Alternative Minimum Tax: The Silent Threat
The alternative minimum tax (AMT), created in 1969, was initially aimed at very wealthy Americans who were paying little or no income tax. Over the years, it has slowly transformed into a silent threat catching middle class Americans off guard. The new targets for the AMT are employees cashing stock options, large families, small businesses, people with high medical bills, and those living in high tax states and cities.
The AMT has somewhat lower rates than regular income tax but it covers a broader base of income with many deductions disallowed. The IRS requires you to calculate both the AMT and regular income tax then pay whichever is higher. Many of the “normal” deductions are not allowed when computing the AMT. Some of the disallowed deductions are state and local taxes and paid miscellaneous itemized deductions such as unreimbursed business expenses. Individuals with large capital gains are at risk especially if they are also taking large deductions. Owners of partnerships, S corporations and other pass-through entities can end up with permanent AMT categorizton since they pass through the credits and depreciation that are disallowed or limited by the AMT. Stock options can create huge AMT liability for unsuspecting employees without careful planning. Double taxation arises when Americans living abroad are forced to pay AMT and foreign tax. Winning a lawsuit and receiving a substantial award can throw you into AMT territory unknowingly. Any of these scenarios can create a tax-planning nightmare, so it always pays to get the professional advice.
Some relief comes in the form of AMT credits, which are created when you actually have to pay AMT tax. You can use the AMT credits to reduce your regular tax liability in any year it exceeds your liability when calculated under the AMT. Unused credits can be carried forward if not used in a particular year.
The AMT has started to attack unsuspecting taxpayers since the 1986 tax act lowered regular rates and indexed the brackets for inflation. The AMT exemption at $49,000 per couple is not indexed. So inflation and income growth would now push more people toward the having to use the AMT. Taxpayers who use too many deductions, exemptions and credits find that their regular tax falls below the AMT amount. Once you reach the AMT liability threshold it does no good to take any additional deductions.
State and Local taxes can create an AMT situation if you are not aware that these are not deductible for AMT. If you pay two years worth of state tax in one year it could possibly throw you into the AMT. A good general rule to follow on this issue is to match income and deductions, take large deductions when you have a lot of income. And, as you might suspect, there are exceptions to this rule. so, if you have a significant change in your income or deductions, we recommend you give us a call.
Capital gains can push people into AMT territory. Capital gains are figured in measuring adjusted gross income which affects how much of your $49,000 credit is allowed. The result is that effective rates are often much higher than stated rates. Definitely check with a financial advisor if you expect to have large capital gains.
If you're running a small business be careful; the IRS could classify you as an employee instead of an independent contractor. If the IRS classifies you as an employee you can no longer file a Schedule C for self-employed taxpayers and all your deductions then become “miscellaneous” deductions. If you pay your own expenses and run your own company, make sure you take the right steps to qualify as an independent contractor. Once again, proper advice and planning is a must.
Tax credits are another area of AMT concern. Certain credits can’t be used to reduce your taxes below the AMT level, although they can be carried forward. If you have a choice between a credit and a deduction and are subject to AMT you are better off taking the deduction.
As mentioned above, incentive stock options can also be tricky AMT territory. The key to navigating this territory is if you exercise an ISO and do not sell the stock before the end of the calendar year, you owe AMT on the difference between what you paid for the stock and what it was worth at the time you exercised.
In all tax situations the best advice is to contact a tax professional to ensure that the silent threat won’t sting you. That's why we're here.