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AMT – Alternative Minimum Tax – How it may soon affect you!

By: Richard Feldman

By: Richard Feldman, CFP, AIF, MBA

Hopefully AMT reform is on the way if you believe what the politicians are telling you. A bipartisan group of senators in January introduced a bill calling for the death of the stealth tax system that lawmakers on both sides have criticized as unfair. “This bill is really a bellwether for one of the Finance Committee’s biggest priorities for this year. This congress intends to provide tax relief to middle-income Americans in a fiscally responsible way, and the AMT is the right place to start,” Senator Baucus said in a statement. We have had two tax cuts in 2001 and 2003 EGTRRA (Economic Growth Tax Relief Reconciliation Act) and JGTRRA (Jobs and Growth Tax Relief Reconciliation Act) that were designed to reduce individual and family tax liabilities in the coming years. The tax packages failed to address the Alternative Minimum Tax which is a complex area of taxation that will affect a much larger percentage of the population and basically negate any tax benefits provided by the two previous tax packages. The bottom line is, if you aren’t aware of the Alternative Minimum Tax and how it is computed then you might end up like a lot of unsuspecting workers by paying a lot more income taxes than you counted on.

The History of the AMT

“The practice of requiring well-to-do Americans to pay a minimum tax was developed more than three decades ago. In January 1969, then Treasury Secretary Joseph W. Barr informed Congress that 155 individual taxpayers with incomes exceeding $200,000 had paid no federal income tax in 1966. The news set of a political firestorm. Members of Congress were deluged with more constituent letters about the untaxed 155 in 1969 than about the Vietnam War. Later that year, Congress created a minimum tax to prevent wealthy individuals from taking undue advantage of tax laws to reduce or eliminate their federal income tax liability.”[1]

What is the AMT and How it Works

In the instructions for form 6251 (Alternative Minimum Tax) the purpose of the form and the tax is stated as follows: “The tax laws give special treatment to some types of income, allow special deductions for some types of expenses and allow credits to certain taxpayers. These laws enable some taxpayers with substantial economic income to significantly reduce their regular tax. The AMT ensures that these taxpayers pay at least a minimum amount of tax.”

Taxpayers subject to the AMT must calculate their tax liability twice: once under regular income tax rules and again under the AMT rules. If liability under the AMT proves higher, taxpayers pay the difference as a surcharge to the regular tax.

AMT Calculation

1.) Start with regular 1040 taxable income

2.) Add back any item that was deductible for the 1040, but not for the AMT

3.) Add preference items

4.) Equals AMT base

5.) Subtract exemptions ($62,550 Joint and $42,500 single – subject to phase-out)

6.) Equals Alternative Minimum Taxable Income

7.) Calculate Alternative Minimum Tax (26% on the first $175,000 and 28% on the excess)

“In computing the alternative minimum tax (form 6251) you are simply adding back some tax deductions and income exclusions to your regular taxable income to arrive at your alternative minimum taxable income. First you have to add back your personal and dependent exemptions ($3,400 each in 2007), then your standard deduction if you don’t itemize ($10,700 for joint filers in 2007; $5,350 for singles in 2007). You also lose your state, local, foreign-income and property-tax write offs, as well as your home equity loan interest, if the loan proceeds are not used for home improvements.

The AMT also ignores some itemized deductions, such as investment expenses and employee business expenses, and some medical and dental expenses. It also counts as income the interest from private-activity bonds, a type of tax-exempt bond issued by governments, usually to finance sports stadiums and the like. Finally, AMT rules force you to pay taxes on the spread between the market price and the exercise price of incentive stock options granted by your employer.”[2]

Problems With the AMT

Over the next few years, the Urban-Brookings Tax Policy Center says the AMT will hit approximately 31 million of taxpayers by 2010. The main people who will feel the affect are the upper middle class: 92% of those with annual incomes of $100,000 to $500,000 are expected to pay AMT in 2010.

More and more people will be affected by the AMT going forward because the AMT has not been changed as the regular income tax laws have changed. The basic problem with the AMT is that it is not indexed for inflation as are the regular income tax brackets. This means that a larger number of persons are required to pay the AMT with each passing year. Another reason is the two recent tax relief Acts. A reduction in the regular income tax bill translates to a larger difference between the regular tax and the AMT since the AMT is calculated at the same historical rates.

“Who is most likely to feel the impact of AMT going forward? Higher income married clients who have large families and so a large number of personal exemptions or those who live in states with higher taxes typically fare poorly under the AMT. Also, individuals who exercise significant stock options or who have substantial losses or depreciation or other preference items will continue to be subject to the AMT. The Urban-Brookings Tax Policy Center study opines that “AMT will become the de facto tax system for filers with incomes between $100,000 and $500,000.[3]

Conclusion

The reason people don’t want to be hit with the AMT is because your income is taxed at a rate of 26% and 28% effectively negating the progressive nature of our tax system (the 10% and 15% brackets). The last two tax cuts have been portrayed as great benefit to the middle class taxpayer when in reality the AMT could negate any benefit that could have been derived.

If you are married and your gross income is greater than $75,000 and you have write-offs for personal exemptions, state income taxes, and home-equity loan interest, you are a prime candidate to be hit with the AMT. Going forward I would suggest that you compute your tax liability under both income tax systems. Because of the complex nature of the AMT, the only way you will know if you are subject to the tax is by filling out the forms or by being audited by the internal revenue service. The latter is not a process you want to participate in because if it turns out you should have paid the AMT but didn’t, you will owe back taxes plus any interest or penalty the IRS decides to hand you. Tax planning can go a long way towards mitigating the affects of the AMT. Consult your CPA or financial advisor to consider strategies that will provide you relief from the dreaded AMT.