Alternative Minimum Tax Planning

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By Roy Lewis

Although the alternative minimum tax (AMT) was intended to apply to high-income taxpayers who take advantage of loopholes (called "tax preferences" in tax lingo), it can also apply to middle-income taxpayers who have not engaged in some tax planning. In fact, the AMT is hitting more and more taxpayers each year.

You're likely not familiar with all of the issues surrounding the AMT. That's not a good thing. Ignorance isn't necessary bliss in this case. So, let's take a few minutes to see where you and the AMT might meet.

The characteristics most likely to give rise to AMT liability for "ordinary" taxpayers who do not operate businesses are:

  • large numbers of personal exemptions
  • large amounts of state and local taxes paid
  • large amounts of miscellaneous itemized deductions
  • large deductible medical expenses
  • the bargain element of Incentive Stock Options
  • large capital gains
If you have any of these issues on your tax return, or any combination of them, you could have the unpleasant obligation of paying the AMT.

Personal Exemptions

While personal exemptions are allowed to reduce your regular tax, they are not allowed for AMT purposes. Consider for a second the Little Old Lady who lived in the shoe. She had 7 children. So, between herself and her kids, those personal exemptions allowed her to reduce her regular taxable income by about $22,400 (8 personal exemptions times $2,800 each) in 2000.

[Please note that we are using tax-year 2000 personal exemption amounts for illustrative purposes only. Personal exemption dollar amounts change each tax year, and the amounts can be found on Form 1040 and are described in IRS Publication 501.]

But, for AMT purposes, personal exemptions are ignored. It's very possible that these personal exemptions, coupled with some other tax issues, could introduce her to the AMT. Living in a shoe might not be her biggest problem.

There is no real way to "plan" your personal exemptions for AMT purposes. After all, obviously you're not going to kick little Johnny or Sue out the door to reduce your personal exemptions. But, you might be able to plan other tax items subject to the AMT, knowing that you're already at risk with a large number of personal exemptions.

State and Local Taxes

State, local, and other taxes paid and claimed as itemized deductions on Schedule A are not allowed as deductions for AMT purposes. This being the case, if possible, try to pay state and local taxes in years when you won't face the AMT -- because otherwise they will give you absolutely no tax relief. Whenever possible, know when you are in the AMT zone, and do your best to move these tax payments to another year when the AMT won't bother you.

Say that you are subject to the AMT this year, but you expect to avoid it next year. You should try to defer your state and local tax payments until next year. Be aware that this might lead to underpayment penalties at the state or local level. But, in most cases, those underpayment penalties are small potatoes compared to the potential tax dollars you might save.

Likewise, if you expect to be subject to only the regular tax for this year and the AMT the following year, your tax payments should be accelerated into this year whenever possible. Just remember that the IRS will not allow a deduction for state and local income taxes unless the taxpayer reasonably believes the taxes were owed when paid. Therefore, you can accelerate your deduction for state income taxes by making estimated tax payments, but only if your reasonable computations indicate that those taxes are actually owed.

In addition, real property taxes cannot be deducted until they are actually paid to the taxing authority. So, if you pay property taxes through a mortgage lender, the lender's cooperation in paying the taxes before the due date will be required to accelerate or defer the deduction. If you make your own property tax payments, you have free rein as to the timing of the payments. Again, deferring those payments might lead to some penalties, but the tax savings could be well worth it.

Medical Expenses

Medical expenses can be deducted for AMT purposes, but they must exceed 10% of adjusted gross income, compared to 7.5% for regular tax purposes. Thus, as with the deduction for state and local taxes, you might be able to time medical deductions to avoid the AMT or at least obtain the maximum benefit from the deductions. Again, medical problems and expenses aren't something that you can usually plan, but you do have a bit of control over when you pay medical bills. So, think about the acceleration and deferral methods that we discussed above when dealing with medical expense payments.

Miscellaneous Itemized Deductions

Miscellaneous itemized deductions that are greater than 2% of your adjusted gross income are deductible for normal tax purposes, but they are not deductible for AMT purposes. These expenses include un-reimbursed employee business expenses, expenses for the production of income, tax return preparation expenses, and many others too numerous to mention here. And, you do have much more control over these expenses. So, if they are large, make sure to do your AMT planning so you don't lose the tax benefit of these expenses.

Large Capital Gains

You might have heard that the lower tax rates for capital gains will not trigger the dreaded AMT. That's true... at least somewhat. For AMT purposes, you'll also receive a lower capital gain rate on long-term capital gains. But, because of the workings of the AMT, a large long-term capital gain could trigger some AMT taxes. So, if you've done well with your long-term investments and are looking to liquidate, at the very least you should review your AMT consequences and determine what (if any) impact such a sale would have. If you look before you leap, you might be able to make decisions that will minimize your AMT taxes (such as selling only part of the investment in each of two or three tax years).

Incentive Stock Options (ISOs)

If you receive ISOs from your employer: Beware. The bargain element (the difference between your exercise price and the fair market value of the stock on the exercise date) is considered a tax preference for AMT purposes. While you'll owe no regular tax on this bargain element, the AMT could certainly kick in. For many of you, this could be a very large trigger for the AMT. ISO issues are much too complicated to discuss here in any detail. Just know that, if you are exercising ISOs, you potentially have big AMT issues. Make sure you know where you stand with your AMT before you exercise your ISOs.

While there is no official IRS Publication on the AMT, there is a report that the IRS gives its auditors to help them review AMT issues on your tax return. It's a step-by-step look at the AMT from the auditor's eyes and it's available for your eyes too -- Alternative Minimum Tax for Individuals. Download IRS Form 6251 and the associated instructions for more information and help. Play with the form to see how the AMT might impact your specific tax situation. Don't be taken by surprise by the AMT. It's worse than the bogeyman!
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