Taxpayers Take the AMT to Court: a Burden That Needs Fixin'

October 2008 Taxpayers Take the AMT to Court: A Burden That Needs Fixin’

By Cherie Hennig, Wendy Gelman and John O. Everett

Cherie Hennig, Wendy Gelman and John Everett discuss how application of the individual AMT has changed since it was enacted nearly 40 years ago and examine recent Tax Court cases involving AMT challenges.

The AMT’s a sneaky tax. Though meant to snare First enacted nearly 40 years ago, the predecessor the wealthy, it burdens workers to the max. Now to today’s AMT was a response to a 1969 Treasury that’s what I call stealthy.1 study that revealed that 155 taxpayers making more than $200,000 in 1967 paid no federal income tax.3 At the time the original minimum tax was enacted, Introduction even though marginal tax rates were as high as 91 percent, a few taxpayers were able to take advan- Thehee AlternativeAlternative MinimumM Tax (AMT), a separatep tax tage of tax loopholes and end up paying no tax at systemysttem thatthatpat parallelspaara the regularregular incomein ome tax,tax was all. The original intent of the AMT was to close tax desdesignedigned toto ensureennsu thatha everyonery withith signiﬁsign cant loopholes for the wealthy and address concerns about incomencoome payspays somesomome federalderal incomeincome tax.ta .2 Whilele there the overall fairness of the tax system.4 Ironically, the are bothbotbth a corporatecorp rat andd indindividualdal AMT,AMT the th focus very essence and framework of the AMT is repeatedly herein isi on the individual AMT. As it applies to broughtg into question based on doctrines of unfair- individuals, the AMT systemstem “double“double checks”chhecks eacheachh ness anda d inequitableinequitab e treatment.t atme t. taxpayer’s return, recalculatingcul gth the taxpayer’staxpayeer’s taxt x TheTheA AMTAMTno no longerongge ensnaresnsnares ththee supsuper-wealthy.er-wwealth liability by adding back certain preferences which Because the original AMT exemption threshold were not included in the calculation of regular tax that triggers the AMT was not indexed annually and adjusting for certain deductions and exemptions. for inflation, the accumulating effect of inflation After deducting an AMT exemption, the alternative is a key source of growing AMT coverage.5 Were minimum taxable income is taxed at the AMT rates it not for “patch” legislation passed by Congress with the resulting tax reduced by an alternative com- each year, which increases the AMT exemption, putation of the foreign tax credit and any allowable many more taxpayers would be subject to the AMT credit carryforwards. AMT.6 Even after applying the annual “patch,” the AMT is a significant source of revenue for the Cherie Hennig, Ph.D., CPA, is Professor and Director of the federal government. Statistics of Income (SOI) data Master of Science in Taxation Program at Florida International for the 2005 tax year reveal that over four million University’s School of Accounting in Miami. taxpayers paid over $17.4 billion in AMT. Fewer Wendy Gelman, J.D., LLM, is a Professor in the School of Ac- than eight percent of taxpayers with adjusted gross counting at Florida International University in Miami. income under $100,000 and no taxpayers with John O. Everett, Ph.D., CPA, is a Professor of Accounting at adjusted gross income in excess of $1 million are Virginia Commonwealth University in Richmond. subject to the AMT.7 Thus the AMT can be classi-

fied as a tax on the middle and upper-middle class. the arguments put forth by these taxpayers, one Taxpayers subject to the AMT when broken down overarching theme emerges: The AMT and its by AGI class include: application are inherently unfair, and the courts 13 percent with AGI between $100,000 and should provide relief. In seeking support for this $200,000, premise, taxpayers make the following arguments, 71 percent with AGI between $200,000 and among other matters: $500,000, and The AMT no longer targets just the rich as it was 52 percent with AGI between $500,000 and $1 originally intended. million. Taxpayers should not be subject to the AMT by When the revenue from the AMT is analyzed by electing not to take a deduction. AGI class, 82 percent is collected from taxpayers Taxpayers should not be expected to antici- whose AGI is between $200,000 and $1 million (see pate that tax penalties may increase their AMT Figure 1). exposure. Taxpayers with foreign source income should Figure 1. Percent of AMT Collected by not have an AMT exposure where they otherwise Income Class, 2005 Tax Year would pay no regular federal income tax. Taxpayers who exercise stock options should $.7 billion not be expected to anticipate ﬂ uctuations in se- 3% curities prices and be subject to the AMT if they $5.3 billion $2.6 billion guess wrong. 15% The Courts Respond 31% Despite the barrage of taxpayer complaints, al- most uniformly the courts have denied taxpayers relief from the AMT and have insisted the Code be strictly applied in all instances. With respect 51%% to the application of the AMT, fairness is not the $8.8$8.8 billiobilli n issue; equitable arguments do not overcome the plain meaning of the statute and the force of precedent. According to the court decisions analyzed,

<$100,000 any change in the application of the AMT should $100,000-$200,000$100,000-$ 0 000 bee addressedaddressed byy thethe Congress,C ngre s, notnot by thethe IRSIRS andan $200,000-$500,000$200 000-$ 00 000 certainlyertainly nnotot byyth thee Tax Court.Court. $500,000-$1,000,000 Uncle Sam, It’s Not Fair! As noted above, a theme of unfairness weaves Taxpayers in Revolt through the tapestry of cases analyzed. Taxpay- The AMT is cumbersome, confusing and universally ers craft other arguments as well to bolster their scorned. Nonetheless, it does not appear to be contention that the AMT is unfair, but ultimately going anywhere, at least in the short term, despite the message is the same. Francis E. and Linda A. occasional bipartisan efforts to repeal the AMT. Falcone confronted the unfairness of the AMT head What’s a hard-working taxpayer to do? Recent on, arguing their case without the assistance of an Tax Court cases suggest many taxpayers are seek- attorney.8 The Falcone’s made numerous mathe- ing redress through the courts to protest an AMT matical errors on their tax return when calculating system they feel is unreasonable and capricious. their AMT liability, which were later corrected by Taxpayers, challenging various aspects of the AMT, the IRS. They did not dispute the revised calcula- are making arguments that, though creative and tions nor did they challenge the amount of the occasionally convincing, all too often attempt to resulting deficiency assessed by the IRS. Their sole appeal to the court’s sense of equity rather than contention was that the AMT, as applied to them, its requirement to enforce the law. In analyzing was inherently unfair. They argued that although 38 October 2008 they were well aware that the Tax Court has no letter of the law. The courts have consistently and right to commandeer the role of Congress, the uniformly maintained they will apply and enforce court should absolve them of their AMT tax li- the Code as written, even if it is unfair. If taxpay- ability, which would send a message to Congress ers have issues and concerns over the merits of and encourage legislators to launch a thorough the AMT and its application, they should address review into the applicability of the AMT. their concerns to the Congress. Similarly, Sandra R. Murray and Khaled M. Equal Opportunity Tax Abouelnoor complained of the harshness of adding It is well documented the AMT was originally back their itemized deductions to calculate AMT, designed to tax the “rich.” Now, however, middle arguing that an IRS publication implied that only and upper-middle class those individuals who taxpayers find them- The AMT is cumbersome, have “adjustments or selves paying the AMT. preferences” would be li- Scott Katz, a low-in- confusing and universally scorned. able for AMT.12 The court come petitioner (also Nonetheless, it does not appear stated that even if the representing himself), to be going anywhere, at least in publication implied that had significant itemized AMT would not apply, it deductions that resulted the short term, despite occasional was not an authoritative in zero taxable income bipartisan efforts to repeal the AMT. source of federal tax law. and zero regular tax lia- Although it may seem bility.9 Nevertheless, the IRS contended and the unfair, the court stated it was bound to apply the Tax Court agreed that Mr. Katz was subject to the law as written. AMT. From a public policy perspective, one can Likewise, Christine Kenton and George Braader question whether the Congress intended for the argued that legal fees stemming from an employ- AMT to snare taxpayers who were not the origi- ment discrimination lawsuit against a former nal targtargetget of tthe AMT. Nonetheless, the court in employer should not be classified as a miscel- Katzattz ssteadfastlyteadfastly maintained that the statute was laneous itemized deduction subject to add back clearleaar oon ititsts face faace andd unambiguous,unambiguou , findingfindin that when computing alternative minimum taxable thehe incinclusionlusion ofo a specificec dollarol AMTMT exemexemption income.13 Although the Code14 was amended by (CodeCoode SSec.ec. 5555(d))(d)) wwass clear evidenceeviden e of Congres-Co the American Jobs Creation Act of 2004, effective sionalnall iitintentnteenttt tto applyap the AMT A Ttot to taxpayers with October 22, 2004, to allow the deduction of legal alternativei minimum taxable income regardlessg of fees relating to lawsuits similar to the Kentons’ original policy considerations.rat ns inn ccomputingomputinng aadjusteddjuste grogrosss iincome,nc me, thehe chchangeang was notnot made m retroactiveretro tive andandd didid notnota applypp yt to Miscellaneous Itemizedi dD Deductionsd ti the taxpayer. For many taxpayers, the AMT “vastly complicates one of the most basic of questions: whether to Is Deducting Itemized itemize deductions.”10 In calculating the AMT Deductions Optional? liability, most itemized deductions are effec- In a unique set of facts, Naila M. Qureshi decided tively disallowed. In fact, Jack and Janet Freeman NOT to deduct her state income tax expense as an claimed that the disallowance of certain mis- itemized deduction since its disallowance when cellaneous itemized deductions violated their computing her alternative minimum taxable income “constitutional rights.”11 Despite this emotional would result in her paying an AMT of over $1,400.15 and creative appeal, the Tax Court was unsym- Ms. Qureshi even fi led suit in the U.S. Court of Ap- pathetic and stated, “It was clearly the intent of peals to no avail.16 Ms. Qureshi fi rst argued that she Congress to restrict the benefits of miscellaneous was not subject to the AMT because she chose not itemized deductions through the application of to deduct her state and local income taxes for 2002. AMT. That the result was inequitable to the tax- The court rejected this argument since the AMT payer could not overcome the plain meaning of fi rst computes a “tentative minimum tax” based Code section 56.” The court was not defending the on “alternative minimum taxable income” which merits of the law but rather simply applying the equaled her taxable income with certain adjust-

TAXES—THE TAX MAGAZINE® 39 Taxpayers Take the AMT to Court

ments. Ms. Qureshi’s total tax due was solely based for the purpose of calculating their AMT liability. on this alternative minimum taxable income, which Rather than deciding whether the Code and treaty does not adjust for state and local income taxes. were in confl ict (which the court admitted was a Therefore, the amount she owed due to the AMT, close call), the court instead rejected the taxpay- the “tentative minimum tax,” in no way depended ers’ argument after concluding the Code provision on whether she chose to take a deduction for state came after the treaty and therefore the Code provi- and local income taxes for purposes of computing sion would trump the treaty in any event.19 her regular tax liability. In a 2005 case, the Tax Court examined a similar situation involving comparable provisions contained Estimated Tax Penalty and the AMT in the U.S.-Czech Tax Treaty. Rather than using the With respect to the AMT, the courts have also “last in time” analysis applied in Kappus, the Tax stressed the importance of adhering to procedure Court tried to harmonize the treaty and Code Sec. in addition to complying with the substance and 59, reasoning that the treaty implicitly recognized content of the law. Robert A. and Karen L. Alston the existence of the AMT limitation on the foreign made total estimated payments for the 2004 tax tax credit and was therefore not inconsistent with the year, which exceeded their tax liability. However, treaty. Ironically, the IRS acknowledged in this case estimated tax payments were not made in four that some “double taxation” would result from this installments, resulting in an estimated tax penalty. application of the AMT.20 The Alstons treated this additional tax as part of the “regular tax” when computing their AMT. Agreeing For Incentive Stock Options, with the IRS, the court held that the additional tax the AMT Is Not Optional! levied for failing to pay estimated taxes is not a Without proper planning, exercising incentive “regular tax” because it is included in a different stock options (ISOs) can trigger an AMT hit.21 Tax- section of the Code and therefore cannot be used payers can be caught in the AMT trap when the to reduce their AMT.17 exercise of an ISO and the sale of the stock occur in two different tax years. The best way to avoid TaxaxxTx TreaTTreatiesatiee the AMT is to exercise ISOs early in the tax year. UntilUnttil re recently,centtly, ataa tataxpayeryer coulcouldd offset oonlynly 90 ppercent Should the value of the stock decline substantially, off ththeirheir fforeignoreeigng tax paymentsym agagainst AMT liabliability,18 the taxpayer can avoid an AMT by selling the stock leadingeadding to a numbernun mb r of before the end of the tax disputesputetes involvingininvol ing tax- year.22 Taxpayers who payers whoh claimed that The AMT has not evolved—it has failed to sell the stock existing tax treaties pro-- mutatedmutated aandnd chchangeha ge iiss neeneeded.eded. A in the sasameme tataxx yyearea ththe tected them from whatat taxax originally originallyd ddesignedsig ed to afaffectfect ononlyly ISISOO iss exercisedexerc seddh haveav was essentially “double the wealthy has become an April 15 tried different tactics in taxation.” Perhaps Con- court, without success. gress was aware of the concern for every taxpayer. Don A. Hernandez and numerous taxpayers liti- Kathryn C. Hernandez gating this issue and responded by changing the law unsuccessfully argued that the exercise of stock for tax years beginning after December 31, 2004! options and their loss on the stock, which occurred Consider the following arguments made by taxpayers in different tax years, qualified as an alternative tax with foreign sourced income. net operating loss. They asserted that, under the In a 2003 case, a married U.S. citizen who AMT statute, they were entitled to carry back the worked and lived in Canada argued that a provi- AMT capital loss sustained in year 2000 to offset sion of the U.S. Canada Tax Treaty that prohibited the positive AMT adjustment in 1999, even though “double taxation” should supersede Code Sec. each occurred in different tax years.23 59(a)(2)(A), limiting foreign tax credits to 90 per- Jonathan N. and Kimberly A. Palahnuk exercised cent of their tentative minimum tax. The taxpayer an ISO in 2000, increasing their AMTI by over $2 insisted that due to the prohibition against “double million. The sale of the stock in 2001 resulted in a taxation,” they should be allowed to a full credit regular capital loss in excess of $150,000 and an for tax payments made to Canada in a given year AMT loss of approximately $2 million. They argued 40 October 2008 that the AMT loss sustained in 2001 should be fully Table 1. Case Study, deductible, resulting in their ability to offset their Howard and Martha Jones 2001 regular tax liability with their 2000 AMT credit carryforward. The court disagreed and held Salaries $ 162,000 their 2001 AMT loss was subject to the $3,000 Long-term Capital Gain (Sale of ISO stock) (a) $ 20,000 capital loss limit under Code Sec. 1211(b).24 Short-term Capital Loss (Sale of ISO stock) (b) $ (4,000) Anthony J. Kadillak made a valid Code Sec. 83(b) Interest Income (taxable bond) $ 15,000 election and was required to recognize the excess of Private Activity Bond Interest (c) $ - the vested and nonvested stock’s fair market value Dividend Income (qualifying foreign stock, over the exercise price for purposes of the alterna- $660 foreign tax paid) $ 3,000 tive minimum taxable income. When the nonvested State Tax Refund $ 1,000 stock was forfeited in the next tax year, the taxpayer Exercise of Incentive Stock Option (ISO) (d) $ - was not entitled to carry back the loss as either an Sole Proprietorship Income (e) $ 58,000 AMT capital loss or an AMT net operating loss to Gross Income $ 255,000 reduce his AMTI for the year in which the Code Less: Sec. 83(b) election was made.25 Robert J. Merlo ex- SEP-IRA $ (10,780) ercised an incentive stock option only to have the 1/2 Self Employment Tax $ (4,098) stock become worthless in the following year. The Adjusted Gross Income $ 240,122 resulting capital loss could not be carried back as Itemized Deductions: an AMT net operating loss to offset the AMT paid Medical ($24,259 less 7.5% of AGI) $ (6,250) in the year the option was exercised.26 Interest—Qualifi ed Acquisition Indebtedness $ (7,900) Ronald and June Speltz argued that they should Interest—Home Equity Indebtedness (f) $ (3,000) be allowed to make an offer in compromise for an Interest—Investment Activities (g) $ (15,000) unpaid tax liability based solely upon their regular Taxes—State and Local $ (31,000) tax liability without taking their AMT into consid- Contributions—Cash $ (41,600) erationion becausebeccau the tax liability resulted from an Miscellaneous ($5,802 less 2% of AGI) $ (1,000) AMTMTM onon anan incentiveincec stock option on stock which Total Itemized Before Reduction $ (105,750) hadadd sigsignifi gnificgnifi ccantcantlytly declinedined in value. The coucourt held Less: Reduction $ 1,675 thathatt thethe ffactact ththeirhe taxx bill wawas muchh highehigher than Net Itemized Deductions $ (104,075) thehe valuevalue ofo thethe stocksto k wasw notot a reasonon for thet IRS Personal Exemptions (4 @ 3,400, less reduction) $ (13,056) to acceptacceepttt theirtth i offerffeff in comcompromise.omise 27 Regular Taxable Income $ 122,991 AMT Credit Carryforwardy rward RegularReg tax $ 18,845 In another AMT ISO case,se, Danielniel D. Moss MMoss arguedargued TaxT x on L/TL T capitalcap tal gaingai andd dividenddividend incomei come $ 22,85085 that the entire AMT credit carryforward resulting Regular tax liability (RT) $ 21,695 from an AMT paid on the exercise of stock options Less: Foreign Tax Credit $ (406) should be refunded in full in the year in which the $ 21,289 stock was sold since “there was no assurance that Alternative Minimum Tax (from Table 2) $ 20,763 he would be able to use the tax credit carryforward.” Less: Child Care Credit $ 800 The court stated that this issue should be addressed by the Congress, not by the courts.28 taxpayer’s long-term unused minimum credit for the tax Fortunately, the Congress responded with a legisla- year, or (3) the amount (if any) of the AMT refundable tive fi x in the Tax Technical Corrections Act of 2007 credit amount determined for the taxpayer’s preceding (P.L. 110-172), permitting individuals with long-term tax year (Code Sec. 53(e)(2)(A)). 29 The component parts unused minimum tax credits for any tax year begin- of the AMT credit are determined using Form 8801, ning before January 1, 2013, a refund of not less than which computes the AMT credit from the prior year, the “AMT refundable credit amount” regardless of the the AMT credit carryforward applicable to the current minimum tax credit otherwise allowed to the taxpayer year and the refundable credit if any from any unused (Code Sec. 53(e)(1)) with an additional amount of the long-term credit carryforwards. credit allowed being refundable (Code Sec. 53(e)(4)) The long-term unused minimum tax credit for a up to the greater of (1) $5,000, (2) 20 percent of the tax year is the portion of the minimum tax credit

TAXES—THE TAX MAGAZINE® 41 Taxpayers Take the AMT to Court

attributable to the adjusted net minimum tax for tax on phantom gains from incentive stock options years before the third tax year immediately proceed- could potentially benefit from the new refundable ing such tax year. For this purpose, the credits are long-term unused AMT credit. treated as allowed on a fi rst-in, fi rst-out basis (Code Sec. 53(e)(3)). However, high income taxpayers Case Study should beware: The AMT refundable credit amount is phased out at the income levels applicable to the In order to gain a better understanding of how the phase-out of the personal exemption deduction!30 AMT affects individual taxpayers, a case study for a Long-term unused AMT credit relief is intended hypothetical married couple, Howard and Martha primarily for individuals who exercised incentive Jones, was developed. Howard is an employee of stock options at a profit and sold the stock in a a large publicly traded corporation, and Martha is different tax year when the stock price had signifi- self-employed. They have two children and spent cantly declined. Individuals in this situation would $4,000 for after-school day care. Tables 1 and 2 il- have paid an AMT on the profit in the year of the lustrate their 2007 regular tax (RT) and alternative exercise, and subsequently incurred a significant minimum tax (AMT).31 capital loss when the stock was sold. Individuals Some items in Table 1 require additional expla- in this situation may have a large minimum tax nation. Howard was granted and has exercised credit carryforward that potentially they could various incentive stock options from his employer. never use—the very issue raised in the Moss case! During 2007, he sold some stock acquired two After a four-year wait, taxpayers who paid an AMT years ago through the exercise of an incentive stock option. While he Table 2. must report a RT long-term Howard and Martha Jones—AMT Computation capital gain of $20,000, his AMT gain is only $10,000 Form Items (D = Deferral, E = Exclusion) All Exclusion 6251 because his 2005 AMT adjustment—the difference Linee#e # TaxableTTaxabble IncomeIn n (from Table 1) $122,991 $122,991 between the FMV at date of [E] PersPersonalonao Exemptionpption DDeductionsuctions (n(none allowed)llo $ 13,056 $ 13,056 1 TaxableTTbaxabble IncomeIn Inco ass AdjustedAd $136,047 $136,047 exercise less the exercise AMTAMT AdjuAdjustmentsjustm (m(may be ppopositive or negativenegative):g price results in a smaller 2 [E][E] MedicalMed (7.5%.5% vs. 10%0% limit) $ 6,003 $ 6,003 AMT gain. This generated 3 [E][EE] State Staat andan Localcal Taxes Taxe (nonenone allowed) al ow $ 31,000 $ 31,000 an AMT credit carryfor- 4 [E][EE] Interest I Expense (Home Equity Disallowed) $ 3,000 $ 3,000 5 [E] Miscellaneous Itemizeded (none allowed)w $ 1,0001 0 $ 1,000 ward of $2,600. Howard 6 [E] Less Disalloweded ItItemizedzed DeDeductionsductions (T(Tableable 1) $ (1,675)( 675 $ (1,675)(1,675 exeexercisedc sed anotheranot er incen-incen 7 [E] State Tax Refundnd $ (1,000)(1 000) $ (1,000)(1 000 tiveive stockstock optionoptioni inn2 200700 8 [E] Adj. Expenses for AMT (Add’l Invest. Int Expense) $ (3,000) $ (3,000) when the FMV at date of 11 [E] Private Activity Bond Interest Income $ 7,000 $ 7,000 13 [D] Incentive Stock Option Exercise (FMV – Ex Price) $ 50,000 $ - exercise was $10,000 and 16 [D] Adj. Gain (Loss) (Regular Tax – AMT Amount) $ (10,000) $ - the exercise price was 17 [D] Post-1986 Depreciation (MACRS – ADS), 2007 Asset $ 5,000 $ - $8,000. Before the close of 17 [D] Post-1986 Depreciation (MACRS – ADS), 2003 Asset $ (6,648) $ - the tax year, Howard sold 26 [E] Other Adjustment; SEP IRA Contribution $ 306 $ 306 the stock for $4,000 result- 28 Alternative Minimum Taxable Income (AMTI) $217,033 $178,681 29 AMT Exemption (a) $ (49,492) $ (59,080) ing in a short-term capital 30 Net Alternative Minimum Taxable Income $167,541 $119,601 loss of $4,000. Since the [(167,541 – 9,000) x 0.26) + (9,000 x 0.15)]; 31 stock was sold in the same [($119,601 – 9,000) x 0.26) + (9,000 x 0.15)] $ 42,571 $ 30,106 year as the option was ex- 32 Less: AMT Foreign Tax Credit $ (519) $ (449) 33 Tentative Minimum Tax (TMT): $ 42,052 $ 29,657 ercised, there is no AMT 34 Less Regular Income Tax Liability (Table 1) $ (21,289) $ (21,289) adjustment for the differ- 35 Alternative Minimum Tax (AMT) (to Table 1) $ 20,763 $ 8,368 ence between the FMV 2007 AMT Credit Carry forward (Timing Differences ) $ - $ 12,394 at date of exercise and $ 20,763 $ 20,763 exercise price ($2,000). It Notes: Exemption amount computations: All, $66,250, less 25% x ($217,033 - $150,000); is important to note that if Permanent, $66,250 less 25% x ($178,681 - $150,000). Howard would have wait- 42 October 2008 ed until 2008 to sell the stock, he would have a by isolating those items whose treatment differs positive AMT adjustment of $2,000 in 2007 and between the regular tax and AMT computations. a $6,000 AMT capital loss in 2008. If he has no Note that the fi rst adjustment to taxable income other capital gains, the AMT loss would be subject in Table 2 (the line numbers for the Form 6251 to the $3,000 capital loss limit. are shown in the fi rst column) is to add-back the Howard and Martha reported qualifying dividend personal and dependency exemption deductions income on stock owned in a foreign corporation on when computing taxable income on line 1. The which they paid foreign taxes of $660. Since their disallowed itemized deductions are subtracted on foreign tax exceeds $600, they are required to fi le line 6 so that the taxpayer initially benefi ts from all Form 1116, Foreign Tax Credit, which computes of the itemized deductions. Those itemized deduc- their allowable foreign tax credit based upon a ratio tions not allowable for the AMT are then added of their net foreign income to their total income. back on lines 2 through 5. Only $406 of the foreign tax paid can be claimed AMT adjustments involve the substitution of spe- as a regular tax credit. The remaining $254 is car- cial AMT treatment for the regular tax treatment of ried over. The AMT foreign tax credit is computed certain items specifi ed in Code Sec. 56 and Code by completing a second Form 1116, using the re- Sec. 58. In general, the adjustments shown in Table vised ratio of net foreign income to AMT income 2 either (1) accelerate income recognition, (2) resulting in a credit of $519 with an AMT foreign decelerate expense recognition, or (3) deny cer- tax credit carryforward of $141. Alternatively, tain deductions altogether. These adjustments are they can elect to forego the AMT foreign tax credit designed to ensure that a taxpayer with substantial computation and use the RT FTC. It is to their ad- economic income cannot avoid tax through the use vantage not to make the election, since their AMT of special regular tax exclusions, deductions and FTC is $113 larger than their RT FTC. However, credits. Howard and Martha have the following should they make the election, they are bound adjustments, which, unlike “preferences,” may be to follow that method in all subsequent tax years. positive or negative: Traditionallyadittionally the foreign tax credit was the only On line 8, additional investment interest expense creditreddit aallallowedllowed aagainst the tentative minimum tax of $3,000 is allowed because the tax-exempt pri- liability.iababbilityySiy. SinceSince otherot credits (includingncludi g all pepersonal vate activity bond interest is an AMT preference credits)credits) aarerre nnotot partt of thee AMT computcomputation, (discussed below). withoutwithhout specifispecificfi c lelegislationlation theyhey wowoulduld only offset On line 13, the $50,000 unrealized gain from the regularregular taxt liabilityabb to the point that thtth the net tax the bargain element of the option, is accelerated liability equals the tentative minimum tax liability. to the date of exercise for AMT ppurposes, rather To remove taxpayers withth vvariousious chchildhild aandnd edueduca-ca- thanh n ththee ddateate ththee sstockck iss sold.o d. tion credits from possibleble impositionposit on of o theeAM AMT,MT, OOn lineline17 17,,th thee $5,000,000d depreciationep eciat on adjust-adjus Congress has granted one-year waivers to permit ment “slows down” the MACRS depreciation nonrefundable credits to reduce the tentative mini- for AMT purposes. mum tax.32 The tentative minimum tax is compared A number of itemized deductions are reduced or to the regular tax less the foreign tax credit, ignoring eliminated altogether because of the less favorable all other credits. Regarding the child care credit, it AMT rules, including the following: is important to note that this credit is allowable for On line 2, medical expenses are reduced by 10 both regular and alternative minimum tax purposes, percent rather than 7.5 percent of AGI. so no adjustment is required. On line 3, state and local taxes are not allowed, The two columns of Table 2 facilitate the explana- and on Line 7, the state tax refund is eliminated tion of the AMT and the AMT credit carryforward. since state taxes are not deductible. In reviewing this example, several observations On line 4, the interest on the home-equity line of about the AMT can be made. Although the al- credit is not allowed for AMT since the loan pro- ternative minimum tax is technically a second ceeds were used to purchase a personal auto. tax computation with its own set of income and On line 5, miscellaneous itemized deductions deduction rules, normally the AMT is computed are not allowed. by converting taxable income to alternative mini- AMT preferences are somewhat similar to adjust- mum taxable income (AMTI). This is accomplished ments, with one major difference: Preferences are

TAXES—THE TAX MAGAZINE® 43 Taxpayers Take the AMT to Court

taken into account only when they are positive (nega- minimum tax before the alternative minimum tax tive preference items are ignored). On line 11, the foreign tax credit is $42,571. $7,000 of private activity bond income is included The AMT is the excess of the tentative minimum in AMTI since this is an AMT preference item (Code tax (TMT) over the regular tax liability (RT). If an Sec. 57(a)(5)). excess exists, the assumption is that the taxpayer Generally, line 26, Other adjustments, is used has unfairly benefited from various tax-favored to recompute gains, losses and deductions when treatments in the Code and must increase the their tax treatment differs for regular tax and AMT. regular tax liability. The AMT is then added to For example, if a charitable contribution of ordi- the regular tax liability; in effect, the taxpayer nary income or capital “pays” the larger of the gain property to which Taxpayers and their tax advisors regular tax liability (RT) Code Sec. 170(e) applies or the TMT. The Jones’ and the property has an must continue to engage in the 2007 tax liability is in- AMT basis that is differ- intricate tax planning needed to creased from $21,695 to ent from its regular tax minimize the current AMT liability $42,458 because of the basis, an adjustment is $20,763 AMT. required on this line. If and hopefully maximize refundable When Congress re- a Code Sec. 179 election long-term AMT credits. duced the regular tax to expense deduction rates for individuals in was not allowed in full for regular purposes, but 1986, the regular tax rates and the AMT tax rates is allowed for AMT purposes because the earned were not substantially different. This led to con- income reported for AMT purposes is higher, the cerns that the AMT would create double taxation additional Code Sec. 179 deduction is taken on on the same items, i.e., once as part of the AMT this line. Should earned income be less for AMT and later as part of the regular tax liability when than for regular tax purposes, reductions in the the items were reported for regular tax purposes. self-employed-emmployed health insurance deduction and/ To provide some “rough justice” in reducing this orr self-employedselflf--emplloyey retirement deduction may be double taxation possibility, Congress came up required.equuiredNd. NNo aadjustmentdjdju ent is rerequiredquired foror differdifferences with the idea of a minimum tax credit and enacted thathatt areare basedbaasedd uponu oro limitedte by AGI. Martha’sMa Code Sec. 53. The basic theory of the minimum linenee 17 adjustmentadjustmem nt forr her post-1986post-198 depreciationdeprec tax credit is that a portion or all of the AMT paid is a negativeneegativei adjustmentdjudj ment of o $1,648$1 648 ($5,000 ($5 – during a tax year may be used in future years as a $6,648)) and her retirement deduction of $10,780, credit against regular tax liability in those years. based upon her Scheduleule C nenetet iincome,nccome, mmustust bee However,Howe er, in noo casecase can the creditc e it reduceeduce theth recomputed. The $306 redreductionon to her rretirementetireme t carryoverarryover year’syear sr regulareg ar tax tax liabilityiabi ty belowbelow theth deduction, reported on line 26, is an exclusion TMT liability for that year. There is no limit on item and does not give rise to an AMT credit. the number of years that an AMT credit may be For 2007, individual taxpayers are allowed an carried forward. initial AMT exemption of $66,250 on a joint return For individual taxpayers, only that portion of the ($44,350 on a single return). This amount is reduced current year’s AMT that relates to “deferral items” $0.25 for each $1.00 of AMTI before the exemption of adjustments are eligible to be carried forward that exceeds $150,000 on a joint return ($112,500 as an AMT credit; any portion of the AMT related on a single return). The exemption reduction results to “exclusion items” of adjustments and prefer- in a net AMT exemption of $49,492. ences is not eligible for AMT credit treatment. A two-tier AMT rate structure applies with the In order to apportion the AMT between deferral ﬁ rst $175,000 of AMTI (for married ﬁ ling jointly) and exclusion items, the normal procedure is to taxed at a 26-percent rate, and any excess AMTI compute the AMT including both deferral and taxed at a 28-percent rate. Since long-term capital exclusion items (the normal AMT computation), gains included in AMTI are taxed at the appropriate and then recompute the AMT with only exclu- regular-tax capital gains rates, the $9,000 long- sion differences. The difference in the two AMT term capital gain is taxed at a 15-percent rate for numbers is the AMT credit, since it relates solely both regular tax and AMT purposes. The tentative to exclusion items. 44 October 2008

The “exclusion” adjustment items are listed in Table 3. Code Sec. 56(b)(1), and the “exclusion” preference AMT Credit Carryovers items are listed in paragraphs (1), (5) and (7) of and Refundable AMT Credit Code Sec. 57(a). All other items of adjustment and preference are presumed to be “deferral” items. 2005 Incentive Stock Option $10,000 @ 26% $ 2,600 Thus, the computed $12,394 AMT credit for 2007 2003-06 Equipment, Sum of MACRS - ADS @ 26% $ 6,050 (Table 2) may be used in future years to offset AMT Credit Carryover to 2007 $ 8,650 regular tax liability (but not tentative minimum 2007 Refundable Credit tax liability). (2003 credit of $1,857 x 94%) $ (1,746) The Exclusion column in Table 2 illustrates how to Prior Years AMT Credit Carryover to 2008 $ 6,904 compute the AMT credit carryforward of $12,394. 2007 Credit Carryover to 2008 (from Table 2) $ 12,394 The 2007 Exclusion items will be entered on the Maximum AMT credit in 2008 $ 19,298 2008 Form 8801, Credit for Prior Year Minimum Tax. If the 2008 regular tax is greater than the tentative possibly receive a refundable credit of $2,600 in minimum tax, all or a part of the credit can be used 2009. Since the credits are refunded on a fi rst-in, to offset their regular tax. Any unused credit can be fi rst-out basis (Code Sec. 53(e)(3)(B)), the remain- carried forward to 2009. ing 2003 and 2004 credits will be refunded before The total tax expense shown in Table 1 is the 2005 credit. $49,447 (reported on line 63 on Form 1040). This amount is reduced by federal income tax withheld Planning Opportunities and any estimated tax payments. In addition, a refundable tax credit is allowed when the taxpayer As this case illustrates, taxpayers with AGI above has “long-term unused minimum tax credits,” $100,000 may find themselves in an AMT position defined as any minimum tax credit attributable to before considering other deferral and exclusion the adjusted net minimum tax for tax years before items. Taxpayers for the most part have little or no the thirdthirrd taxtaax yeary immediately preceding the cur- flexibility in reducing expenditures for state and rentent taxtax yearyeear (Code(C Sec. 53(e)(3)). In the Jones’ local taxes, interest expense on a home equity case,asete, thist wouldwooul be their minimumminim m tax credit loan, or for investment expenses subject to the fromromm 20032003 or eearlier.r. Marthaha placeded in sservice two-percent-of-AGI limit. Taxpayers may be able inn 22003003 ddepreciableeprece iab e equipequipmentment wwithth a reregular/ to restructure their investment portfolio to elimi- AMTMTM depreciationd epreciae i t on differenceerenc of $7$7,142,142 creating nate income from Private Activity bonds, reduce an AMT credit carryforward, which results in a foreigng source income so that the simplified for- refundable credit in 2007007 off $1,857.$$1 8557. SinceS nce theirtheir eignign taxt x ccreditredit canc be usedsed whenwhen foreignf reign taxtax paidpa AGI of $240,122 exceedsds the personalpersonal exemptionexemmption issle lessss thanthan$6 $600,00, renegotiater got ate investmentinvestment feesfeees to t phase-out threshold of $234,600, the credit is minimize AMT adjustments and preferences and reduced by six percentage points, resulting in a perhaps sell investment assets to pay off home refundable credit of $1,746 ($1,857 x 94%). The equity loans. disallowed portion of the 2003 credit of $111 is There may be greater fl exibility in the timing of carried forward to 2008. When the credit carry- AMT preferences and adjustments that are deferral forwards are added to the 2007 credit, which will items. Careful consideration should be given to be computed on the 2008 Form 8801, they will the timing of when incentive stock options should have a potential refundable credit of $19,298 as be exercised and when the stock should be sold. shown in Table 3. They may be entitled to a refund- Depreciable asset acquisitions should be spread able credit in 2008 of $2,897 ($111 from 2003 across two or more tax years in order to stay under plus $2,786 from 2004), subject to the phase-out the Code Sec. 179 election to expense threshold, requirements discussed above.33 especially in tax years in which the self-employed It is important to note that even though Howard taxpayer is making the maximum allowable re- sold the stock acquired through exercise of an tirement contribution. Also, taxpayers should pay incentive stock option in 2005, the AMT paid on special attention to accurately completing form the exercise is not refunded in 2007 because they 8801 so that refundable AMT credits are taken in are in an AMT position for that year. They will the fi rst year the taxpayer is eligible.

TAXES—THE TAX MAGAZINE® 45 Taxpayers Take the AMT to Court

Conclusion alternative minimum taxable income in excess of $150,000 receive little or no benefit from the The AMT has not evolved—it has mutated and AMT patch. Other legislative fixes have granted change is needed. A tax originally designed to selected taxpayers relief from the AMT—those with affect only the wealthy has become an April 15 FTC credits, those who have exercised ISOs where concern for every taxpayer. It appears that the the stock has declined in value, those who have “class tax” of 1969 has transformed into the “mass paid legal fees from court awarded judgments, tax” of 2007.34 If the AMT is a problem for so many, and those with unused long-term AMT credits. why does it continue to exist? Clearly, there is no For buildings placed in service after December coherent policy behind the AMT. As the case study 31, 2007, low-income housing and rehabilitation illustrates, taxpayers with gross income in excess credits will offset the AMT liability and tax-exempt of $100,000 are likely to be in an AMT position interest income from qualified residential project simply by virtue of the fact that they have signifi- bonds, qualified mortgage bonds and qualified cant itemized deductions and have two or more veterans’ mortgage bonds will not be an AMT dependent children. The Congress has responded preference.36 In spite of this patchwork of legisla- with an annual AMT “fix” with current proposals tive changes, many ordinary taxpayers continue to calling for a $75,000 AMT exemption for mar- be caught in the AMT trap. It will be difficult to ried taxpayers ($46,250 for unmarried taxpayers) eliminate the individual AMT because it raises a for the 2008 tax year.35 Yet, Congress has not significant amount of revenue. Taxpayers and their raised the phase-out range for the AMT exemp- tax advisors must continue to engage in the intri- tion, starting at $150,000 for married filing joint cate tax planning needed to minimize the current taxpayers ($112,500 if single). Without increas- AMT liability and hopefully maximize refundable ing the phase-out range, married taxpayers with long-term AMT credits.

ENDNOTES 1 AMTMT OwedOwed OdeO by Madeline Begun Kane, mary Opinion 2005-178 (Dec. 5, 2005). 18 Act Sec. 421(a)(1) of The American Jobs Cre- www.madkane.com,wwww.mmadkaane.coom 2005. 13 C. Kenton, 91 TCM 679, Dec. 56,419(M), ation Act of 2004 (P.L. 108-357) amended 2 Joi Jointint EEconomicconommic ComCCommittee Study, TheTh Al- TC MemMemo. 2006-13. Code Sec. 59(a) by striking paragraph (2), ternativeternative MiMinimumnimum TTax forr InIndividuals:ls: A 14 Code Sec.Se 62(a): GENERAL RULE—For which limited the AMT FTC to 90 percent GrowingGrrowinng Burden Burrden (May(Ma( 2001).1). purposes of this subtitle, the term “ad- of the TMT. 3 Da Davidavid EE.. RoRosenbaum,senbauma m, Tax PanelPan Wantsts tot justed grossgr income” means, in the case 19 T. Kappus, CA-DC, 2003-2 USTC ¶50,611, Endndn AlternativeAlt ternattive M Minimumimum Tax, N.Y.NY TIMESES, of an individual, ind gross income minus the 337 F3d 1053. July 21,21 2005.20055 following deductions: 62(a)(20) COSTS 20 J.J. Vax, 89 TCM 1411, Dec. 56,051(M), TC 4 Leonard E. Burman, William G. Gale, Jeffreyffrey INVOLVINGV DISCRIMINATIONINATIO SUITS, Memo.o. 2005-134; see alsoa P.M. Haver, CA-DC, Rohaly and Benjamin H. Harris,s, TaxTa Policyolicy ETC.ETC. —Any—Any deddeductionduc allallowablew ble undeunder 2006-120 1 USTCUST ¶50,269,¶50 269 444444 F3dF3d 656.656 TaxpayersTaxpaye Issues and Options, The AMT outut of Control,rol, thisthis chachapterpter fforo attattorneyey fefeeses and courtourt argueda d the treattreatyy witwithh GermaGermanyny trtrumpedumped tthe No. 5, Sept. 2002, available at www.irs. costs paid by, or on behalf of, the taxpayer Code provision and therefore they should not ustreas.gov/pub/irs-soi/urban.pdf. in connection with any action involving have to pay any AMT. The Court reasoned the 5 Congressional Budget Ofﬁ ce, Alternative a claim of unlawful discrimination (as Code could be read in harmony with the treaty Minimum Tax (A Revenue and Tax Policy defined in subsection (e)) or a claim of a since the treaty conditioned the tax credit on “the Brief), No. 4, Apr. 15, 2004, available at violation of subchapter III of chapter 37 limitation of the law of the United States …” www.cbo.gov/ftpdoc.cfm?index=5386. of title 31, United States Code or a claim 21 Smart Money Tax Guide, Avoiding the AMT 6 Jeanne Sahadi, Baucus, Grassley Introduce made under section 1862(b)(3)(A) of the on ISOs, available at www.smartmoney. Bill to Repeal AMT (2007), available at Social Security Act (42 U.S.C. 1395y(b) com/tax/capital/index.cfm?story=amtiso. http://money.cnn.com/2007/01/04/pf/taxes/ (3)(A)). The preceding sentence shall not 22 Code Sec. 56(b)(3) Treatment of incentive amt_legislation_introduced/index.htm. apply to any deduction in excess of the stock options. Code Sec. 421 shall not apply 7 SOI Bulletin, Fall 2007, Table 2, at 40. amount includible in the taxpayer’s gross to the transfer of stock acquired pursuant to 8 F.E. Falcone, T.C. Summary Opinion 2006- income for the taxable year on account the exercise of an incentive stock option. 139 (Sept. 12, 2006). Note that this is a small of a judgment or settlement (whether by Code Sec. 422(c)(2) shall apply in any case tax case procedure and, pursuant to Code suit or agreement and whether as lump where the disposition and the inclusion for Sec. 7463(b), may not be used as precedent sum or periodic payments) resulting from purposes of this part are within the same and is not appealable. such claim. tax year and such section shall not apply 9 S.W. Katz, 87 TCM 1222, Dec. 55,612(M), 15 N. Qureshi, FedCl, 2005-2 USTC ¶50,586, in any other case. The adjusted basis of any TC Memo. 2004-97. 67 FedCl 783. stock so acquired shall be determined on 10 CBO, supra note 5. 16 N. Qureshi, CA-FC, 2006-2 USTC ¶50,564, the basis of the treatment prescribed by this 11 J. Freeman, 82 TCM 643, Dec. 54,496(M), 200 FedAppx 973. paragraph. TC Memo. 2001-254. 17 R.A. Alston, T.C. Summary Opinion 2007- 23 D.A. Hernandez, DC-CA, 2006-2 USTC 12 S.R. Murray and K.M. Abouelnoor, T.C. Sum- 155 (Sept. 5, 2007). ¶50,545, 450 FSupp2d 1112. 46 October 2008

24 J.N. Palahnuk, 127 TC 118, Dec. 56,644; credit amount. option exercise. As discussed above, the see also P. Norman, DC-CA, 2006-2 USTC 30 For 2007, the exemption phase-out starts at computation of the AMT credit requires that ¶50,429, for a similar result. $234,600 for married ﬁ ling joint taxpayers the AMT be recomputed in each year with 25 A.J. Kadillak, 127 TC 184, Dec. 56,670. ($156,400 if single). only the Exclusion items. 26 R.J. Merlo, 126 TC 205, Dec. 56,494, aff’d, 31 A copy of the completed tax return is avail- 34 Burman, Gale, Rohaly and Harris, supra CA-5, 2007-2 USTC ¶50,554, 492 F3d 618. able from the authors upon request. note 4. 27 R.J. Speltz, 124 TC 165, Dec. 55,961, aff’d, 32 Tax Increase Prevention Act of 2007 (P.L. 35 Senate budget resolution (S. Con. Res. 70) CA-8, 2006-2 USTC ¶50,403, 454 F3d 782. 110-166). and House budget resolution (H. Con. Res. 28 D.D. Moss, DC-OR, 2007-1 USTC ¶50,249. 33 For simplicity, assume that the AMT credit 312) passed on March 14, 2008. 29 CCH-EXP, 2008FED ¶4872.033, Credit for carryforwards are 26 percent of the Deferral 36 Act Secs. 3012 and 3022 of the the Housing Prior Year Minimum Tax: AMT refundable items for depreciation and incentive stock Assistance Tax Act of 2008 (P.L. 110-289).

This article is reprinted with the publisher’s permission from the TAXES–THE TAX MAGAZINE, a monthly journal published by CCH, a Wolters Kluwer business. Copying or dis tri bu tion without the pub lish er’s per mis sion is prohibited. To subscribe to the TAXES–THE TAX MAGAZINE or other CCH Journals please call 800-449-8114 or visit www.CCHGroup.com. All views expressed in the articles and col umns are those of the author and not necessarily those of CCH.

TAXES—THE TAX MAGAZINE® 47