Alternative Universe

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.

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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.

Doing the Math

While alternative minimum tax calculations can be complex, you can conduct a fairly
simple exercise to see if you’ll be forced to pay it. The math starts with ordinary
income. To that, add back disallowed deductions or preference items that are excluded
from income under the regular tax systems. Then subtract the AMT exemption for
your income level. Using the tax rate schedules, calculate your AMT income tax liability.
If the resulting figure is greater than your regular taxable-income calculation,
you are subject to the AMT, says Jere Doyle of Mellon Financial.

The AMT exemption is, in effect, a substitute for all the other deductions and
exemptions you have to forgo. It is not indexed to inflation and, in fact, was actually
reduced in 2005. The maximum exemption for 2006 for an individual filer is $40,250;
for couples filing jointly, the exemption is $62,500. The exemption equals $250 for every
$1,000 of taxable income earned above a threshold (currently set at $112,500 for individuals
and $150,000 for couples), but eventually reaches a limit so that by the time an
individual reaches $273,500 in income or a couple reaches $382,000, the exemption
maxes out and you are on the tax hook for every dollar. No wonder some financial planners
suggest that AMT actually stands for “alternative maximum tax.” — M.L.