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Strategies to Minimize The Alternative Minimum Tax Liability

Congress originally devised the alternative minimum tax (AMT) rules to ensure that high-income individuals who take advantage of multiple tax breaks will owe money to the IRS each year. In recent years, however, that concept has eroded. Now, even upper-middle-income taxpayers are likely to owe the AMT.

How the Alternative Minimum Tax Works

Think of the AMT as an alternate set of tax rules that are similar to the regular federal income tax system. But there are key differences. For example, under the AMT rules, certain types of income that are tax-free under the regular federal income tax system are taxable. The AMT rules also disallow certain deductions and credits that are allowed under the regular federal income tax system. And the maximum AMT rate is only 28% compared to the 39.6% maximum rate that applies under the regular federal income tax system.

In addition, taxpayers are allowed a relatively large inflation-adjusted AMT exemption, which is deducted when you calculate AMT income. Unfortunately, the exemption is phased out when your AMT income surpasses certain levels.

If your AMT liability exceeds your regular federal income tax liability for the tax year, you must pay the higher AMT amount.

Why Upper-Middle-Income Taxpayers Get Hit

After repetitive tax law changes, the AMT now doesn’t apply to just the wealthiest taxpayers in the highest tax bracket. That’s because many of their tax breaks are already cut back or eliminated under the regular federal income tax rules before getting to the AMT calculation.

For instance, the passive activity loss rules greatly restrict the tax benefits that can be reaped from “shelter” investments, including rental real estate and limited partnerships. And, if your income exceeds certain levels, phaseout rules are likely to reduce or eliminate various tax breaks, such as personal and dependent exemption deductions, itemized deductions, higher-education tax credits and deductions for college loan interest.

Moreover, individuals in the 35% or 39.6% tax brackets are less likely to be hit with the AMT, which has a maximum tax rate of 28%. Finally, the AMT exemption — which is deducted when you calculate AMT income — is phased out as income goes up. This phaseout has little or no impact on individuals with the highest incomes, but it increases the likelihood that upper-middle-income taxpayers will owe the AMT.

Alternative Minimum Tax Risk Indicators

Various inter-related factors make it hard to pinpoint who will be hit by the AMT. But taxpayers are generally more at risk if they have:

  • Substantial (but not necessarily huge) salary income (more than $250,000 per year).
  • Significant long-term capital gains and/or dividends.
  • Large deductions for state and local income and property taxes.
  • A spouse and several children (e.g., at least four) who provide personal and dependent exemption deductions for regular federal income tax purposes. (These deductions are disallowed under the AMT rules.)
  • Significant miscellaneous itemized deductions, such as investment expenses, fees for tax advice and unreimbursed employee business expenses.
  • Interest from private activity bonds. This income is tax-free for regular federal income tax purposes, but it’s taxable under the AMT rules.
  • Significant depreciation write-offs for personal property assets, such as machinery, equipment, computers, furniture, and fixtures from your own business or from investments in S corporations, LLCs or partnerships. These assets must be depreciated over longer periods under the AMT rules.

Another noteworthy factor that’s likely to trigger the AMT is exercising in-the-money incentive stock options (ISOs) during the tax year. The so-called “bargain element” — the difference between the market value of the shares on the exercise date and the exercise price — doesn’t count as income under regular federal income tax rules, but it counts as income under the AMT rules.

A significant spread between a stock’s current market value and an ISO’s exercise price can result in an unexpected AMT liability. Consult your tax professional before exercising your options. Depending on current and anticipated market conditions, it may be advantageous to exercise them over several years to minimize the adverse AMT effects.

Strategies to Minimize the Alternative Minimum Tax

Any strategy that reduces your adjusted gross income (AGI) might help to reduce or avoid the AMT. AGI includes all taxable income items and certain non-itemized deductions, such as moving expenses and alimony paid.

By lowering AGI, you may be able to claim a higher AMT exemption. Here are some considerations that may help reduce your AGI:

  • Contribute as much as you can to your tax-favored retirement plan, such as a 401(k) plan, profit-sharing plan or SEP.
  • Contribute to your cafeteria benefit plan at work. Contributions lower your taxable salary and AGI. Most cafeteria plans include healthcare and dependent care flexible spending account arrangements.
  • Harvest losses from investments held in taxable brokerage firm accounts. Then use the capital losses to offset any capital gains. Any leftover capital losses up to $3,000 are deductible against income from salary, interest, dividends, self-employment and other sources.
  • Defer the sale of appreciated investments held in taxable brokerage firm accounts until next year. Doing so will defer the resulting taxable gains.
  • Prepay deductible business expenses near year end if you run a business as a sole proprietorship, limited liability company, partnership or S corporation. The resulting business deductions will be “passed through” to you, thereby lowering AGI. Similarly, postpone the receipt of business income until next year to reduce your AGI in the current tax year.

Important note: Lowering AGI will also slash your state and local income taxes, which are disallowed for AMT purposes and, therefore, increase your AMT exposure. Likewise, if you’re likely to be hit with the AMT, the traditional tax year-end strategy of prepaying state and local income and property taxes that are due early next year won’t help you. Those taxes aren’t deductible under the AMT rules. So prepay them in a year when you have a chance of not being in the AMT mode.

Most individuals in the higher tax brackets probably have some risk factors. The IRS has trained auditors to find unsuspecting folks who owe the AMT. If you’re not careful, you could owe back taxes, interest and potential penalties under the AMT rules.

Contact us if you need assistance identifying whether you’re at risk for the AMT, so we can help find ways to reduce your exposure.

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