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 1st 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.
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!