Strategies for the Alternative Minimum Tax

By Jacob Barr, CPA, CA

Question: Are any of your clients subject to the Alternative Minimum Tax (AMT)?

Answer: Probably.

After two recent rounds of federal tax cuts (the Jobs and Growth Tax Relief Reconciliation Act of 2003 and the Economic Growth and Tax Relief Reconciliation Act of 2001), the AMT is probably here to stay. If you're not prepared or aware of what's going on, you and your clients will suffer the consequences.

The AMT strikes just when you think you have reduced your clients’ tax liability to a manageable level. It increasingly impacts middle-income wage earners who claim common deductions, which they have always taken for granted. As the regular tax rates have been reduced, the incidence of the AMT will, by definition, increase. This is because the marginal rate, at the low end, is 10 percent, 15 percent and 25 percent, and all tax brackets have increasingly larger ranges. The expansion of the joint-return standard deduction and the absence of AMT exemption indexing provisions are largely responsible for middle-class taxpayers being subjected to the AMT.

Key-indicator clients might fall prey to the AMT in the following ways:

Itemizing deductions — claiming large deductions for state and local taxes, employee business expenses or legal fees in court settlement.
Taxpayers with home equity lines of credit who use the money to do something other than buy, build or improve his or her home home.
Exercising incentive stock options (ISO) unless the taxpayer disposes of the stock in the same year.
Claiming a large number of personal exemptions on a return.

Generalized tax planning strategies will not work

The question CPAs should ask is whether their goal is to avoid the AMT.

As with many tax issues that seem unfavorable, careful planning and strategizing can hold the AMT beast at bay. Determining whether the AMT is ready to pounce is challenging. The best course of action is to engage in proactive, year–round, “real-time” tax planning based on your clients’ financial goals.

The first important step is to determine the proximity of your client’s tax position to the AMT. Always incorporate the AMT with regular tax planning to assess the total tax liability, and watch for the “crossover” or “breakeven” point (a useful, practical tax planning tool) at which regular tax and the AMT are approximately equal. Such computations are somewhat complicated, but rough estimates are possible.

For example, say a taxpayer has taxable income of $200,000 in 2005 which, for the purpose of this illustration, we will assume results in a regular tax of $70,000 (0.35 x $ 200,000). His AMTI is $265,000 (including $65,000 of AMTI adjustment) and produces a tentative minimum tax of about $70,000 — (0.26 x $175,000) + (0.28 x $90,000). He is at the crossover point where the tentative minimum tax equals the regular tax. It is the load-up point at which the maximum adjustments and preference items can be loaded into AMTI without triggering an AMT. “Breakeven” can be used to determine the number of options that could be exercised to equate regular tax and AMT (weight risk of holding expired options).

Clients at the “crossover” may want to accelerate non-preference deductions, deferring non-preference income and incurring some AMT liabilities that produce minimum tax credit by accelerating income (not attributable to a deferral items). However, there is no simple answer as to whether particular measures help or hurt, so it is best to simply recalculate both tax liabilities.

OK, the AMT beast coming. How do I keep it away?

Planning strategies can be divided into business, investment and personal items.

Consider pre-tax planning techniques to reduce the AMT base. Maximize the 401(k) elective deferral and pre-tax health savings plans.
Assess itemized and non-itemized deductions, because they are a doorway into the AMT. Personal exemptions can be salvaged by giving them to qualified family members. If itemized deductions are close to the size of standard deductions, “bunch” deductions in alternate years. If regular tax and the AMT are fairly close, shift the ones that can trigger AMT liability from year to year. Itemize even if they are below the standard deduction when AMT continues to be a potential problem. For married taxpayers, evaluate whether filing separately would be more beneficial. Employees with unreimbursed business expenses should renegotiate employment terms to avoid a 2 percent miscellaneous itemized deduction. Accelerate charitable gifts by increasing your charitable deductions. Since 1993, the spread on appreciated property is no longer a preference item.
If you know your client won't face the AMT this year but could be a potential victim in subsequent years, consider prepaying the fourth-quarter estimated state income tax during the current year. Conversely, if you know your client will face the AMT this year, postpone state income tax payments until next year. Take any potential penalties into consideration with the tax savings with this approach.
Plan investment and property transactions carefully. Corporate bonds rather than municipal (tax exempt) bonds yield fully taxable interest income, which potentially can get you out of the AMT and yield a higher after-tax income. Delay the sale or spread the gains from long-term capital gain assets over multiple years by using an installment sale (unless long-term capital gains are so large that they will phase out the entire AMT exemption). Take advantage of an asset's separate AMT higher adjusted-basis calculation by selling an asset in a year in which the AMT problem already exists and reducing the tax on the gain. Treat non-salvageable deductions as an adjustment to the asset’s basis. Consider the Section 179 deduction. Consider leasing rather than purchasing assets. Check the year in which ISOs are exercised to control the adjustment for AMT purposes. In some cases, electing to report capital gains and dividend income as investment income may also narrow the difference between AMT and regular tax. Allocate a fixed account management fee to commission on security sales above the line.

The AMT is no longer just a net to prevent wealthy folks from avoiding all income tax. However, it's not a reason to renounce your citizenship and flee the country. A good thing can even happen if you have to pay the AMT: It can result in a credit for prior-year minimum tax, which can offset regular tax liability in the future. (There is no carryback). No credit is allowed to the extent the minimum tax is attributable to addbacks for taxes and miscellaneous itemized deductions subject to the 2 percent threshold.

Jacob Barr, CPA, CA, is a managing principal of Barr CPA LLC, a firm specializing in tax planning, high net-worth individuals, closely held businesses and QuickBooks Consulting. He can be reached at jbarr@barrcpa.net.

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