Understanding and Planning for the Alternative Minimum Tax

FEATURE | UNDERSTANDING AND PLANNING FOR THE AMT

By Michael E. Kitces, MSFS, MTAX, CFP®, CLU, ChFC, RHU, REBC, CASL

he alternative minimum tax has its systems: the regular tax system and the AMT—Basic Calculations roots in the late 1960s, as the gov- alternative minimum tax system. Taxpayers The basic approach of the AMT system is rel- T ernment sought to increase taxation, ultimately owe a tax liability based on atively straightforward. On a stand-alone in large part as a means to help pay for whichever of the two systems produces the basis, it nearly functions as a basic flat tax: the ongoing Vietnam War. Research at the higher tax liability. Thus, to the extent the Add up your income, claim one large exemp- time revealed that so-called “tax expen- AMT results in a higher tax burden than tion (to relieve lower-income taxpayers from ditures”—tax deductions or exclusions the regular system due to restrictions on any exposure to the AMT system), and flat- legally granted under the Internal Revenue various tax deductions, exclusions, and tax the rest. In practice, the AMT is only Code that functioned as an expenditure by other preferences, then the AMT pushes up slightly more complex: Taxpayers claim a few Washington to support/subsidize a particu- the total tax liability and sets the bar as the other deductions besides the broad-based lar social/public policy activity—had grown new alternative minimum amount of tax exemption, the exemption itself phases out at to an incredibly high level and represented that must be paid. higher income levels, and the system has two a significant drag on total tax revenue. tax brackets—26 percent and 28 percent— The solution at the time was to allow tax Over the ensuing decades the AMT system not just a single flat rate. Nonetheless, the expenditures for the majority of taxpayers shifted. It began as a method to ensure that AMT system is actually much simpler than but scale back or outright reverse them those—generally high-income folks—who the regular tax system, which has far more for a portion of higher-income taxpayers. were taking aggressive advantage of various deductions to calculate, phaseouts to account The call for an implementation of the new tax preferences would still be subject to for, and seven tax brackets to navigate. system was hastened when a “scandalous” some minimum tax liability and pay their report hit the media in 1969 that 155 “fair share,” but tax reform in subsequent The determination of any AMT liability is high-income individuals earning more than decades significantly adjusted the effective far more complex in practice, though, due to $200,000 in 1966 (more than $1 million of scope of the AMT. Many of the tax prefer- the fact that the tax code does not actually income in today’s dollars) paid $0 in tax lia- ences that originally were allowed for regu- determine AMT exposure by adding up bilities that year due to the legal implemen- lar tax purposes and then disallowed under income, subtracting a few deductions and tation of various tax exclusions and deduc- earlier versions of the AMT have since, exemptions, and applying the two tax brack- tions. Thus, the alternative minimum tax from ongoing tax reforms since the late ets to whatever is left. Instead, the AMT is (AMT) was designed in essence to ensure 1960s, been stricken entirely from the tax calculated by starting with the result under that even—and especially—high-income code. As a result, instead of having a regu- the regular tax system and then winding taxpayers paid their “fair share” of taxes, lar tax system with many deductions and backward to determine what the tax liability under one system or the other. exclusions, and an AMT system that put would have been under the AMT system. many of them back into income for tax In its early form, the AMT simply limited purposes, we now have two systems that AMT is calculated by first identifying the the amount of an individual’s income that share the majority of their deductions, individual’s Taxable Income and then add- could be excluded or treated as tax-exempt. exemptions, and exclusions, and result ing back any personal exemptions that were For example, if you earned $200,000, and in remarkably similar tax liabilities for a claimed under the regular tax system. Next, all $200,000 was excluded from income large number of clients. In turn, this means the taxpayer adds or subtracts any AMT under various rules, the early AMT simply that small changes to either the regular or adjustments (alternative methods to calcu- stated that you couldn’t exclude more than AMT systems at the margins can result in late gains, losses, and deductions under the 50 percent of that income, so at least a large number of taxpayers crossing the AMT system), and adds back any AMT $100,000 of it must be taxed. In later years, line from one system to the other, which preference items (specific deductions or it was expanded into its present form, creates complexity and planning opportu- exclusions under the regular tax system that which establishes an overlay of two tax nities for many. are outright disallowed under the AMT

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system). Once personal exemptions have Figure 1: Steps to Calculating the AMT been added back, AMT adjustments have been added and subtracted, and AMT pref- Regular Tax System AMT System erences have been added such that only a Gross Income Taxable Income from Regular System limited number of the regular tax system’s – Above-The-Line Deductions + Personal Exemptions original deductions or exclusions remain, = Adjusted Gross Income +/– AMT Adjustments – Personal Exemptions + AMT Preferences the resulting amount is called “alternative – Standard/Itemized Deductions = AMTI minimum taxable income” (AMTI). = Taxable Income – AMT Exemption × Tax Rates × AMT Tax Rates Once AMTI has been determined, the tax- = Regular Tax Liability = Tentative Minimum Tax payer deducts from it the AMT exemption amount—the large single exemption/ deduction that all taxpayers get unless it’s and deductions are calculated, although in Minimum Tax Credit phased out due to high income—and the today’s tax code many of the AMT adjust- The minimum tax credit (MTC), reported remainder is taxed at a rate of 26 percent ments simply represent outright deductions on IRS Form 8801, is created by AMT on the first $182,500 (in 2014), and 28 per- under the regular tax system that must be adjustments that affect the timing of cent on the excess. These calculations are fully added back for AMT purposes. income, such as the exercise of incentive summarized in figure 1. stock options (where taxes on the gain Some of the most common AMT adjust- would be paid but the AMT accelerates the Once the tax rates have been applied to ments include the following: timing). When created by an AMT-related AMTI (less the AMT exemption), the result- timing adjustment, the MTC reduces an ing amount is called the “tentative minimum • Miscellaneous itemized deductions sub- individual’s future regular income taxes tax” and represents the taxpayer’s liability ject to the 2-percent-of-AGI floor due, but only to the extent that it does not under the AMT system. This is then com- • State and local (and foreign) taxes paid push the individual’s regular tax liability pared to the individual’s original tax owed • Medical expense deductions recomputed below the tentative minimum tax liability. under the regular tax system. If the regular with 10-percent-of-AGI floor If the MTC cannot be (fully) utilized, it is tax liability exceeds the AMT system’s tenta- • No deduction for home equity indebt- carried forward to the following tax year tive minimum tax, then that is simply the edness mortgage interest (acquisition until it is fully used. amount owed. However, if the tentative min- indebtedness mortgage interest remains imum tax liability exceeds the amount owed deductible) Example 2. Harold has a $12,000 mini- under the regular tax system, the individual’s • Inclusion of incentive stock option bar- mum tax credit. This year, his regular tax regular tax liability is increased to equal the gain element, which is the difference liability is $21,000, and his tentative mini- tentative minimum tax. Technically, this between the strike price and the current mum tax is $19,200. As a result, Harold can increased amount of taxation—to bring up market price; if the stock is sold before the claim $1,800 of his minimum tax credit, the regular tax liability to equal the tentative end of the year, triggering income recog- pushing his regular tax liability from minimum tax—is the amount that actually nition for regular tax purposes, there is no $21,000 down to $19,200, to match his ten- goes on the line labeled “Alternative AMT adjustment because it already was tative minimum tax. The remaining Minimum Tax” on the tax return. recognized for regular tax purposes $10,200 of his MTC will be carried forward • Alternative depreciation schedules for to the following tax year. Example 1. Under the regular tax system, business property (under the AMT sys- Jim’s total tax liability is $18,000. When recal- tem, property is generally eligible for The purpose of the MTC is to ensure that culated under the AMT system with the less-favorable depreciation deductions, an individual does not recognize income appropriate adjustments, preferences, etc., and the recalculation may result in a for AMT purposes in one year, and then Jim’s tentative minimum tax is $18,400. positive or negative adjustment for AMT recognize income again on the same prop- Because Jim’s tentative minimum tax exceeds purposes, depending on the point in the erty with the same gain in a subsequent his regular tax liability, Jim will have to pay property lifetime) year, by assessing the AMT liability early $18,000 of regular taxes plus $400 of AMT • Alternative gains/losses on disposition but having it create a tax credit to offset the (the difference between the two), which will of business property (because deprecia- second point of taxation in the future. bring his total tax liability up to $18,400, tion is calculated differently for AMT equaling his tentative minimum tax. purposes, when property is disposed of AMT Preference Items the gains and losses must be calculated AMT preference items represent tax exclu- AMT Adjustments under each tax system) sions or preferences that apply under the In theory, AMT adjustments represent dif- • No standard deduction or personal regular tax system but are not allowed for ferent ways that gains, losses, exclusions, exemptions AMT purposes. Many of the original AMT

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• high state income tax rates Table 1: AMT Example under Two Tax Systems • high property tax rates (or substantial Regular Tax System AMT System amounts of property) Income $175,000 $175,000 • large number of dependents Deductions $49,000 $20,000 • high miscellaneous itemized deductions Exemptions $19,750 $0 (subject to the 2-percent-of-AGI floor) Taxable Income $106,250 $155,000 Exclusion $0 $82,100 Although any number of the AMT adjust- Total Tax $18,275 $18,954 ments and preferences discussed above may potentially lead to a point where the tenta- Table 2: Evaluating Potential Exposure to the AMT (2014) tive minimum tax exceeds the individual’s regular tax liability (i.e., AMT is due), in Amount of AMT adjustments and preferences that practice the common AMT adjustments may cause AMT to apply listed here will be the ones that trigger Regular Taxable Income Joint Single AMT exposure for most clients. This is $50,000 $57,456 $34,939 especially true in the current tax environ- $100,000 $46,379 $30,856 ment, where a relatively modest amount of $150,000 $36,971 $23,933 total AMT adjustments and preferences $200,000 $30,048 $18,581 from the common list are sufficient to trig- $300,000 $21,421 $12,866 ger AMT exposure. $400,000 $15,707 $35,699 $500,000 $30,010 $77,128 Table 2 shows the total amount of AMT adjustments and preferences that it takes preference items have since been disallowed excess of $182,500). Compared to the regu- for AMT to apply, based on an individual’s or changed under the regular tax system, lar tax system, which has far more deduc- taxable income; i.e., the amount of add- and as a result they are no longer AMT tions to analyze and evaluate, many with backs that must apply after all deductions preference items. Consequently, very few their own adjusted gross income (AGI) have been taken to lead to an AMT liability. AMT preferences commonly apply anymore threshold, a varying number of exemptions, and even the following are likely applicable and seven tax brackets drawn at arbitrary As table 2 reveals, when income begins to to only a limited number of taxpayers: intervals instead of one simple threshold, rise, the raw amount of AMT adjustments the AMT is arguably a simpler system from required to become subject to the AMT Tax-exempt interest on private activity this perspective. A comparison between the declines, due to the phaseout of the AMT municipal bonds becomes taxable. If two, using a hypothetical example for a exemption (discussed further below). At bond interest is received from private activ- family of four that donates $5,000 to char- moderately high levels of income, this can ity municipal bonds and was excluded from ity, pays $15,000 in mortgage acquisition reach the point where the standard deduc- income for regular tax purposes, it must be indebtedness interest and $5,000 of home tion and personal exemptions alone—which added back to income for AMT purposes. equity interest, $9,000 in real estate taxes, all taxpayers receive, even if they do not and $15,000 in state income taxes, is sum- claim any itemized deductions—can come Certain oil and gas depletion and intangi- marized in table 1. It results in an AMT lia- close to triggering the AMT. In fact, with a ble drilling-cost deductions are limited. bility of $679 (the difference between standard deduction for married couples of The tax code allows for increased deductions $18,954 and $18,275). $12,400, and two personal exemptions (hus- associated with oil and gas depletion and band and wife) of $3,950 each, a married intangible drilling cost (IDC) deductions for Evaluating Potential AMT Exposure couple has a baseline of $20,300 of AMT investors in such business ventures. Under Because the most common AMT adjust- adjustments. As shown in table 2, however, the AMT, certain excess deductions are dis- ment (and preference) items these days are the threshold amount is $21,421 for a mar- allowed, and taxpayers receive only a more relatively typical deductions, not rare and ried couple approaching $300,000 of limited straight-line depreciation deduction. esoteric aggressive tax preferences, AMT income; these couples may be unable to exposure itself is most often triggered by avoid being subject to the AMT because Calculating AMT Exposure large amounts of those typical deductions virtually any additional deductions can be The AMT is not complex at all. In fact, it (which in turn lead to large positive AMT sufficient to trigger AMT exposure. In other has fewer deductions, just one exemption, adjustments to AMTI, increasing the tenta- words, clients at these income levels are and one tax rate of 26 percent (or two for tive minimum tax and the likelihood of an nearly subject to the AMT simply by virtue those in the higher AMT tax bracket of AMT liability). Some of the most common of personal exemptions and the standard 28 percent for AMTI-after-deductions in AMT triggers include the following: deduction alone.

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Notably, at very high income levels, the Figure 2: Marginal AMT Tax Rates as AMT Exemption Phases Out AMT exemption is fully phased out, and

additional income is being taxed at the cur- Marginal Individual AMT Rates rent top ordinary income tax bracket of 40.0% End of AMT* 39.6 percent, while the top AMT rate is only 37.5% 28 percent, and as a result the required 35.0% AMT add-backs to trigger the AMT actu- 32.5% ally begins to grow larger and taxpayers 30.0% Defer/Spread Avoid the AMT Accelerate become less exposed to the AMT. Income Here “Bump” Zone Income Here 27.5% The AMT Exemption Phaseout 25.0% As discussed above, all taxpayers receive a $0 $22,000 $44,000 $66,000 $88,000

flat AMT exemption amount, which in 2014 $110,000 $132,000 $154,000 $176,000 $198,000 $220,000 $242,000 $264,000 $286,000 $308,000 $330,000 $352,000 $374,000 $396,000 $418,000 $440,000 $462,000 $484,000 $506,000 $528,000 $550,000 $572,000 $594,000 is $82,100 for married couples and $52,800 Individual for single taxpayers. However, the AMT exemption amount itself begins to phase out Marginal Married Filing Jointly AMT Rates 40.0% at $0.25 per $1 of income above specified End of AMT* 37.5% thresholds of $156,500 of AMTI for married couples and $117,300 of AMTI for singles. 35.0% 32.5% Defer/Spread Avoid the (Bigger) AMT Accelerate Thus, higher income levels that phase out the 30.0% Income Here “Bump” Zone Income Here AMT exemption do not necessarily automat- 27.5% ically trigger AMT exposure. As income rises 25.0%

and the AMT exemption is phased out, more $0 and more income is subject to the minimum $22,000 $44,000 $66,000 $88,000 AMT tax rate of 26 percent, and the phase- $110,000 $132,000 $154,000 $176,000 $198,000 $220,000 $242,000 $264,000 $286,000 $308,000 $330,000 $352,000 $374,000 $396,000 $418,000 $440,000 $462,000 $484,000 $506,000 $528,000 $550,000 $572,000 $594,000 Married Filing Jointly out itself causes higher marginal tax rates for clients in that income range. *End of AMT depends on exact combination of income and AMT-related deductions and may vary higher or lower from one individual/couple to the next. Source: Michael Kitces, www.kitces.com Therefore, clients who are phasing out the AMT exemption face a higher marginal tax rate than their AMT tax bracket alone AMTI of $484,900. Once the AMT exemp- be separated into the following three AMT implies. Those in the 26-percent AMT tax tion has been phased out entirely, any addi- planning categories: bracket face a marginal tax rate of 26% × tional income is simply taxed at the 125% (due to AMT exemption phaseout) = 28-percent upper AMT tax bracket, and it Regular Tax Land 32.5 percent. Those in the upper AMT tax continues to be until eventually income rises These clients are firmly rooted in the regu- bracket face a marginal tax rate of 28% × high enough to revert back to the 39.6-per- lar tax system and only an extraordinary 125% = 35 percent. cent regular tax bracket, as shown in figure 2 AMT adjustment or preference item would (though the exact crossover point will vary be sufficient to cause AMT exposure. For clients already subject to the AMT, this depending on the portion of deductions that phaseout of the exemption leads directly to are AMT adjustments or preference items). In practice, this means that unless the client a higher marginal tax rate. For those not yet has a very large event such as the exercise subject to the AMT, the phaseout of the It is also notable that the AMT exemption of incentive stock options (ISOs), there is AMT exemption can ultimately lead to the phases out simply based on AMTI, regard- little direct planning to do with respect to point where a relatively modest level of total less of the type of income that makes up the AMT. If the client doesn’t have any ISOs AMT adjustments is sufficient to result in at AMTI. Consequently both ordinary or expect any other significant new AMT least some AMT liability (see table 2). income and long-term capital gains can adjustments, the client can largely ignore trigger an AMT exemption phaseout. the AMT system. A significant planning On the other hand, at some point the entire opportunity emerges for clients who may AMT exemption is phased out; at a rate of Planning Implications of AMT have been previously subject to the AMT $0.25 per $1 of income, the $82,100 AMT Planning opportunities and strategies in and may have a minimum tax credit carry- exemption for married couples is fully response to the alternative minimum tax forward available to use. Otherwise there is phased out after $328,400 of income has depend on the potential level of exposure little direct AMT planning for clients who been earned above the threshold, or a total that a client faces. Accordingly, clients can are squarely in regular tax land.

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On the Border Clients who are considering borrowing ties to traditional tax planning. The AMT These clients sit close to the boundary against a primary residence with a cash-out system is actually a relatively simple tax between being subject to the AMT or not— refinance or home equity loan that will not system: Add up all income, take relatively i.e., the tentative minimum tax is close to be used to build or substantially improve few deductions and one large exemption the client’s regular tax liability—such that the residence, must realize that the loan afforded to everyone (unless phased out at any changes made at the margin to income interest is home equity indebtedness and higher income levels), and tax the rest on a or deductions could materially impact total will not be deductible in AMT land. nearly flat tax basis (with two tax brackets, AMT exposure and liability. 26 percent and 28 percent). It is important to remember that many other Significant tax savings are available to clients itemized deductions are no longer deductible Yet in practice the determination of AMT who can effectively time deductible expendi- for AMT taxpayers as well, including every- exposure is far more difficult: Add up all tures to fall in regular tax years (when they thing classified as a miscellaneous itemized income; claim above-the-line deductions, are deductible) and not AMT years (when deduction subject to the 2-percent-of-AGI personal exemptions, below-the-line they would be adjusted back into income). floor. On the other hand, clients may be able deductions (itemized or the standard In practice, some types of deductible pay- to claim miscellaneous itemized deduction deduction); determine a tax liability using ments offer little flexibility in the timing of expenses elsewhere on the tax return—e.g., the regular tax tables; then go back to tax- payments (i.e., real estate taxes). However, tax preparation fees associated with a per- able income, add back personal exemp- some types of payments (i.e., investment sonal business may be claimed as a business tions, add and subtract AMT adjustments, expenses) may offer a little more flexibility expense on Schedule C (not subject to AMT) add back AMT preferences; and only then and others, such as fourth-quarter state esti- rather than as an itemized deduction on reach the point of taking the AMT exemp- mated tax payments, which can be paid Schedule A (subject to AMT adjustment). tion and applying the basic AMT tax shortly before the end of the current tax year rates—just so that a tentative minimum tax or at the beginning of the following tax year, Planning opportunities for clients slightly on can be calculated to measure against the should be timed for payment in the year the AMT side of the border include claiming regular tax liability so that the difference in where it will yield a tax deduction. itemized deductions instead of the standard turn can be measured as the actual AMT deduction or allowing eligible children to liability. The complexity is not the AMT Other potential strategies may include not claim themselves as dependents. Furthermore, system itself but the fact that it is deter- taking the standard deduction (if the stan- strategies that accelerate income into an AMT mined relative to the regular tax system. dard deduction will be lost anyway for year may be relevant if the client may be out AMT purposes, but some underlying of AMT land in a future year due to higher A thorough understanding of a client’s cur- deductions would be available for AMT, it income, given the top AMT tax bracket of rent and prospective AMT exposure ulti- may be beneficial to itemize even though only 28 percent. As a result, managing the mately should be supported by a multi-year the deductions are nominally less than the AMT exemption becomes a key tax plan- tax projection. At a minimum, to address standard deduction), and having clients ning consideration for clients in AMT land. the tax planning implications, the planner consider whether any family members who should have some understanding of are claimed as dependents could legiti- A client’s potential exposure to the AMT whether the client is likely or not to be sub- mately support themselves (e.g., college-age can be determined by referencing the AMT ject to the AMT this year, and next year, so children) to shift the dependent exemption exposure chart in table 2. If the client’s total that the planning process can begin. to the child’s own tax return (given that it AMT adjustments and preference items won’t provide any benefit to the parents add up to an amount far lower than the Michael Kitces, MSFS, MTAX, CFP®, CLU, subject to the AMT). Notably, though, it is number indicated in table 2 for a given CHFC, RHU, REBC, CASL, is a partner and still not an effective strategy to avoid claim- level of taxable income, then the client is in director of research for Pinnacle Advisory ing deductions that are AMT adjustments regular tax land. If the total AMT adjust- Group; he also publishes the e-newsletter just to keep from paying the AMT, because ments/preferences for the client add up to The Kitces Report and the financial-planning that will simply raise the client’s regular tax an amount that is close to the amount listed industry blog Nerd’s Eye View. He earned a liability by the same amount (or more). in table 2, the client is on the border. If the BS in psychology with honors from Bates total amount of AMT adjustments and College, a master’s in taxation with honors AMT Land preferences far exceeds the amounts listed from University of Tulsa, and an MS in finan- These clients’ tentative minimum tax is so in table 2 for a given level of taxable cial services from American College. Contact far above the regular tax liability that they income, the client is already in AMT land. him at [email protected]. cannot help but be fully subject to the AMT system, and only a major change in income, Bringing It All Together deductions, or the tax law itself would end Planning for clients in a world of increasing the AMT exposure. AMT exposure introduces new complexi-

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