Understanding the Alternative Minimum Tax (AMT)

The year it went into effect, the Alternative Minimum Tax affected fewer than 20,000 taxpayers. Now that number is in the millions. Since the Alternative Minimum Tax affects more people, it's seems like a good idea to stop viewing it as a vague, shadowy boogeyman and shine a light on it to see what form it really takes.

What is the Alternative Minimum Tax?

If you aren't sure what the Alternative Minimum Tax or AMT is, you can divine it from the name. The AMT is an alternate set of rules used to determine the minimum amount of tax that persons should be required to pay. The AMT was first introduced in 1969 in an effort to ensure that those with very high incomes paid their fair share of income taxes rather than escaping taxation through loopholes or special tax benefits. Now millions of taxpayers must suffer through completing the forms to see if they must pay this alternative minimum tax because the AMT is not automatically adjusted for inflation. Sadly, many of those taxpayers don't have a very high income or don't claim a lot of special tax benefits.

Who Must Pay the Alternative Minimum Tax?

Unfortunately, the only way to know for certain whether or not you have to pay the alternative minimum tax is to calculate your tax liability both ways. If your AMT liability is larger than your standard income tax liability, then you have to pay the alternative minimum tax. There are certain circumstances and tax items that are more likely to trigger the AMT. The most common triggers are gross income greater than $100,000, lots of itemized deductions, or several personal exemptions. The list is a bit lengthy and there are a lot of web sites that have a list similar to the one below. My list comes directly from the undisputed AMT authority - yes - the IRS web site.

If you use the AMT assistant on the IRS web site, you'll be asked about the following right off the bat:

• Accelerated Depreciation
• Stock by exercising an incentive stock option and you did not dispose of the stock in the same year - more on this later
• Tax exempt interest from private activity bonds
• Intangible drilling, circulation, research, experimental or mining costs
• Amortization of pollution-control facilities or depletion
• Income (or loss) from tax-shelter farm activities or passive activities
• Income from long-term contracts not figured using the percentage-of-completion method
• Interest paid on a home mortgage NOT used to buy, build or substantially improve your home
• Investment interest expense reported on Form 4952
• Net operating loss deduction
• Alternative minimum tax adjustments from an estate, trust, electing large partnership or cooperative
• Section 1202 exclusion
• Any general business credit claimed on Form 3800
• Empowerment zone and renewal community employment credit
• Qualified electric vehicle credit
• Alternative motor vehicle credit
• Alternative fuel vehicle refueling property credit
• Credit for prior year minimum tax

If any of the above apply to you, you should complete the AMT worksheet included with your form 1040 paperwork when preparing your taxes. If you don't and the IRS runs the numbers when you submit your return (and they will) and finds you do owe alternative minimum tax you'll get the fines, the interest, and the hell that appearing on the IRS's radar brings including the threat of an audit.

Manually completing the AMT worksheet is semi-painful and no fun. There are a couple of ways you can reduce the pain (three if you include ingesting mass quantities of alcohol - kidding). The IRS web site has an AMT assistant. About 5-10 minutes of answering online questions (it's anonymous) and the results will tell you that either you do not owe the AMT or that you must complete Form 6251 (painful - like redoing your taxes, but less painful than an IRS audit) to find out if you owe the AMT. If you use Turbo Tax (I do), then the program will determine if you owe any alternative minimum tax and you don't have to calculate a thing - pretty painless.

How to Avoid Paying the Alternative Minimum Tax

A major issue with the alternative minimum tax is that the many items that can be deducted from income to reduce your regular taxes are not deductions when calculating AMT. Thus, AMT taxable income is higher. Consider Brangelina. With the addition of the twins, Brad Pitt and Angelina Jolie have 6 children (for now) so between them and their children they have a total of eight personal exemptions - a significant reduction in personal income for the Jolie-Pitts. Except when they calculate their AMT, those kids won't help - the personal exemptions aren't counted. Neither are the standard deduction, state and local tax deductions, and miscellaneous itemized deductions.

One might not feel too sorry for Brangelina, but for us ordinary folks, there are a few ways to avoid or minimize the impact of the AMT. The key is careful planning. Follow these suggestions.

Time your capital gains and your deductible expenses. If you can delay the sale of an asset sale until after year end or sell it in an installment sale to spread the gain over a period of years you may avoid triggering the alternative minimum tax. Time your deductions to fall in years when you won't pay the AMT. This is especially true of medical deductions.

Major Red Flag

If you are one of those lucky workers who received a stock options package from your employer and exercised those options you may want to cry. Yes, there is no immediate taxation, but you must report and adjustment for alternative minimum tax purposes - it's the difference between the exercise price and the fair market price. Here's a scenario that could actually happen in today's economy - you exercise your stock options and purchase shares of your company's stock for $25 below market price. You must then report the $25 difference in what you paid and the market value for AMT purposes. Then, what if the market continues to tank and the market value of your stock drops to below what you paid for it. Now you've got an actual loss plus the AMT adjustment. Ouch!

Ironically, generating additional taxable income may be a good thing if you are currently subject to the AMT. The AMT tax rate (28%) once it is activated trumps the ordinary tax rate. Thus if you are in the 30% or 35% federal ordinary income tax bracket and are subject to AMT, your income and your IRA distributions (over age 59 1/2) would be taxed at the lower AMT rate of 28%.

It's important not to go to extremes just to avoid the alternative minimum tax. Some otherwise happily married couples actually contemplate divorce to eliminate their AMT. I recommend consulting a good tax advisor before calling a divorce attorney.