The AMT issue

The AMT side of this issue stems from the impact that capital gains have on an individual taxpayer’s AMT. While long-term capital gains are taxed at the same tax rates for both the Regular Tax as well as the AMT, an increase in an individual’s taxable income, whether from ordinary income or from capital gains, in many cases means a decrease in the individual’s AMT exemption amount.

Here is how this works: once a certain level of Alternative Minimum Taxable Income (AMTI) is reached, every dollar of additional income will reduce the taxpayer’s exemption by 25 cents. The threshold level for a married couple filing jointly is $150,000; it is lower for singles and marrieds filing separately. These thresholds, as well as the mechanics of the AMT exemption phaseout, are explained in the lower part of the IRS Form 6251.

The estate tax issue

Here is the estate tax issue: capital gains are the excess of the selling price of a capital asset, such as a security, over the taxpayer’s basis in that security. The most common concept of basis is what the taxpayer paid for the security when he bought it. For example, a share of stock purchased for $100 will have a tax basis of $100; if it is later sold for $120, the taxpayer has a capital gain of $20 on which he will pay tax. But in the case of inherited securities the determination of basis is very different.

So long as the estate tax is in effect, a beneficiary receives a tax basis in any inherited property equal to its fair market value on the date of death. In the vast majority of cases, this is a “stepped-up” basis because, over time, stocks generally appreciate. This is especially the case for senior citizens because they generally have a long-term hold strategy. All of this means that a decedent’s tax basis typically is well below a stock’s current price. In the above example, that share of stock worth $120 may have been acquired by the decedent for $50, or even less.

The two rules together

With the estate tax in place, if the decedent passes away when that stock is worth $120, that amount is now the tax basis for the heir when the shares are distributed to him. Thus, if the heir sells it for $120, he has zero gain to pay tax on, and this has zero effect on his AMT exemption amount.

Suppose, however, the estate tax is not put back in place. In this case the heir’s tax basis in the above example is $50 because he receives a “carryover” basis instead of a stepped-up basis, and a sale at $120 would result in a $70 capital gain. If the individual has AMTI over the specified threshold, this $70 gain on each share of stock sold would decrease his AMT exemption by $17.50 (25% of the gain). If enough shares are sold, this could have a significant and direct impact on the individual’s Alternative Minimum Tax liability.

Summary

Warren Buffet and Bill Gates are long-standing advocates for the estate tax. While these two probably are not AMT payers, every one of the 4.3 million individuals currently subject to the Alternative Minimum Tax, as well as all other taxpayers who are at risk of being drawn into the AMT, should be right there joining these two in advocating reinstatement of the estate tax!

Our tax system is complicated, but the underlying concept is basic:

- we pay taxes on a calculated number that is known as “taxable income”
- we arrive at taxable income by adding different sources of income and then subtracting a certain number of deductions
- not all income is subject to tax
- little of what we spend each year may be taken as a tax deduction
- we apply the appropriate tax rate to our taxable income
- the result is our individual share of the national tax burden.

This same concept applies for the AMT as it does for the Regular Tax, but the individual components of the computation are different:

- more income is taxed under the AMT than it is under the Regular Tax
- fewer deductions are allowed under the AMT than under the Regular Tax.

The key to remember is that, under these alternative computations, the tax that will be due is the greater of the AMT or the Regular Tax. While this may not seem fair, and in many cases it isn’t, that’s just the way it is. One has no choice.

The bulk of the AMT “hit” comes from the deduction side – deductions that an individual is allowed to take for the Regular Tax but is not allowed to take for the AMT. Some deductions are not allowed at all for the AMT, while others are allowed, but to a lesser degree. The Regular Tax deductions that are not allowed at all for the AMT are:

- the standard deduction
- the deduction for personal exemptions
- the itemized deduction for state and local taxes
- interest on certain second mortgages or home equity lines of credit
- miscellaneous itemized deductions

The Regular Tax deductions that are allowed to a lesser extent for the AMT are:

- the itemized deduction for medical and dental expenses
- many business expenses such as depreciation, depletion, and research expenses, among others

On the income side, there are fewer differences. The key ones are:

- tax-exempt bond interest that is from a “private activity bond”
- income from the exercise of an “incentive stock option” (“ISO”)
- state income tax refunds

It is important to note that tax planning opportunities exist for all of these AMT items. Each one is different, of course, but the planning generally falls into the following groupings:

- paying certain expenses that are AMT items in one year versus another
- choosing a different accounting method
- altering an investment strategy
- altering a financing strategy

Certain AMT items cannot be avoided in their entirety (property taxes, for example, at least while one owns a home), but because income and deductions and tax rates do not remain static from year to year, the AMT almost always can be reduced in part by moving the AMT item into a different year. Other AMT items, however, may be eliminated in part or in full if they are covered by one of the other tax planning strategies listed above. Thus, the essence of AMT planning is 1) first determining which items are causing the taxpayer to fall into the AMT, and then 2) taking the appropriate action to lessen, if not eliminate, the effect of each item.

In general, a passive activity is either: 1) a trade or business in which the taxpayer did not materially participate; or 2) an investment involving rental real estate. “Material participation” means active involvement in the operations of the business on a regular, continuous and substantial basis. A typical passive activity is an investment partnership in which the taxpayer is a passive investor, not involved in the day-to-day management.

The passive activity rules were enacted as a way to curtail the use of tax shelters, where individual investors had ownership interests in partnerships that were generating tax losses that the individuals reported in their tax returns. Before the passive activity rules, these investors were allowed to offset other income, like dividends, interest, and salaries and wages, with these losses.

Passive activity losses are very limited in how that may be used against other income for purposes of the Regular Tax. If they cannot be used in the year they are first generated, the losses are carried forward to a future year when they can be used against income generated from the passive activities. In many cases this is the year the taxpayer exits the activity.

For purposes of the Alternative Minimum Tax, these same limitations apply, but the difference is that there also may be AMT items included within the computation of the passive activity loss itself. One common example is depreciation, whether the activity is rental property or a trade or business. For purposes of computing the amount of AMT loss that may be used against AMT passive income, whether in the current year or to be carried forward to be used in a future year, AMT adjustments like depreciation must be taken into account.

As an example of how this works, assume a taxpayer is a partner in a partnership and the Schedule K-1 the taxpayer receives shows the following:

- a Regular Tax passive activity loss of $2,500
- a depreciation adjustment of $500 (less depreciation allowed for the AMT)
- an adjustment of $250 to the gain from sale of property (less gain for the AMT)

In this case the taxpayer’s passive activity loss for Alternative Minimum Tax purposes is $2,250. It is important for the taxpayer to keep records of this difference in order to be able to properly compute his Regular Tax and his AMT in the years the loss is utilized, particularly in view of the impact it could have on his overall AMT planning.

Note – the taxpayer must be careful to have the AMT adjustments going in the right direction. In the example above, one adjustment decreased the loss while the other increased the loss. See the articles on amtblog.com on these two common passive activity AMT items, Depreciation, and Disposition of Business or Rental Property, that appeared on the blog on January 20th and January 24th, respectively.

For the Regular Tax, an itemized deduction is allowed for medical expenses paid during the year. A tax benefit is received, however, only to the extent the expenses exceed more than 7.5% of the taxpayer’s adjusted gross income (AGI). AGI is the number on the last line (Line 37 for 2009) of page one of the Form 1040.

For purposes of the AMT, however, there is a slight difference – the threshold a taxpayer must exceed is 10% of AGI, instead of 7.5%. This difference in the computation is the AMT item reported on the Form 6251.

The tax-saving strategy for medical expenses is essentially the same for the AMT as it is for the Regular Tax, but it also requires keeping an eye on that 2.5% difference. As mentioned above, the key is when the medical expenses are incurred and, most importantly, when those expenses actually are paid.

If an individual currently is in the AMT, to the extent any elective surgery, dental, vision work, etc. could be delayed until next year (so long as these expenses are not covered by medical insurance, and are not cosmetic improvements that would not be deductible medical expenses in the first place), consideration should be given to doing so. If the taxpayer is not in the AMT next year, a tax benefit might be achieved that would not be obtained this year. Also note that, even if the individual is in the AMT again next year, to the extent a grouping of medical expenses results in exceeding the10% threshold, the taxpayer will at least get a benefit for that amount.

For example, assume AGI is $100,000 and that it will be the same next year. The taxpayer decides to get “fixed-up” a bit, and the list includes a physical exam with diagnostic tests and x-rays, seeing the dentist for braces, and Lasik eye surgery – all together, $20,000 in medical expenses. For a taxpayer in the AMT, it would be a disaster to do half of this now and half next year – the total after-tax cost would be the full $20,000. If instead all the work is done in one year, the IRS offers a nice subsidy – as much as $2,800 for an AMT payer ($20,000 less $10,000 (10% of AGI), multiplied by the 28% AMT bracket).

Even better, if in this example the taxpayer is in the AMT this year but through tax planning will not be in it again next year, the IRS’ subsidy possibly could be $5,000 ($20,000 less the 7.5% of AGI, times the 39.6% bracket – the expected highest Regular Tax bracket in 2011).

Certainly something to think about!

When property is disposed of, a taxpayer calculates the gain or loss based on the difference between the selling price and his tax basis. For something like a stock or a bond, tax basis is the amount originally paid for the investment – that is all that is needed. This same concept also applies to the sale of business or rental property, but with one important difference – depreciation. In the case of depreciable property, tax basis is the amount originally paid, but then reduced for any depreciation taken.

The tax basis of depreciable property changes every year. In the example in the last article, a $10,000 machine was depreciated by taking a $4,000 deduction in the first year, and a $2,400 deduction in the second year. At the end of year 2, therefore, the tax basis of this machine was $3,600 ($10,000 less the $6,400 of total depreciation taken).

What would happen if the machine were sold at this point? The same basic principle of computing the difference between selling price and tax basis applies. Assume, for example, a sales price of $5,000. In this case the taxpayer’s gain would be $1,400, and this amount would be included in taxable income. This is the Regular Tax treatment.

The AMT item arises at the time of sale of property because, in general, a taxpayer uses a different method of depreciation for purposes of the Alternative Minimum Tax than is used for Regular Tax purposes. To the extent the taxpayer has these AMT items from differences in depreciation in prior years, the tax basis of that property similarly is different for the AMT than it is for the Regular Tax. Therefore, gain or loss on a sale of the property also is different. Essentially, the AMT difference in computing the gain or loss is a reversal of the Regular Tax-AMT depreciation differences in the past.

Continuing with the same example, if after two years a taxpayer has been allowed $5,100 in depreciation deductions for the AMT (see the prior article), the machine’s AMT tax basis is $4,900. Assuming a sale for $5,000, taxable gain for AMT purposes would be $100.

This $1,300 difference in taxable gain (the $100 of AMT gain compared to the $1,400 of Regular Tax gain) is an AMT item in the year of sale. This is a favorable adjustment in computing the taxpayer’s Alternative Minimum Tax. It would be entered as a negative number on the Form 6251, making Alternative Minimum Taxable Income $1,300 less than Regular Tax taxable income.

One out of every 14 AMT payers has this item, so it is important that both the Alternative Minimum Tax basis and the Regular Tax basis of depreciable property are properly calculated. Incorrect calculations can have the effect of negating other AMT planning that a taxpayer may have accomplished, costing real tax dollars.

There are numerous ways depreciation may show up in an individual taxpayer’s Form 1040. One is rental property the individual owns; another is business property if the business is being operated as a sole proprietorship. Other ways are if the business or rental property is in a “pass-through” entity. Examples of these include LLCs, partnerships, and S corporations, in which case the income and expenses, and any of the separate AMT items, are reported on the individual owners’ tax returns.

Here’s how depreciation works. Assume a business asset cost $10,000, and that the period over which it will be used (its “useful life”) is 5 years. Under the basic “straight-line” method of depreciation, the taxpayer would report an expense of $2,000 per year over this period.

But, in an effort to encourage investment, Congress allows a choice of other depreciation methods, all of which allow more of the expense to be deducted in the early years of the property’s life. For example, under something called the “double declining balance” method, here is how the cost would be recovered:

Year 1 – 40%, or $4,000
Year 2 – 24%, or $2,400
Year 3 – 14%, or $1,400
Year 4 – 11%, or $1,100
Year 5 – 11%, or $1,100

Total – $10,000

While the double declining balance method may be used for Regular Tax purposes, it is not allowed for purposes of the Alternative Minimum Tax. The most accelerated depreciation method that may be used for a taxpayer’s AMT calculation in this example, the so-called “150% declining balance” method, would result in depreciation deductions as follows:

Year 1 – 30%, or $3,000
Year 2 – 21%, or $2,100
Year 3 – 17%, or $1,700
Year 4 – 16%, or $1,600
Year 5 – 16%, or $1,600

Total – $10,000

Matching these two schedules, the AMT item in each of the 5 years is the difference between the two:

Year 1 – $1,000 AMT item (AMT income is higher than Regular Tax income)
Year 2 – $300 AMT item “
Year 3 – ($300) AMT item (AMT income is lower than Regular Tax income)
Year 4 – ($500) AMT item “
Year 5 – ($500) AMT item “

Total – $0

The planning opportunity here simply is to choose a depreciation method that does not result in an AMT item. For Regular Tax purposes, a taxpayer may choose to use the 150% declining balance method (the AMT method) or the straight-line method instead of the double declining balance method. By doing this, there will be no AMT item to report. Note that this election is available each year for property that is placed in service during that year. Note also, however, that the choice of method is made at the entity level, so if the property is in an LLC, partnership or S corporation, the election is made in the filing of that entity’s tax return.

Depreciation – Rental property and property used in a business may be depreciated. The law allows a taxpayer to choose among several depreciation methods, and this choice is not made until the tax return is filed. Some depreciation methods result in an AMT item while others do not.

Depletion – A taxpayer investing in oil & gas or other mineral properties may take a deduction for his investment in a manner similar to depreciation. Also similar to depreciation, some depletion deductions are AMT items while others are not. This choice is made when the tax return is filed.

Intangible drilling costs and mining costs – The same as depreciation and depletion above, certain cost-recovery methods for these types of investments, which are chosen at tax return time, can trigger the AMT.

R&D – Research and development costs incurred by a business may be deducted currently instead of being amortized over time, resulting an AMT item. If the business is an LLC, partnership or S corporation, this AMT item will be reflected on the taxpayer’s individual Form 1040. The choice of deduction is made at tax return time.

Circulation costs; long-term contracts – Certain types of businesses receive more beneficial treatment of deductions for the Regular Tax than for the AMT, resulting in AMT items. Similar to the R&D, the AMT effect depends on the type of business entity. The choice of deduction is made at tax return time.

Incentive Stock Options (ISOs) – ISOs receive very favorable Regular Tax treatment at the time of their exercise – they simply are not taxed at that time. Instead, assuming the numerous ISO requirements are met, income from these options is not taxed until the underlying stock is sold at a later time. At that point, the income is taxed at favorable long-term capital gain rates instead of ordinary income Regular Tax rates. Under this normal scenario, an AMT item is triggered on the date of exercise. However, a taxpayer has until one year after date of exercise to “disqualify” the options, resulting in ordinary income but also completely eliminating the AMT item. A future article will discuss in some detail this “disqualification” concept as an AMT-planning strategy.

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!

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

State and local taxes

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

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

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

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

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

Stock options, in particular Incentive Stock Options (ISOs)

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

Capital gains

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

Summary

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

The House has adjourned for the year, and the Senate is putting all of its energies into the massive health care reform effort. Left behind – far behind in fact – is any thought of relief for the 24 million taxpayers who will become subject to the Alternative Minimum Tax for the first time on January 1, nor for the significant increase in the amount of AMT paid by each of the four million-plus already enveloped by it.

The issue? The AMT exemption level and the so-called annual “patch.” Below is a reprint of two articles that appeared on amtblog.com earlier in the year, after President Obama signed the 2009 Stimulus Act into law.

The AMT “patch”

Once again we read that Congress has fixed the AMT problem by enacting a temporary “patch” in the recent stimulus bill. With this, 24 million taxpayers who otherwise would be in the AMT in 2009 are spared – but only for one year. Come January 1 these 24 million people again risk falling into the AMT.

What is this all about? It’s simply another example of the law of unintended consequences. When the first minimum tax was enacted back in 1969, it seemed like a good idea – 155 taxpayers making over $200,000 were paying no taxes at all under the regular income tax, so a “minimum” tax would make sure that they did. But today that 155 has exploded to over 4 million who are paying the AMT. Unfortunately, this patch does nothing for these 4 million – it just keeps the other 24 million from joining this exclusive club.

Why is this happening? The principal reason for this kudzu vine-like growth in the number of AMT victims is the failure to index the AMT for inflation, while the Regular Tax is so indexed. The annual patch fixes this with a catch-up AMT indexing adjustment. In our next article we will explain indexing and this annual adjustment.

Why just a one-year patch and not a permanent fix? The answer is simple economics – the revenue loss for the 2009 fix alone is 70 billion dollars. A permanent fix, using Congress’ 10-year forecasting model, could approach a cost of nearly 1 trillion dollars. Now you’re starting to talk about real dollars.

Indexing

The AMT “patch” that Congress passed in the recent stimulus bill saved 24 million taxpayers from falling into the AMT in 2009. As mentioned in the last article, this temporarily fixed the problem caused by Congress’ original failure to index the AMT for inflation.

What is indexing? Under our system, tax brackets are progressive – i.e., the more you make, the higher your tax bracket. Some time ago Congress decided it wasn’t fair to have taxpayers fall into a higher tax bracket if the only increase in income simply reflected inflation. For example, in 2008 a single taxpayer hit the 33% bracket when taxable income reached $164,550. In 2009, that same taxpayer will be able to earn $171,550 before hitting 33% – a 4.3% increase. Presumably the CPI increased by 4.3% during this period. (Economists reading this are welcome to write in and explain how all this actually works).

For the AMT, the level at which an AMT payer goes from the 26% bracket to 28% ($175,000) has not changed. Instead, the Congressional fix is to index the AMT “exemption amount.” For a single taxpayer, in 2008 the exemption amount was $46,200. This is an increase of 4.2% over what it was the previous year, because of Congress’ 2008 patch. If the patch is not enacted, however, the exemption amount reverts all the way back to what it was in 1993 – $33,750 for singles. This is the reason such a large number of taxpayers – 24 million – are left hanging out there every year!

Keep an eye on this issue – the so-called AMT “patch.” It will be in the news, as it is every year.