISO or nonqualified – he or she has. The second, assuming it is an ISO, is to calculate the AMT impact from the exercise of different amounts of options, and then to select the amount that avoids the AMT. It’s simple and easy to do, and the result could be saving thousands of dollars of taxes.

Posted in AMT Items, AMT Planning in General, Capital gains & Dividends, Incentive Stock Options Exercised | No Comments »

Alternative Minimum Tax Fails to Hit the Wealthy With any Real Impact

Sunday, February 12th, 2012 | Print This Post | Email This Post

Everyone knows the history of the Alternative Minimum Tax – its intended purpose was to ensure that the wealthy were paying at least something like what today is called their “fair share” of taxes. But as everyone also knows, its real impact has landed on the masses who are far from finding themselves in this wealthy category. How the AMT has failed in its purpose is easily seen by looking at the income tax return of someone who really can be considered “rich.”

Presidential campaign season

Once again (how does it come around so often?) we find ourselves in the throes of a Presidential campaign. Along with the many unpleasantries being exchanged by candidates is the challenge to release personal income tax returns. After much prodding, one candidate recently, but reluctantly, released his Form 1040, and this tax return shows that he in fact definitely is in the wealthy, even “super wealthy,” category.

Do the wealthy pay the AMT?

The positive news is that the answer to this question is “yes.” However, the not-so-good news is seeing the actual amount of Alternative Minimum Tax that this individual in fact is paying. In the two tax years that this presidential candidate has paid the AMT, the additional tax burden that resulted was barely over one percent of his income. Specifically, without the AMT his total Federal tax rate was 13.3% in 2010, and 14.3% in 2011. The AMT added 1.1% each year, for a whopping tax rate of 14.4% and 15.4%, respectively. And this is on over $20 million of income in each of the two years!

What are the Alternative Minimum Tax triggers at this level of income?

The items that are high on the list of every single AMT payer are the same ones that also hit the wealthy. These are both on the income side as well as on the deduction side, and they principally revolve around capital gains and itemized deductions, and for the itemized deductions in particular the deductions for state income taxes as well as for property taxes.

Capital gains

Without even looking at this individual’s tax return, as one quickly can conclude from the tax rates shown above, most of this individual’s income comes from long-term capital gains which are eligible to be taxed at the low 15% rate instead of ordinary income rates of 35%. These large capital gains cause two Alternative Minimum Tax problems – the obvious one is the loss of the AMT exemption because of the high level of taxable income. But the other is the effect of having to pay state income taxes on these capital gains as well as high property tax payments.

State income taxes

Most, if not all, states tax capital gains at the same rate as ordinary income. Thus, a large capital gain will carry with it the same state income tax burden as would the same amount of ordinary income. The larger an individual’s state income tax of course the greater his chances of being caught in the Alternative Minimum Tax. This same basic problem exists for the wealthy as it does for every other AMT payer.

Property taxes

Along with wealth comes the need to own homes – usually large ones and usually more than one. Accompanying this ownership privilege is the requirement to pay significant amounts of property taxes – surprisingly the wealthy get no break on their property taxes. Just like state income taxes, property taxes are one of the most common items for individuals who are stuck in the Alternative Minimum Tax.

What could this individual do to reduce his Alternative Minimum Tax?

There are no secrets here – the same actions that every AMT payer can take would help a wealthy individual reduce his Alternative Minimum Tax. For example, one is watching the timing of payment of state income taxes and property taxes at year-end. If a taxpayer is in the AMT one year but not the next, whether the individual is wealthy or not wealthy, trying to get the state tax deductions paid in the year he is not in the Alternative Minimum Tax will make a big difference. Also, if an individual has multiple homes, the opportunity to change his domicile to a state that doesn’t have income taxes – like Florida, for example – would save significant state income taxes and correspondingly reduce the individual’s AMT burden. The same Alternative Minimum Tax planning concepts apply to everybody!

Posted in AMT Items, AMT Planning in General, Capital gains & Dividends, State Income & Other Taxes | 2 Comments »

IRS Statistics Show the Alternative Minimum Tax Decreasing – What Gives?

Saturday, January 14th, 2012 | Print This Post | Email This Post

Periodically the IRS publishes what it calls its Statistics of Income Bulletin. This document reports data that has been compiled from all of the tax returns filed for the previous year, including data on the Alternative Minimum Tax. This year’s report shows that, for the first time after six straight years of the AMT increasing, the amount of AMT paid and the number of taxpayers paying it decreased from the previous year. Are we finally seeing some needed relief from this burden? Hardly; rather it is just another result of the terrible economy we find ourselves in.

Fall 2011 SOI Bulletin

The Fall 2011 Bulletin includes statistics for tax returns filed in 2010 for the tax year 2009. For this period a total of 142.5 million individual income tax returns were filed, 3.8 million of which were Alternative Minimum Tax payers paying a total of $22.6 billion of AMT. These figures represent a decline from the previous year, during which 3.9 million individuals paid the AMT in the total amount of $25.7 billion. For tax year 2009 the average AMT paid was $5,900, compared to $6,500 for the previous year.

Who are the AMT payers?

The Bulletin breaks down the makeup of AMT payers by level of adjusted gross income (AGI). Even with the decline, this data shows that the distribution stayed essentially the same as the prior year, with 24% of AMT payers being those in the $100-200,000 AGI range and the majority – 63% – being in the $200-500,000 range. So many of those well below what President Obama considers “the rich” are stuck paying this tax that originally was designed to hit only the true wealthy.

Why did the AMT burden drop?

The explanation for the decrease in number of AMT payers and total dollars of Alternative Minimum Tax paid is not the result of any change in our government’s tax policy, unfortunately, but rather is explained simply by the current economic downturn. Specifically, as incomes decrease individuals are having less of those items that trigger the AMT. This applies both on the deduction side of the Alternative Minimum Tax as well as on the income side.

- Itemized deductions, in particular the deduction for state and local taxes

The amount of itemized deductions taken by individuals decreased from 2008 to 2009. The one most important to Alternative Minimum Tax payers, the deduction for state and local income taxes and property taxes, itself decreased 7.5 percent. As all AMT payers know, the more state and local taxes paid, the greater the Alternative Minimum Tax burden. It follows logically, therefore, that lower taxes paid potentially means a lower AMT burden. This won’t necessarily apply to all taxpayers, particularly those whose state legislators saw fit to increase taxes such as Illinois, but in general this result follows.

- Capital gains and dividend income

Capital gains and dividends are taxed at the same low rate both for the Regular Tax as well as the Alternative Minimum Tax. However, the more of these items a taxpayer has the more the taxpayer’s AMT exemption will be phased out and the correspondingly higher his Alternative Minimum Tax burden will be. It follows, therefore, that the worse the stock market does, and the more that companies cut back on their dividends, the less that individuals will see this impact on their AMT exemptions. Again, this won’t necessarily apply across the board, but it generally explains the result.

What should AMT payers do?

Planning to minimize the Alternative Minimum Tax is the same regardless of any changes in a taxpayer’s individual position. If an individual was on the cusp and the current state of the economy dropped him out of the AMT, there are opportunities to time some of his income and deductions to take advantage of this. For example, folks not in the AMT may want to accelerate the deduction of property taxes to take advantage of the opportunity to get a Regular Tax benefit that is not available once back in the AMT. But caution needs to be exercised as a slight change in facts can throw the individual right back into the AMT again. So planning still is, and always will be, the key.

As taxpayers get ready to undertake preparation of their 2011 taxes, this information will be very useful in thinking about 2012 planning. Certainly the 3.8 million still stuck in the AMT need to do this, as well as the 100,000 that dropped out of the AMT last year.

Posted in AMT Exemption, AMT Items, AMT Planning in General, Capital gains & Dividends, State Income & Other Taxes | No Comments »

Year-End Tax Planning – Should You Accelerate or Defer Income to Minimize Your Alternative Minimum Tax?

Saturday, November 19th, 2011 | Print This Post | Email This Post

In connection with year-end tax planning, much has been written about accelerating or deferring deductions. The sometimes-overlooked question of accelerating or deferring income deserves just as much attention, especially for those in the Alternative Minimum Tax. This article will look at what needs to be considered in planning around income recognition, including a summary of the different types of income to which this planning can apply.

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!

Posted in AMT Exemption, AMT Items, AMT Planning in General, Calculation of the AMT, Capital gains & Dividends, Incentive Stock Options Exercised, Investor, Self Employed, Type of Taxpayer | No Comments »

IRS Releases 2011 Version of Form 6251 – Alternative Minimum Tax-Individuals, a Reminder That It’s Time to Start Thinking about Year-End Tax Planning

Saturday, September 24th, 2011 | Print This Post | Email This Post

The IRS recently released its 2011 version of the Form 6251 – Alternative Minimum Tax – Individuals. With year-end only a few months away, this serves as a timely reminder that anyone stuck in the AMT needs to start thinking about the ways they can reduce this burden. The most effective AMT planning strategies must be implemented by December 31 in order to have any impact on the current year’s taxes. This article provides a general overview of some of the more important of these planning strategies.

AMT exemption amount

Late last year Congress once again adjusted the AMT exemption amount for inflation - for 2011 it is $74,450 for married couples filing a joint income tax return and $48,450 for singles. While Congress hasn’t even started thinking about the “patch” that will be needed again on January 1, 2012, we can guess that at some point that will be taken care of.

Phaseout of the exemption

For taxpayers whose incomes reach a certain level, the exemption is gradually phased out. This phaseout is at the rate of $1 of exemption lost for every $4 of income above the threshold. For 2011 the threshold for marrieds filing jointly is $150,000, and for singles it is $112,500. If a couple’s income is $160,000, for example, the exemption is reduced by $2,500. If the couple’s taxable income reaches $447,800, the exemption is zero.

Capital gains and dividends

While capital losses may be more typical these days due to the stock market’s wild gyrations, it’s important to note the AMT impact that results from capital gains as well as dividend income. These sources of income are taxed at the same 15% rate for both the AMT as well as the Regular Tax, but there is a direct impact on an individual’s AMT burden because of the exemption phaseout discussed above. For example, a $10,000 capital gain by itself can result in $700 of AMT being paid (loss of $2,500 of exemption times the marginal AMT rate of 28%).

Itemized deductions – state and local income taxes

The one item that affects the greatest majority of folks stuck in the Alternative Minimum Tax is the itemized deduction for state and local income taxes. While allowable for the Regular Tax, this deduction is disallowed in its entirely for the AMT. For taxpayers who expect to be in the AMT for 2011, serious consideration should be given to postponing payment of some portion of these taxes into 2012. If the taxpayer is not in the AMT in 2012, real tax dollars can be saved that otherwise would have been “wasted” by not ding this basic planning.

Itemized deductions – property taxes

The next biggest item in terms of AMT exposure is property taxes which, similar to state and local income taxes, are not deductible in computing the Alternative Minimum Tax. Many taxpayers receive their property tax bills in the fall, with a period of months before the taxes are actually due. Just as with the state income tax planning mentioned above, taxpayers currently in the AMT might be better off pushing the payment of these property taxes into 2012.

Other AMT items

There are quite a few other AMT items in addition to those mentioned above. Some of these items are deductions from income that are allowed for Regular Tax purposes but not allowed for the AMT, while others are certain types of income that are treated differently for the Alternative Minimum Tax. The Form 6251, available on the IRS’ web site, serves as a list of all of these items. Taking a look at last year’s tax return serves as a great starting point to see which items are likely to affect the taxpayer again this year.

The value of planning

The average amount of AMT paid by each taxpayer caught in its tentacles is over $5,000. Just a little bit of time spent on basic tax planning can result in some significant amounts being saved!

Posted in AMT Exemption, AMT Items, AMT Planning in General, Capital gains & Dividends, State Income & Other Taxes, Uncategorized | No Comments »

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

Sunday, May 15th, 2011 | Print 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 | 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 »

I Am an Investor – Does the AMT Apply to Me?

Friday, March 4th, 2011 | Print This Post | Email This Post

Every taxpayer with an investment portfolio of any size definitely needs to be concerned about the Alternative Minimum Tax. Certain types of investments, and the income earned on those investments, are likely to trigger the AMT. Most investors also have expenses associated with managing these portfolios, and certain of these expenses also can have an AMT impact.

It should be noted that only investments outside of qualified retirement plans – e.g., those investments not in a 401(k), an IRA or an employer’s retirement plan – are affected by the AMT, so it is these investments that are the focus of this article.

Investment income

Municipal bonds, in particular Private Activity Bonds

Interest earned on municipal bonds is exempt from the Regular Tax. For the Alternative Minimum Tax, however, certain municipal bonds – those labeled “private activity bonds”- are subject to tax. These types of bonds are used to support “private activities,” an example of which would be a local government’s development of an industrial park as an inducement for companies to locate in the area.

The concern to the investor is the negative impact that being subject to the AMT has on the bond’s effective yield. For example, a municipal bond fund in today’s market may be yielding in excess of 4 percent, but if private activity bonds are a part of that fund’s portfolio, more than a quarter of the yield on this part can be lost due to the AMT. That 4 percent quickly drops to a net-after-tax 3 percent yield!

Partnership investments

For an individual investing in a partnership, after the close of the year a tax form known as a “K-1” will be received. Because the partnership is a pass-through entity for tax purposes, this form tells each partner what income or losses to report on his or her individual tax return.

On the Form K-1 there also is a box labeled “Alternative Minimum Tax (AMT) Items.” If the partnership itself has any AMT items, they pass through and are reported by the individual partners just as the income or losses are. It is fairly common for investment partnerships to have activities that generate AMT items, so investors should consider inquiring about this when initially evaluating the investment. Here again, the anticipated yield can be reduced significantly if the AMT has to be paid.

Capital gains

Long-term capital gains are a bit of a sleeper issue with regard to the Alternative Minimum Tax. Although officially they are taxed at the same tax rate for purposes of the AMT as they are for the Regular Tax (currently 15 percent), and they are not a specifically-identified AMT item, nonetheless they can have a significant impact on an individual’s Alternative Minimum Tax. The reason for this is the fact that, as taxable income increases, the AMT exemption amount is gradually phased out. Since capital gains are included in taxable income, that 15 percent Regular Tax rate easily creeps closer to a 20 percent rate when figuring the AMT. This is especially important for those folks already in the phaseout income range ($150,000 to $440,000 for marrieds filing jointly; varies by filing status).

Investment expenses

Investment interest expense

If money is borrowed for the purpose of making investments, in general the interest paid on the debt is computed the same for the Alternative Minimum Tax as it is for the Regular Tax. There are two exceptions, however. One is if home equity indebtedness is used to acquire investment property. This type of interest is first disallowed for the AMT because it is not considered “qualified residence interest,” but when used for investing it generally is considered an allowable deduction for the AMT. The other exception is for interest on debt the proceeds of which were used to acquire private activity bonds. Because this interest is disallowed for purposes of the Regular Tax under the rules that disallow interest if loan proceeds are used to acquire municipal bonds, the interest expense related to the private activity bonds is an allowable deductible for the AMT.

Investment interest income

Investment interest expense is an allowable deduction, but only to the extent the taxpayer has investment interest income. For purposes of the AMT, investment income is computed somewhat differently than it is for the Regular Tax. For example, if an individual has private activity bond interest, this is included in AMT investment income because it is taxable for the AMT. Another example applies to taxpayers who have rental properties, where the Regular Tax-AMT differences in computing depreciation will result in a difference in investment income, thus affecting the amount of investment interest expense that may be deducted.

Other investment expenses

Investment-related expenses such as fees paid to an investment advisor, trust fees, safe-deposit box fees, etc. and any other expenses incurred in deriving income may be deducted for the Regular Tax, subject to certain limitations that apply. The AMT allows no deduction for these expenses, however, so this item may factor into an individual’s Alternative Minimum Tax computation.

Summary

Taxpayers with an investment portfolio easily can find themselves caught in a number of traps set by the Alternative Minimum Tax. But as the individual has total control over the investments made, these traps generally can be avoided with a little advance planning. For investors currently stuck in the AMT, a review of the items triggering this tax will allow the individual to consider rearranging the portfolio to lessen this AMT impact. The thing always to keep in mind is the simple fact that it is only the after tax yield that ends up in the individual investor’s bank account!

Posted in AMT Planning in General, Capital gains & Dividends, Investment Interest Expense, Investor, K-1 / All other AMT Items, Misc Deductions 2-percent Floor, Private Activity Bonds, Type of Taxpayer | No Comments »

Real Estate and the AMT: Property Used in the Taxpayer’s Trade or Business

Sunday, October 10th, 2010 | Print This Post | Email This Post

The Alternative Minimum Tax is a very important consideration when real estate is involved because just about every tax rule applying to real estate is different for the AMT than it is for the Regular Tax. This last part of our four-part series will talk about real estate used in a taxpayer’s trade or business. This is a big investment for most small businesses, and the differences in tax treatment between the Regular Tax and the AMT can be significant.

For this article we are talking about businesses held in the form of a sole proprietorship, an S corporation, an LLC or a partnership. All of the Regular Tax and AMT issues discussed here show up on the individual owner(s) Form 1040 because every one of these types of businesses is treated as a “pass-through” entity for tax purposes.

Following the order of the issues described in the earlier parts of this series, here is a look at them as they apply to trade or business property.

Interest expense

Interest paid on a mortgage taken out to acquire business property is fully deductible, both for the Regular Tax and the Alternative Minimum Tax. Similar to the last article on rental/investment property, the limitations discussed in the first article on home mortgage interest simply not apply.

If the equity in the business property is used as security for an additional loan – a second mortgage, for example – then the taxpayer must look to the use of the proceeds of that loan. If the proceeds are used for a car loan or to finance a child’s education or for any other purpose, then the interest is nondeductible personal interest. So long as the proceeds are used in the business, the interest is fully deductible.

Property taxes

Property taxes paid on trade or business property are allowed in full both for Regular Tax purposes as well as for the Alternative Minimum Tax.

Depreciation

Depreciation is allowed for property used in a trade or business. The portion of the cost allocable to land is not depreciable, but for the building itself and the furniture & equipment a depreciation deduction may be taken.

Real property (the legal definition of the building) used in a trade or business may only be depreciated for Regular Tax purposes under the “straight line” method over a useful life of 39 years. Thus, a property with $390,000 allocated to the building would be depreciated at the rate of $10,000 per year.

Personal property (this is the legal definition of things such as machinery and equipment, furniture and fixtures, and computer equipment) may be depreciated for Regular Tax purposes under an “accelerated” method over a useful life of five or seven years. An accelerated method allows a larger depreciation deduction in the early years, in recognition of the obsolescence factor in new property (computers are a good example).

For purposes of the AMT, however, personal property may only be depreciated by using a straight-line method. Thus, an AMT item will be generated in the early years if the accelerated method is used.

Planning idea – consider electing to use the straight-line method of depreciation for Regular Tax purposes. While giving up a little tax benefit from the greater depreciation in the early years, it could mean avoiding paying the AMT.

Active/passive investment rules and the “at-risk” rules

The active/passive investment rules generally do not apply to a small business, because the business owner almost always is heavily involved in the day-to-day operations of the enterprise, and, thus, by definition is active. These rules would apply, however, to a financing partner or a silent partner who is not so involved. As a reminder, these rules as well as the at-risk rules would apply only in the years the business had losses.

Sale of the property

Several different AMT issues can arise on the sale of business property. These are essentially the same issues as those discussed in the last article, on Rental/Investment Property, with perhaps a few minor differences.

One AMT issue is that the taxpayer’s gain or loss will be different for the AMT than it is for Regular Tax purposes if the business personal property was depreciated using an accelerated method for Regular Tax purposes. Because the straight-line method had to be used for Alternative Minimum Tax purposes, the gain or loss will be different and the taxpayer will have an AMT item to report on the Form 6251.

Gains on the sale of business property generally are capital gains, although a portion will be treated as ordinary income if the accelerated depreciation method was used. Capital gains in and of themselves are not an AMT item, but they definitely can result in AMT being paid. This is because the AMT exemption – that keeps many taxpayers out of the Alternative Minimum Tax – is phased out for taxpayers above certain income levels. Additional income, even capital gains, can have the result of reducing the exemption which in turn increases taxable income for AMT purposes.

This issue is discussed in an article posted on amtblog.com on December 13, 2009. This article also can be found by searching for “alternative minimum tax planning – investments – capital gains.”

This is the final of four articles on Real Estate and the AMT. A new series of articles will begin soon, focusing on different types of taxpayers and the things to watch out for, along with associated planning opportunities, for each of these types. Stay tuned!

Posted in AMT Planning in General, Capital gains & Dividends, Depreciation & Disposition of Property, Investment Interest Expense, State Income & Other Taxes | No Comments »

Real Estate and the AMT: Rental or Investment Property

Wednesday, October 6th, 2010 | Print This Post | Email This Post

The Alternative Minimum Tax is a very important consideration for taxpayers who own real estate because just about every tax rule applying to real estate is different for the AMT than it is for the Regular Tax. This third part of our four-part series on Real Estate and the AMT will address those situations where the individual holds the real estate as an investment, typically as rental property. The differences in tax treatment between the Regular Tax and the AMT can be significant.

Following the order of the issues described in the earlier articles in this series, here is a look at them as they apply to rental/investment property.

Interest expense

Interest paid on the mortgage taken out to acquire the property is fully deductible, both for the Regular Tax and the Alternative Minimum Tax. Unlike itemized deductions that allow a tax benefit for what amounts to personal expenses, the tax law generally allows all deductions a taxpayer has to make in the pursuit of business income. Thus, the limitations discussed in the previous article on home mortgage interest do not apply.

If, however, the equity in the rental property is used as security for an additional loan – a second mortgage, for example – then the taxpayer must look to how the proceeds of that loan are used to determine interest deductibility. If the proceeds are used for a car loan or to finance a child’s education, for example. then the interest is nondeductible personal interest. If the proceeds are used to improve the rental property, the interest is deductible.

Suggestion – it is best that taxpayers keep personal borrowings separate from business borrowings. Mixing the two creates recordkeeping challenges and can result in disputes with the IRS.

Property taxes

Property taxes paid on rental or investment property are allowed in full both for Regular Tax purposes as well as for the Alternative Minimum Tax.

Planning idea – if you have an opportunity to pay your property tax bill either this year or next, pay it in a year when you have enough income from the property so as not to generate a rental loss. This strategy can help avoid triggering the passive activity loss limitations described below.

Example – in Florida property tax bills are mailed in October, and are payable under the following discount schedule: November – 4%, December – 3%, January – 2%, February – 1%. If you have a loss from the property in 2010 but expect to generate income in 2011, do not pay your bill in November or December – forgoing that small discount could help you avoid the loss-limitation rules.

Depreciation

Depreciation is allowed for property held for investment. The portion of the cost allocable to land is not depreciable, but for the building itself and the furniture, appliances, carpeting, etc. a depreciation deduction may be taken.

Real property (this is the legal definition of the house or other building) held for rental/investment may only be depreciated for Regular Tax purposes under the “straight-line” method, over a useful life of 27.5 years. Thus, a property with $275,000 allocated to the building would be depreciated at the rate of $10,000 per year.

Personal property (this is the legal definition of things such as furniture, appliances, carpeting and the like) may be depreciated for Regular Tax purposes under an “accelerated” method over a useful life of five years. An accelerated method allows a larger depreciation deduction in the early years, in recognition of an obsolescence or decline-in-value factor that you see in new property (cars are a good example).

For purposes of the AMT, however, personal property may be depreciated only by using a straight-line method. Thus, an AMT item will be generated in the early years if the accelerated method is used.

Planning idea – for personal property consider electing the straight-line method for Regular Tax purposes. While giving up a little tax benefit from the greater depreciation in the early years, it could mean avoiding paying the AMT.

Active/passive investment rules and the “at-risk” rules

A taxpayer who is not “active” in managing investment property may not use losses from rental property to offset other income such as salaries and wages, dividends, interest, capital gains, etc. Instead, these losses are deferred until the taxpayer either sells the property or generates passive income from this or other passive investment sources.

The at-risk rules similarly deny using these types of losses to the extent the taxpayer has acquired the investment with borrowed money and does not have personal liability on the debt.

Planning idea

If these loss limitations apply, consider the planning ideas mentioned above to minimize the losses being generated each year. They are not doing you any good anyway.

Sale of the property

Several different AMT issues can arise on the sale of rental/investment property. One is that your gain or loss may be different for the AMT than it is for Regular Tax purposes. This would be caused if different depreciation methods were used. For example, if the personal property was depreciated using an accelerated method for Regular Tax purposes, then the basis in that property when calculating gain or loss on sale would be different because the straight-line method had to be used for Alternative Minimum Tax purposes.

Gain on the sale of investment property generally is capital gain, although a portion may be treated as ordinary income depending on the accelerated depreciation method was used. Capital gains in and of themselves are not an AMT item, but nonetheless they can result in AMT being paid. This is because the AMT exemption amount is phased out for taxpayers at certain income levels, so this additional income can have the result of reducing the exemption which in turn increases taxable income for purposes of the Alternative Minimum Tax.

This issue is discussed in some detail in an article posted on amtblog.com on December 13, 2009. This article also can be found by doing an internet search for “alternative minimum tax planning – investments – capital gains.”

Next in this series on Real Estate and the AMT – property used in a taxpayer’s trade or business.

Posted in AMT Planning in General, Capital gains & Dividends, Depreciation & Disposition of Property, Investment Interest Expense, State Income & Other Taxes | No Comments »