As the election season enters the final stretch, we’re hearing about the presidential candidates’ plans for the economy and taxes (well, we’re hearing a lot of arguing about them). I’m all in favor of revamping the tax code to make it simpler and more straightforward to understand, especially when it comes to reforming the out-of-date Alternative Minimum Tax (AMT) system.
If you haven’t had the pleasure of meeting the AMT, it is a parallel tax system instituted in 1969 when it was discovered that 155 people with adjusted gross incomes greater than $200,000 paid no federal income tax on their 1967 income. According to a May 2001 report by the Joint Economic Committee, the ensuing outrage prompted more letters of complaint to Congress than the Vietnam War. In response, Congress enacted a minimum income tax, the precursor to the AMT.
One could argue that the real purpose of the AMT was to defuse the outcry about some not paying their fair share. Sound familiar?
But because the AMT was never permanently indexed for inflation, when combined with effect of the 2001 and 2003 tax cuts, more and more taxpayers who were never originally targeted have been caught up in the calculation and millions of Americans now pay AMT. Each year in recent years, Congress has passed a patch to index AMT for inflation to keep an additional 16 million taxpayers from being subject to AMT.
What was intended to be a true minimum tax has turned into a tax nightmare for many unsuspecting Americans. Because of the complex calculations it’s difficult to say exactly who might be hit, but it is possible for a married couple with a few children and a gross income of $75,000 to be subject to the tax. You can have AMT liability because of one big item on your tax return, such as incentive stock options, or because of a combination of many small items like high property taxes and unreimbursed employee expenses. If there is any question at all, you will need to calculate your taxes twice; first the regular way; and then again according to the AMT rules. You get to pay the one that is higher. Some say it’s like a fence within a fence—if your deductions make it past the first fence, they just might get snagged by the second one.
How hard can it be?
No one ever said our tax code was simple, and the AMT calculation is no exception. Using Form 6251 to calculate your AMT income, start with your regular taxable income, add back your personal and dependent exemptions, and then your standard deduction if you don’t itemize. If you do itemize, add back your state, local, and property tax deductions, all of your miscellaneous itemized deductions, as well as a portion of any medical deductions for starters. That’s right, in calculating the AMT, you don’t get to take those. Adjustments must also be made for things such as certain depreciation, some tax exempt interest, incentive stock options, passive losses, and various credits. After you’ve figured that out, subtract your AMT exemption amount, subject to a phase-out of course, multiply by the AMT rate, which is 26-28%, and compare to your regular tax. If your regular tax is lower, you pay the difference. A study by the General Accounting Office provides this example of the effect of AMT on a hypothetical family for tax year 2000: The family is comprised of a husband, wife, and six children. This family had wage earnings of $80,000, rented rather than owning its house, and had no significant tax deductions. A standard deduction of $7,350 plus personal exemptions of $22,400 would reduce its taxable income to $50,250. Under the regular income tax, the family would owe $5,377 in federal income tax. Under the AMT, not all the deductions and exemptions that the family has taken are allowed. Instead of paying $5,377, the family must pay $6,100 — an increase of $723. It is important to note that the AMT is only the difference between the two taxes and not the entire tax, because in some cases a credit for AMT paid is available in future years.
That patch that Congress has passed each year to keep the AMT exemption amount on pace with inflation? We don’t have one yet for 2012. While the exemption amount was $74,450 for married taxpayers filing jointly in 2011, it is only $45,000 at this point for 2012. That means that if Congress by some chance fails to act, the AMT will hit many more taxpayers than in the past. In my opinion, it is very highly likely that Congress will pass another patch and the AMT, but probably not until almost the end of the year.
What can we do about it?
Again, it is hard to know exactly who will be snagged by the AMT, but the likelihood is increased if any of these apply: your gross income exceeds $100,000, you have several children, significant itemized deductions, large capital gains, you own a business, or receive incentive stock options. I have seen a definite increase in the returns that must at least run through the calculation, as well as those that are subject to the tax. Fall is a good time to do a “sneak preview” of your taxes and head off any surprises with good tax planning.
Here are eight ways to avoid the AMT:
1. Don’t prepay state income and property tax in years you are subject to the AMT.
2. If your employer reimburses business expenses, such as mileage, make sure you have an “accountable” plan to keep them off your return.
3. Consider not claiming exemptions for college-age children. The AMT disallows personal exemptions, so there’s no extra tax to pay by giving them up. Letting children claim their exemptions can save income tax and possibly qualify for tuition credits that may be lost.
4. Avoid private activity municipal bonds, and consider using AMT-free mutual funds where they make investment sense for you.
5. Defer exercising Incentive Stock Options where it makes investment sense.
6. Capitalize, rather than deduct, investment expense.
7. Schedule business equipment purchases when you can use your full depreciation deductions.
8. Defer recognizing capital gains as they increase taxable income subject to the AMT.
What is the future of the AMT?
Certainly repeal of the AMT would simplify tax compliance for not only those who pay it, but the multitude of taxpayers who must make the calculations just in case. But there are so many tax and economic issues on the table right now, if we manage to get any reform done, I don’t know if AMT will make the cut.