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The ABC’s Of The AMT

Why have an alternative minimum tax?

It is difficult to imagine a time when wealthy families did not pay any federal income tax. Instead of paying the U.S. Treasury like the rest of us, these families paid for high-priced legal advice, as well as the services of big accounting firms and other financial advisors, to develop slick strategies that hid money and income where the IRS could neither find nor tax the assets and earnings.

By the late 1960s, the U.S. Congress peeked out from under its see-no-evil blindfold and stopped all the winking and nodding, enacting laws to create a parallel universe called the Alternative Tax to catch those clever enough to avoid paying their income tax. Dissatisfied with the results, Congress later improved the legislation in an evilly ingenious way by not indexing the tax to inflation and renaming it the Alternative Minimum Tax (AMT), arguably the most reviled tax of them all.

We ended up receiving a law of unintended consequences with the AMT snagging billions of dollars from taxpayers of more modest means throughout the years since Congress enacted the law. Today, the AMT exemption is only $69,950 for married couples filing jointly and $46,200 for all others (meaning single, head of household or married individuals filing separately). This means if your income exceeds either of these thresholds, then you may have an AMT liability and not even know it, depending on your individual circumstances.

What is the AMT?

For starters, the AMT is neither “alternative” nor “minimum.” In fact, the AMT is mandatory for those who fall under its jurisdiction and is hardly “minimum,” with tax rates ranging from 15 percent to 28 percent. One AMT system applies to individuals and households, including those who own closely held businesses that create flow-through income to the taxpayer’s individual tax return. The other AMT applies to C corporations.

The AMT targets certain income and expense items with characteristics the government deems typical of higher-income taxpayers, which otherwise would deprive the treasury of income under the non-AMT portion of the Internal Revenue Code. In other words, the AMT is a “gotcha” tax.

Who is subject to the AMT?

The simple answer to this question is that you might be subject to the AMT, even if you escaped AMT liability in past years. The pie chart on the following page, provided by the Tax Policy Center, shows that by 2010, fully 45 percent of households with income at or below $200,000 would be subject to AMT liability. The AMT is clearly no longer a wealthy person’s tax.

Small business owners earning flowthrough income from subchapter S corporations, partnerships and limited liability companies should be especially cautious. Most tax preparation software for consumers and CPAs alike cannot adequately perform AMT calculations and often cannot detect whether or not an AMT liability exists. Even IRS agents struggle with the AMT—this is a frequent criticism of the tax code.

How does the AMT work?

Knowing what triggers the AMT may help you plan accordingly. Depending on the level, nature and sources of income, the AMT sends a costly signal to taxpayers who:

  • Have more children;
  • Incur substantial medical expenses;
  • Pay state and local income taxes, personal property taxes, foreign taxes or real estate taxes on primary residences, vacation homes and rental income property;
  • Pay for financial advisory services to hedge funds, for capital markets advice or to a brokerage house for “wrap account” fees, among others;
  • Pay extraordinary professional fees such as architectural or attorney fees (except in certain anti- discrimination lawsuits); or
  • Have passive income such as rents, royalties, interest (even tax-free interest) and dividends, plus other income not falling under W-2 wages or certain 1099 categories.

The good news is that Internal Revenue Code Section 55(e) exempts many small C corporations from AMT liability, namely those with average sales of $5.0 million or less in their first three years of operation and less than $7.5 million annually on a three-year rolling average after three years. In addition, any corporation paying AMT in the past has a 93 percent chance of overpaying the tax by an average of $11,638, according to the U.S. Treasury Department’s Inspector General.

AMT credits

The complexity of the AMT becomes apparent when CPA firms and software sold as a one-click tax solution cannot comply with this most challenging portion of the tax code. If the AMT itself is difficult to sort out, then AMT credits can be even more baffling.

Theoretically, the corporate AMT can take the form of a tax payment in advance on certain “deferral preferences,” a fancy term for costs of doing business that create timing differences such as a non-cash expense like accelerated depreciation on machinery and equipment. In any case, AMT credits claimed later should equalize any advance tax payments when the preference reverses as income, such as when a fully depreciated piece of machinery is sold for a price greater than the depreciated “book” value. Unfortunately, the AMT credit does not work quite that way.

Taxpayers can expect to wait many years before using their AMT credit. Due to the way the law is structured, taxpayers may find their AMT credit reduced, even when not previously used to offset regular tax, once they are eligible to use the AMT credit. This makes tax planning and compliance more difficult and frustrating.

Is the AMT unfair?

When you fill your tank with gasoline, you easily make the connection between the cost of federal and state gas taxes and the benefit of having quality roads and safe bridges. The same reasoning applies when paying property taxes for schools and libraries or buying an airline ticket with TSA security fees and airport infrastructure charges added on. But where is a similar connection between the AMT and some tangible benefit to taxpayers?

The AMT is little more than a massive wealth transfer with neither rhyme nor reason except that, in the past, a handful of wealthy Americans escaped paying income tax and Congress put a stop to it. In doing so, a revenue tidal wave derived tax receipts from more modest income individuals of far less wealth who never purposely avoided any tax like those wealthy families once did.

We have the AMT because with so many taxpayers now in the revenue dragnet, the AMT grew into an important moneymaker for the U.S. Treasury. The AMT will generate between $800 billion and $1.5 trillion for the government over the next 10 years. With a proposed budget deficit topping $1.5 trillion, politically and fiscally speaking, the administration cannot afford to repeal the AMT just yet, not until a giant pushback from us, the governed, comes along.

What can you do?

So why do American taxpayers tolerate such a costly and unwieldy tax, one that even the IRS does not understand? In colonial America, tar and feathering was a common punishment ordinary people meted out to abusive tax collectors. Other events in American history have demonstrated Americans’ aversion toward unfair taxes such as the Boston Tea Party, the Battle of Alamance, the Depression-era Chicago Tax Strike and the actions of Howard Jarvis.

Even if some regard the AMT as unfair because it stings an ever-growing number of ordinary taxpayers each year, you can take control over your own tax situation. Planning is the mother of success. If you do not approach taxes with a plan, there is no question about it—you will certainly pay too much.

Sound financial planning, along with a professional strategic tax plan, will help determine how the AMT will influence your tax return. By dealing squarely with the AMT and other tax and asset protection issues, you can determine how much you and your family will be able to keep from what you worked so hard to earn.