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The Basics
8 ways to escape the AMT tax sting
'Alternative minimum tax' is a mind-numbing term, but its provisions, as a growing number of taxpayers now know, can hit you like a ton of bricks. Here's now to minimize your exposure.
By Jeff Schnepper

Want to understand the true essence of pain? Watch the face of a taxpayer who completes a tax return showing a $2,000 refund. Then remind him of the Alternative Minimum Tax (AMT), and tell him it results in a net $3,000 in additional taxes owed.
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It isn't pretty, and increasingly, you and I are becoming exposed to it. But with a good idea of what you’re up against, you can plan for the AMT and, I hope, avoid it entirely.

How it works
Congress designed the AMT in 1969 to cause pain. I jest. It's supposed to ensure that everyone -- especially the most affluent -- pays at least some tax. Without the AMT, the General Accounting Office says, 14,000 taxpayers in 1997 would have paid the government nothing in income taxes. (It doesn't always work. In 1998, 1048 taxpayers with incomes above $200,000 paid no income tax.)

It mandates a recomputation of your federal income tax bill at a flat 26% rate. (You pay the higher of the two bills.) It becomes a flat 28% rate on AMT taxable income over $175,000 for all taxpayers except those in the "married filing separately" category (for them, the 28% rate applies to income above $87,5000).

That rate is applied on your income after your standard or itemized deductions but before your personal exemptions. However -- and this is where the pain starts -- this amount (line 37 on your Form 1040) is then increased by what are called “tax preferences.” And finally, the number is reduced by an exemption amount that phases out as your AMT taxable income increases.

“Tax preferences” are nothing more than tax benefits or deductions that Congress has decided to give -- and then take away from you. Here’s what I mean.
  • If you took the standard deduction, forget it. It’s a preference.
  • Did you itemize? Medical expenses are normally deductible to the extent they exceed 7.5% of your adjusted gross income -- but not for the Alternative Minimum Tax. Under this computation, you can only deduct the excess over 10% of your adjusted gross income.
  • Forget the deduction for state and local income taxes or property taxes. They’re all tax preferences, and are added back into your AMT income. Congratulations if you live in a high income-tax state like New York or California, or pay substantial real estate or personal property taxes!
  • Kiss your miscellaneous itemized deductions goodbye. That means investment expenses, tax preparation costs, job hunting expenses and all non-reimbursed employee business expenses lose their tax benefits. (There’s a delicious irony here, however. In some situations, you can actually decrease your net tax due by not claiming these deductions.)
Want to really see a taxpayer cry? If you exercise an incentive stock option -- the ones the big bosses get -- there’s no immediate taxation. But the spread between the exercise price and the fair market value is a preference taxed by the Alternative Minimum Tax.

I can still hear the wailing of one of my clients who exercised incentive stock options at $50 a share when the stock was selling at $75 a share, only to watch the stock value dive to $10 a share. It’s bad enough to watch your potential profit disappear -- but it really hurts when the original $25 gain is found to be a tax preference and the taxpayer has to pay a tax on an investment where he actually lost money.

(Under normal circumstances, incentive stock options allow the executive to defer taxes until after he’s sold the shares. Exercising a non-qualified option, a staple of technology company compensation, triggers a taxable event if the market price of the stock is higher than the exercise price.)

Right now, the number of taxpayers who are exposed to this morass is relatively small -- about 1.3 million taxpayers, or about 1% of the total, the GAO says. But by the year 2010 (and probably regardless of the Bush tax cut), the number of taxpayers affected by the AMT will rise to as many as 17 million, or about one in six. The revenue gain for the Treasury: from $5.8 billion a year to $38.2 billion a year.

The reason more of us will be affected by the AMT in 2010 than now is that the AMT, unlike normal tax brackets, isn’t indexed for inflation. If it were indexed, as much of the tax code is, the projected increase would only be to 2.1 million taxpayers.

Among the taxpayers increasingly exposed will be those with large families because of exclusions of such items as child credits.

Plan, plan, plan!
Congress is currently reviewing several proposals to modify or eliminate the Alternative Minimum Tax. But, until lawmakers get their act together, what can you do to minimize the AMT's sting?

As always, the answer is planning. If you fear you’re going to be subject to the AMT, your strategy is to accelerate income and defer deductions.

Under the AMT, you’re going to be taxed at a 26% or 28% rate. If you’re in a higher bracket under the regular tax computation, income acceleration will yield a smaller net tax under the AMT. Alternatively, deduction deferral to a year in which you’re in that higher bracket should give you a greater tax benefit.

To accelerate income, you can:
  • Take prepayments of salary or bonus.
  • Redeem Series EE U.S. Savings Bonds.
  • Redeem certificates of deposit.
  • Recognize short-term capital gains.
  • Convert tax-free bonds to higher yielding taxable bonds.
  • Withdraw money from your IRA or other retirement funds.
To defer deductions, you can:
  • Depreciate rather than deduct business furniture and equipment.
  • Hold off on the payment of non-AMT deductible items.
Let’s consider two more issues: property taxes and state and local income taxes. If you pay your property taxes into escrow, I would normally suggest making your Jan. 1 mortgage payment or your January estimated state income tax payment on Dec. 31 in order to get the deductions in the earlier year. But, if you’re subject to the AMT, you won’t get any tax benefit from either payment – the taxes are added back into your income as a preference. So, effective tax planning here might be to move you to bunch such taxes into a year where they’re allowable -- i.e., when you won’t be subject to the AMT. The same planning strategy applies to medical expenses, investment expenses and employee business expenses.

The Institute for Policy Innovation in Lewisville, Texas has estimated compliance costs for the AMT to exceed $1.5 billion, almost one-third the total revenues generated by the tax. The inclusion of certain municipal interest as a tax preference increases the cost of capital for municipal borrowers. Unless you’re in the business of tax preparation, the AMT clearly is a deterrent to the promotion of efficiency or growth. I think it’s a bad tax!

Sen. Chuck Grassley, R-Iowa, chairman of the Senate Finance Committee, says he wants to get the AMT fixed, but so far Congress hasn’t addressed it. I think it’s a dark cloud over our tax system. I have a simple way to fix it -- get rid of the tax.