FEATURE | UNDERSTANDING AND PLANNING FOR THE AMT Understanding and Planning for the Alternative Minimum Tax 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 30 INVESTMENTS&WEALTH MONITOR ©2015 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved. IWM JanFeb15 composite BL.indd 30 1/13/15 2:08 PM FEATURE | UNDERSTANDING AND PLANNING FOR THE AMT 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.