It has been called "illogical," "horrific," "a slow-motion train wreck," and, most colorfully, the "roach motel" of taxes: you check in but you never check out. The alternative minimum tax (AMT), dreamed up by Congress in the late 1960s to make sure the rich don't exploit tax loopholes, now affects more than 3 million American taxpayers, and could apply to as many as 31 percent of all taxpayers by 2010.
Today, most people who pay the AMT make between $75,000 and $400,000 a year — above the national average, but far from rich. And while Congress used the same "tax the rich" political rhetoric in 1986 when it revised the law, those changes actually seem to have widened the pool of taxpayers subject to the AMT.
Critics say that the AMT is a misguided effort to close tax loopholes that were eliminated 20 years ago. The rules that govern the AMT create a sort of alternate tax universe, one in which a slew of popular deductions cherished by the middle class (state, local, and property taxes; children; mortgage interest under certain circumstances; and others) are replaced with a single exemption that has not kept pace with inflation. If a taxpayer is subject to the AMT, he or she pays at or near the highest tax rate on all income, versus paying a progressive rate that reaches the 28 percent maximum level only on income above $74,000.
Can't Go Home Again
Based on data from the Internal Revenue Service, the
average AMT filer paid an additional $6,000 in taxes
in 2004. Other calculations put the average tax hike
at more than $13,000 for someone making $100,000
annually (assuming a tax base after deductions of
$71,000).
In one way, unfortunately, the AMT is an undeniable success: it is written to make it very hard to avoid. The fundamental strategy for escaping it is to analyze your potential deductions and any income that you may be able to time (such as stock sales) so as to avoid slipping into the AMT's grasp. "You have to run the numbers again and again" looking for the optimal combination of deductions and income that will keep you rooted in the conventional tax system, says Alan Dlugash, a tax accountant with Marks Paneth and Shron who works with high-net-worth clients.
Movin' to Montana
One way to avoid the AMT is to kick the
kids out and move to Montana. That's cold
(in more ways than one), but it illustrates
the frustrations posed by the AMT. The
$3,300 (inflation-adjusted) deduction families
receive for each member is ignored in
the AMT calculation, so larger families
often find themselves within striking distance
of the AMT even if their incomes are
fairly modest. State and local taxes account
for 48 percent of the preference items subject
to AMT but not to regular taxes, so
wage-earners living in high-tax states like
New York, California, and Massachusetts
are also ripe for the AMT.
If moving to Montana is not an option, some more-reasonable steps include:
- Be Wary of Long-Term Capital Gains. LTCGs are taxed at the 15 percent rate whether they fall under the regular tax code or the AMT. However, the gains can pump up AMT income and trigger a loss of part or all of the AMT exemption. If possible, try to time gains so they are recognized in years when you have more exemption wiggle room.
- Monitor Your Private Activities. Avoid investing in private activity bonds (tax-exempt — that is, exempt from regular taxes — municipal debt instruments that fund nonessential government services) unless you are sure they make sense for your portfolio. The interest earned could trigger the AMT, which would effectively reduce the yield. And note that municipal-bond mutual funds, which are very popular, often own private-equity bonds.
- Consider Your Options. The spread, or profit, made on exercising incentive stock options is a preference item under the AMT, and therefore has to be added into the income calculation. Do a two-year tax projection to determine how much AMT you'll pay, and how much you'll recover the following year as a credit. Then consider whether the tax benefit is great enough to justify the investment risk of holding the shares.
- Take Credit for the AMT. In years when you do fall into the AMT category, the accelerated-income items may give rise to a credit for future years. Such credits become available when you report income earlier than you would have under the regular (non-AMT) tax rules. Incentive stock-option spreads are the most popular credit item: they produce AMT income when the option is exercised but aren't recognized as income under regular tax rules until the underlying stock is sold. That means that when the stock is sold, you get an adjustment that may help you claim a credit that recovers some or all of the AMT paid in a previous year.
- Postpone State Taxes. Timing the payment of state, local, and property taxes can get complicated, especially if you have no control over payments — as is often the case with automatic payroll or property-tax payments. However, in some cases changing the timing of your itemized deduction can reduce your income levels enough to avoid triggering the AMT.
- Employee Business Expenses. If you deduct employee business expenses, you may lose the deduction under the AMT. Talk to your employer about business expenses you incur and work out an arrangement so you don't have to claim those expenses as deductions. For example, if you normally incur $3,000 in expenses on a salary of $60,000, and you're faced with losing the expense deduction as a result of AMT, you could ask your employer to pay those expenses and reduce your salary to $57,000.
Marie Leone is senior editor of CFO.com.
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