Avoiding The Alternative Minimum Tax

Whether AMT stands for "alternative minimum tax" or "another miserable tariff" in your book, the fact is the number of taxpayers exposed to the AMT has dramatically increased over the past several years. And while it is true that many of these new alternative minimum taxpayers are among the so-called nouveau riche of the tech boom just ended, a growing minority paying the AMT are average investors. In fact, one organization dedicated to reforming the alternative minimum tax features on its website some of the very middle-class people who've been hit with the AMT. Many of these taxpayers, claims Reform AMT, are struggling to work out payment plans with the Internal Revenue Service, while others have had to raid retirement and college funds or even sell homes in order to satisfy the AMT.

In the wake of bold new tax legislation (albeit legislation with a 10-year expiration date), investors may be wise to review how the AMT came about. In many ways, the alternative minimum tax is a classic case of "be careful what you wish for because you might get it." Conceived during a time of economic and stock market lassitude, when faith in the ability of average investors to see significant stock gains was low, the AMT can be criticized as a case of class warfare gone awry.

EAT THE RICH?

The alternative minimum tax (AMT) is a fairly clear example of politicians trying to tweak "unfairness" out of the tax system. As Maggie Doedtman, tax specialist with H&R Block and a self-professed "AMT junkie" explains, the AMT began in 1969 as "the minimum tax" and was geared toward reining in the 155 people with adjusted gross incomes in excess of $200,000 (approximately $1.1 million in today's dollars) who nonetheless paid no income tax.

While 155 might seem like an exceedingly small number of taxpayers upon which to base a revision of the tax code (in 1969, there were only between 15,000 and 20,000 taxpayers with adjusted gross incomes over $200,000), there was almost no political fallout from the enactment of the tax. According to Doedtman's research, more people in 1969 were writing Congress to complain about the 155 super-rich tax evaders than were writing Congress about the Vietnam War and that's supporters and opponents combined!

The alternative minimum tax as we know it was established in 1978 as part of a tax plan that also included a 15% "add-on minimum tax." Here, the emphasis was on growing revenues from the built-in tax preferences exemptions, deductions, and so forth for depreciation and real estate. Four years later, the 1982 tax plan exempted individuals from the add-on minimum tax, but moved many of the tax preferences to the alternative minimum tax.

But while tax reforms of various shapes and sizes have been championed in the years since, the alternative minimum tax rarely garnered enough indignation to make politicians seriously consider amending or ending the AMT.

While a variety of AMT reform bills still wait to circulate through Congress, there has been very little momentum behind a major overhaul of the tax. From 1993 until 2001, there were almost no adjustments made to the AMT. Ironically, this was precisely the period when a significant number of Americans slowly began to accumulate the exemptions, incentive stock options, and other normally deductible events that would one day make them unsuspectingly liable for a budget-busting AMT bill.

Says Doedtman: "When I first started doing taxes right around the 1986 tax change, the AMT really made sense, that we would have a separate or parallel system to deal with loopholes that allow people with really high incomes to escape taxation altogether. [It had a] noble purpose," she adds wryly. "Where we've gone since then, though, that's where the problem came in."

AMT AT WORK

Eva Rosenberg, tax advisor and found of the tax information website www.taxmama.com, asserts that those who tend to be affected by the AMT "tend to be people whose income is over $112,000 if they are single, or $150,000 if they are married. You're talking about people who have more than just a job and a home." Nevertheless, those with a high number of deductions or other potentially AMT triggering tax events would be wise to find out whether they will incur some measure of AMT liability.

The best way to figure out if you have AMT liability is to compute (or have your tax preparer or advisor compute) an alternative tax based on the separate set of guidelines that apply to the AMT. Essentially, two versions of your tax return a "normal" one and one based on Amt guidelines are prepared.

Just what does this separate set of guidelines consist of? Primarily, the AMT guidelines call for adding back to regular taxable income a number of exemptions and deductions that would be allowable under the regular income tax. While many people believe these exemptions and deductions are of the more esoteric sort the tax dodges that brought on the AMT in the first place the actual exemptions that are added back under the AMT are surprisingly commonplace. Multiple exemptions (for example, a family with five or more dependents), the standard personal exemption, state and local tax deductions (for those who itemize), and medical expense deductions are just a few that are not allowed under the AMT and must be added back in order to calculate the minimum tax.

There's more. Incentive stock options, which do not have to be reported on regular income tax, must be included when calculating the AMT. This aspect of the AMT has been particularly thorny in the wake of the dotcom boom, as thousands of workers partially compensated with stock options found themselves exposed to huge AMT liability after exercising their options.

Because all value of the options is added to taxable income in the AMT calculation, even options that do not appreciate well can still result in the taxpayer having to pay the AMT. Long-term capital gains are somewhat protected under the AMT, as they are when calculating the regular tax. However, taxpayers can still be liable for the minimum tax because of the way that long-term capital gains can lower the alternative minimum tax exemption amount.

Rosenberg explains how exercising incentive stock options can become a problem under the AMT. Most of those who exercised their stock options, receiving stock in exchange, sold their stock immediately. In this case, those receipts were simply counted as income; these taxpayers paid tax on money they had actually received.

However, she says, there were many who had to exercise their options because they were about to expire, yet didn't want to sell their stock because the stock was still appreciating at the time. The problems came (as many financial problems do) when the stocks stopped climbing. "If they paid for the option at $10 when the price was $30, then they simply paid the difference between what they paid for the option and the price paid on the fair market value," says Rosenberg. However, if the price dropped to $5, the taxpayer would still have to pay tax for exercising the option (the difference between $10 and $30), even though the individual now had a sizable loss on the stock position. "It really is the worst of both worlds," she says.

The alternative minimum tax exemption amount is the "standard deduction" of the AMT. The various AMT exemption amounts for the 2000 tax year were $45,000 for married persons filing jointly, as well as for qualifying widows or widowers; $33,750 for single persons or heads of household; and $22,500 for married persons filing separately. As mentioned, the Bush tax plan calls for increases in these exemption amounts.

After subtracting the AMT exemption amount from the AMT taxable income (regular income with the previous deductions and exemptions added back in), the actual AMT can be calculated. The tax rates for the AMT begin at 26% at the low end and rise to 28% for higher-income taxpayers. This is, incidentally, a narrower range compared to the regular income tax rates, which have a low tax of 15% and a high-end tax of about 39.5%. (In some ways, this difference in range is another thorn in the side of middle class AMT payers, insofar as the AMT top rate is lower than the regular top-tax rate that higher-income taxpayers might otherwise have to pay.)

Finally, the AMT tax is compared to the regular income tax. And in a classic case of "heads-I-win-tails-you-lose," taxpayers are required to pay whichever tax is greater.

AVOIDING THE AMT

There aren't many ways to avoid the alternative minimum tax, just as there aren't many ways to avoid any federal tax. However, you can minimize the effect of possible

AMT liability. Fortunately, those who must pay the alternative minimum tax can receive "AMT credits," which are calculated through a fairly Byzantine process of creating, in effect, yet another AMT. This AMT credit is based on a determination of how much of the current AMT liability comes from what have been called "timing" tax events, meaning those events that allow taxpayers to hold off reporting portions of their income.

Another way tax professionals can help their clients deal with the AMT is by having them not claim their maximum number of exemptions every year. For example, one tax preparer suggested to a client with a number of exemptions (including 10 deductions for dependent children) that only some of the exemptions be claimed in order to avoid a second consecutive year of AMT liability.

So, what's the outlook for wholesale reform of the alternative minimum tax? Like most aspects of tax policy, any reform of the AMT will have to make it through the usual political steeplechase. While suggesting that repeal of the AMT on incentive stock options should be nonpartisan, the Reform AMT organization does not underestimate the power of politics: "Republicans tend to favor total repeal. Democrats tend to favor reforms to fix parts of AMT. Major AMT reform or repeal would require that spending be cut or other taxes raised by about $200 billion over 10 years."

It should be said that President George W. Bush's tax plan responds to the problem of average taxpayers getting rounded up by an AMT net that is increasingly cast too wide. But if the overall tax relief of the Bush plan is only good for 10 years, then the AMT "relief" might not feel much like relief at all; the AMT exemption is increased by a little more than 8% for married couples and about 6% for single filers, but the increased exemptions expire in 2004. What makes matters worse for many average investors, however, is that the tax reductions from the Bush tax plan, which will help the wealthiest taxpayers deal with the AMT, will be less available to average investors many of whom will feel the full brunt of the AMT when taxes come due.

But until the AMT is repealed or reformed, those taxpayers who are subject to it are best off looking for professional tax advice in order to navigate it safely. Says Doedtman: "This whole tax was created on the basis of that minimal amount of people, the ones not paying their fair share, so to speak. Now, instead of 155 people we're talking about 1.3 million people affected by the Amt in 2000, and 1.7 million this year." Further, her research suggests that possibly 35 million taxpayers, one in four, could be affected by the AMT by 2010.

Rosenberg's advice for those with the potential for AMT liability is to act proactively. "If you sit down with somebody, and they understand what you are trying to do before you make the transactions then we can do some planning." She points to tactics ranging from filing as self-employed to creating losses to offset an AMT bill to creating a corporation that would allow for greater deductibility of certain expenses. But her underlying message on the AMT and tax preparedness is clear: "If I may be blunt," she says plainly, "if you are not seeing a tax professional to sort through this, you are a total, absolute schmuck."

David Penn may be reached at DPenn@Traders.com.