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!

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!