Alternative Minimum Tax (AMT)

It’s the IRS sucker punch: make too much money and have too many deductions, and you get ejected from the regular tax brackets into the dimension of alternative minimum tax. The original intent of the 1969 AMT had noble roots – ensure the nation’s wealthy couldn’t tax shelter all their income through deductions.

Over the ensuing years, the popular and practical definitions of “wealthy” adjusted for inflation, but the IRS code code didn’t. And although Congress has approved inflation-adjusted “patches” for many years, the current exemptions stand at just $58,000 for married couples filing jointly and $40,250 for single filers. The 2007 patch increased the levels effective to $66,250 for married couples and $44,350 for singles, and allows nonrefundable personal credits to be used to offset income when calculating AMT.

Now, instead of a tax net for the wealthy, the AMT has become the “stealth tax,”torpedoing upper-middle class taxpayers who don’t see it coming until they hit line 44 of their 1040. According to the Urban-Brookings Tax Policy Center, just 20,000 taxpayers fell under the AMT in 1970. By 2006, that had grown to 4 million. The IRS estimates that number could rise to more than 35 million by 2010.

The problem with the AMT lies not in its tax rate – 28 percent compared to the 35 percent top bracket of the regular tax system – but in the deductions it disallows. You can still take mortgage interest and charitable donations, but the AMT excludes state and local income taxes and property taxes, unreimbursed business expenses, child tax credits, tax preparation fees, legal fees and home-equity loan interest.

Without those exemptions, you end up with higher taxable income. Simply living in a state with high property taxes or having a large family can trigger the AMT, as can a mortgage deduction.

Exercising incentive stock options may be the biggest, most unexpected whammy. Under the AMT, the difference between the exercise price and the market price counts as income. Before you exercise incentive stock options, consult a financial professional. The number of options you exercise and the timing can significantly impact the amount of taxes you’ll owe on the gain.

Private activity bonds, municipal bonds for public projects like airports and stadiums, lose their tax-free status in AMT land. The offering circular for these bonds usually carries a disclaimer saying they may be subject to the AMT. Consult your financial professional before investing in or selling private activity bonds.

The usual tax strategy of delaying income and maximizing deductions may push you into the AMT zone. A financial or tax professional can help you balance ordinary income against deductions, including state taxes and when you pay them, to at least minimize if not eliminate the AMT hit. Such planning should look beyond the present tax year to ensure that minimizing AMT exposure in the current year doesn’t maximize it the next.

Although the income patches Congress has made to the AMT levels have kept some taxpayers out of the AMT’s clutches, a permanent repeal seems unlikely. The Treasury has estimated the resultant loss to the tax coffers would be $500 billion over 10 years. For now, the best strategy will be constant vigilance and competent tax and financial counsel to ensure the AMT doesn’t take the wind out of your financial sails.

Any tax or legal information provided in this article is merely a summary of our understanding and interpretation of some of the current income tax regulations and is not exhaustive. Investors must consult their tax advisor or legal counsel for advice and information regarding their specific circumstances.