How the AMT Might Influence Your Tax Strategy
Did You Know There is an Alternate Tax System?
The alternative minimum tax (AMT) was created by Congress to help ensure that taxpayers – both individual and corporate – who enjoy economic income do not escape taxation through creative accounting and “over-use” of tax benefits provided under the regular tax system. \
This alternate computation must be used when your regular taxable income is excessively reduced by relying on so-called “tax preferences.” In many cases the techniques used to lower your regular income taxes might actually cause you to be in the AMT system, so if you plan to exclude or deduct some large items from your taxable income this year, it might be to your benefit to learn more about the AMT to see if it could affect you.
The AMT is actually part of a separate, parallel tax system with its own rules for determining taxable income, exemptions, deductions and credits. With it, a flat 26% to 28% tax rate is applied to income, adjusted upwards by the preferred items that are used to reduce liability excessively. If this
amount is higher than your regular tax bill, you pay the higher amount.
The basic formula for the AMT is fairly straightforward. The computation begins with your taxable income, as it is computed under the regular tax system. However, the AMT system allows for a different – and usually more conservative – set of exemptions and itemized deductions. Additionally, certain income items are treated differently by the separate tax systems. These items include the exercise of large incentive stock options (ISO), tax-free bonds that generate AMT income (sometimes referred to as “AMT Bonds”) and recognition of large long-term capital gains.
Congress didn’t intend for the alternative minimum tax to apply just because you have long-term capital gains. But when Congress reduced the capital gain rates in 1997 and again in 2003, it stipulated that the lower rates would apply under the AMT system, too. So recognizing a large longterm capital gain may push you into the AMT system.
The AMT exemption amounts are much like personal exemptions under the regular system. For 2004 and 2005, they are $58,000 for joint filers and $40,250 for individuals. Just like in the regular tax system, exemptions in the AMT system are also subject to being phased out if income exceeds certain levels. This is why controlling the recognition of income (such as long-term capital gains) is important.
Some common itemized deductions treated differently are: state and local income tax, state sales tax, mortgage interest, medical expenses, employee expenses, tax preparation fees and investment expenses. As you probably have realized, the AMT system reduces your ability to fully benefit from these types of deductions.
The result of these computations is alternative minimum taxable income (AMTI). To arrive at the AMT, multiply the AMTI by 26% if the AMTI is less than $175,000 ($87,500 for singles) and 28% for AMTI more than $175,000 ($87,000 for singles). Finally, after deducting certain credits, the AMT is compared to the tax computed under the regular tax system. The taxpayer is then liable for the larger of the two taxes.
The interaction between the AMT and the regular tax system can make multi-year tax planning difficult. For this reason, it would be wise to consult with me if you intend to engage in any significant tax planning strategy. I can help you determine whether you risk triggering the AMT, and help adjust your strategy appropriately. I can also help with any questions about your financial plan in general, so feel free to contact me.
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