|BETH B. KERN, CPA, PhD, is assistant professor of business and economics at Indiana University in South Bend. Her e-mail address is firstname.lastname@example.org.|
ongress enacted the alternative minimum tax (AMT) in 1969 to make wealthy taxpayers pay their fair share instead of using tax shelters and other means to reduce—or even eliminate—their federal tax liability. Despite this fair-minded purpose, an unintended result has been that more and more middle-income taxpayers are falling into an AMT trap. The Omnibus Consolidated and Emergency Supplemental Appropriations Act of 1999 gave short-term relief to some of these taxpayers, with a waiver that ensured the AMT did not render their personal tax credits useless for 1998. Despite these modifications, many average taxpayers still found themselves paying AMT last year. Unless Congress addresses the AMT problem more comprehensively—as the AICPA suggested in its AMT proposal (see sidebar, AICPA Proposals on AMT)—the tax will become a thorn in the side of middle-income Americans as well as wealthy ones. Here is some guidance CPAs can use to profile and help clients who may unexpectedly find themselves snared by the AMT.
| Middle-class Muddle |
I n 1997 taxpayers with adjusted gross income of less than $200,000 represented 68% of the tax returns showing AMT and paid 28% of the AMT. By 2007 this group will file 83% of the AMT returns and pay 50% of the tax.
Source: Robert Harvey and Jerry Tempalski; National Tax Journal , September 1997.
As most CPAs are aware, the AMT is assessed on a tax base different from that used for the regular income tax (RIT). Exhibit 1 shows a comparison of the two. Taxpayers must compute their RIT liability and then compute the tentative AMT liability. The taxpayer compares the tentative AMT liability with the RIT liability to find the total tax liability, which is the greater of the two before credits.
|Exhibit 1: AMT and RIT Compared|
Total income from all sources
Less: Deductions for adjusted gross income
Adjusted gross income
Adjusted gross income
Plus: AMT adjustments and preferences
Less: AMT itemized deductions
Less: AMT exemption
Times: AMT tax rate
Tentative AMT liability
Less: Regular tax before credits
Regular tax computation
Adjusted gross income
Less: RIT personal and dependency exemptions
Less: The greater of total itemized deductions or the standard deduction
Times: Regular tax rate
Regular tax liability before credits
Plus: Actual AMT
Less: Nonrefundable credits*
Less: Refundable credits
Plus: Other taxes
*The foreign tax credit may offset 90% of the tentative AMT.
Some taxpayers may mistakenly believe that they need be concerned about the AMT only if they engage in activities that result in tax preferences, such as exercising incentive stock options or investing in oil and gas holdings that result in excess depletion allowances. In reality, it is the difference between AMT and RIT itemized deductions, along with RIT exemptions, that tends to capture the most taxpayers. In 1997 Robert Harvey and Jerry Tempalski looked at the trends for the AMT using recent data. They concluded that 74.4% of the difference between the RIT and AMT tax bases came from personal and dependency exemptions, the standard deduction and from itemized deductions that are allowed for the RIT but not for the AMT. They project that by 2007 this difference will grow to 95.5%. The number of taxpayers subject to AMT is projected to grow at an average rate of 29% per year. Unless Congress makes some major changes, the type of client subject to the AMT will continue to shift dramatically.
IDENTIFYING POTENTIAL VICTIMS
Identifying clients who may be subject to the AMT is essential for effective tax planning. Exhibit 2 shows the most common differences between the AMT and RIT bases. (For a complete list of adjustments, see IRC sections 56 and 57.) The differences are labeled either a tax preference or an adjustment. Both result in a difference between the AMT and RIT bases. Many tax preference items (such as excess depletion allowances and interest on private activity bonds) result in permanent differences. Most AMT adjustments (such as circulation expenditures and post-1986 depreciation) result in timing differences that will eventually reverse. The larger the dollar value of the difference—be it a preference or an adjustment—the greater the probability a taxpayer will have to pay AMT.
|Exhibit 2: Most Common RIT and AMT Differences|
|Regular Tax Deduction or Exclusion||AMT Deduction or Exclusion|
|Tax preferences and adjustments unrelated to itemized deductions|
depreciation allowed under
|Post-1986 depreciation using the |
alternative depreciation system (ADS).
|Excess of percentage depletion over the |
adjusted basis of the property is deductible.
|Excess of percentage
depletion over the |
adjusted basis of the property is not deductible.
|No income recognized
for exercising |
incentive stock options.
of fair market value over cost is a |
|Tax-exempt interest from private
bonds is excluded from income.
|Tax-exempt interest from private activity |
bonds is a tax preference.
allowed to offset passive |
allowed to offset passive |
|Adjustments related to itemized deductions|
|Medical expenditures greater than 7.5%
|Medical expenditures greater than 10% of AGI.|
|State and local taxes are deductible.||Taxes are not deductible.|
|Qualified residence and investment interest.||Qualified housing and investment interest.|
deductions allowed under regular tax |
are allowed under AMT.
|Casualty losses.||Casualty losses allowed under regular tax |
are allowed under AMT.
itemized deductions greater |
than 2% of AGI.
miscellaneous itemized deductions |
greater than 2% of AGI are deductible.
|Other miscellaneous itemized deductions.||Only gambling losses are allowed.|
|Exemptions and standard deduction|
|In 1999 each personal and dependency
exemption is $2,750.
|No dependency or personal
exemptions, but |
there is an AMT exemption:
|$45,000 (Married filing jointly with
beginning when AMT income is over $150,000).
|$33,750 (Single/head of
household with |
phase-out beginning when AMT income is
|$22,500 (Married filing separately with |
phase-out beginning when AMT income is
|Standard deduction is allowed if greater than
itemized deductions. The standard deduction
for 1999 is:
|No standard deduction.|
|$7,200 (Married, filing jointly)|
|$6,350 (Head of household)|
|$3,600 (Married, filing separately)|
For a given level of income, CPAs can calculate a break-even point—the value of combined tax preferences and adjustments that a taxpayer can have before becoming subject to the AMT. The graph in exhibit 3 shows the dollar value of combined tax preferences and adjustments that either a married-filing-jointly or a single taxpayer may have before having to pay the AMT. This graph assumes the taxpayer claims only personal exemptions (two for married filing jointly, and one for single), with no dependency exemptions.
Exhibit 3: AMT Preference and Adjustment Break-even Points
Example 1. John and Mary have taxable income of $100,000 and claim two personal exemptions. Exhibit 3 indicates that this couple may have combined preferences and adjustments of $25,667 above the two personal exemptions they already claim. This can be confirmed by comparing the regular tax liability on $100,000 ($6,457.50 + .28 x ($100,000 – $43,050) = $22,403.50) to the tentative AMT liability (.26 x [$100,000 – $45,000 + $25,667 + (2 x $2,750)] = $22,403.42). There is a slight difference in the break-even point, due to rounding. Although it may seem that taxpayers with income of $100,000 are unlikely AMT candidates, these calculations indicate that once John and Mary exceed $25,667 in preferences and adjustments they will have to pay the AMT.
Example 2. Assume John and Mary have four children. They own a home, on which they pay home mortgage interest of $5,400. The couple live in New York, a state with high income and real property taxes, resulting in state and local tax deductions of $12,000. They also have miscellaneous itemized deductions subject to the 2% floor of $5,000. State and local taxes, most miscellaneous itemized deductions and dependency exemptions are AMT adjustments. John and Mary would have combined adjustments of $12,000 + $5,000 + (4 x $2,750) = $28,000 above the two personal exemptions they already claim. Since their adjustments exceed the AMT break-even point, they would be subject to the AMT. Effectively, $2,333 ($28,000 – $25,667) of their deductions would be permanently disallowed.
The AMT can even ensnare taxpayers with modest taxable incomes and relatively simple tax situations. Exhibit 3 indicates that taxpayers with taxable incomes ranging from $32,696 to $99,999 have break-even points that are even lower than those of taxpayers with $100,000 of taxable income. The lowest break-even point occurs when the 28% marginal tax rate begins.
Example 3. Laurie and Larry have $43,050 of taxable income. They do not itemize deductions but instead claim the standard deduction for married couples filing jointly, $7,200. Exhibit 3 reveals their break-even point, $21,287. If the couple have six dependents and claim the standard deduction, they will have combined adjustments and preferences of $23,700 ($7,200 + [6 x $2,750]). They will be subject to the AMT and effectively permanently lose $2,413 ($23,700 – $21,287) of their dependency deductions because the AMT does not permit personal or dependency exemptions.
FUTURE AMT ISSUES
CPAs will have to face a number of other AMT issues in planning for their clients.
Tax bracket and exemption creep. One of the reasons the AMT has become an issue for more taxpayers is that tax rates and exemptions for the RIT are indexed for inflation, but the AMT exemption is not. In addition, the AMT tax rate has increased over time. For example, in 1986 it was 21%; now it varies from 26% to 28%, depending on the size of the AMT base. The graph in exhibit 3 gives some insight into these issues.
The break-even points do not begin to rise at meaningful rates until regular taxable income is taxed at the highest marginal tax rates of 36% and 39.6%. The break-even point steadily declines over the lowest taxable income range, which is taxed at 15%. When the marginal RIT rate increases to 28%, the break-even point in general rises very slowly. Thus, married taxpayers with $150,000 in taxable income do not have a substantially larger break-even point than those with $75,000 in taxable income. Each time the RIT brackets are indexed for inflation, it effectively widens the "plateau" for middle-income taxpayers. In addition, the combination of not indexing the AMT exemption but indexing the RIT rates and exemptions continues to lower the break-even point for middle-income taxpayers. Indexing the RIT personal and dependency exemptions also erodes the available remaining adjustments and preferences that a taxpayer may have before exceeding the break-even point and having to pay AMT.
Example 4. Tom and Teresa have four children and $60,000 of taxable income. Their current break-even point is $22,590 in either preferences or adjustments. The four children consume $11,000 (4 x $2,750) of these adjustments. As a result, the couple have $11,590 remaining for other adjustments or preferences before having to pay the AMT. Assume the cumulative inflation rate over four years is 12%. This will affect the RIT brackets and exemptions. Changes in these brackets would cause the couple's break-even point to drop to $19,307. The exemptions—indexed for inflation—would increase to approximately $3,100 each. These exemptions would consume 4 3 $3,100, or $12,400, of the available adjustments and preferences, leaving only $6,907. If Tom and Teresa were to use a standard deduction instead of itemizing, they would be subject to AMT because the deduction would exceed the remaining adjustments and preferences. This example shows how even relatively small inflation adjustments work both to lower the break-even point and shrink the available remaining adjustments and preferences, thereby steadily increasing the number of people subject to the AMT.
An additional consideration is that as income levels rise taxpayers are more likely to own homes subject to property taxes and are more likely to pay state and local income taxes at deductible levels. Exhibit 3 indicates that the AMT preference and adjustment break-even point does not rise very much from taxable income levels of $50,000 to about $150,000. The problem becomes even more serious for taxpayers with dependency exemptions. Since these exemptions are indexed over time, the remaining cushion for state and local taxes diminishes.
Tax credits. The AMT even has the potential to affect clients who actually do not have to pay it. In general, tax credits may be used only to the extent that the RIT exceeds the tentative AMT—whether or not a taxpayer pays the AMT. There are a few exceptions, however. Taxpayers can use foreign tax credits to offset 90% of their tentative tax liability. As noted earlier, the Omnibus Consolidated Emergency Supplemental Appropriations Act offered a short-term waiver for 1998 by allowing taxpayers to use personal credits such as the child care and the new education credits to offset a tentative AMT liability.
Example 5. Bob and Barbara are married and have four children. They have taxable income of $50,000 and claim the standard deduction. Bob and Barbara are also eligible for HOPE scholarship credits of $1,500. Their RIT liability before credits is $8,404.50. The tentative AMT is $7,462 (.26 x [$50,000 – $45,000 + $7,200 + $16,500]). Since the tentative AMT is lower than the RIT, they do not have to pay the AMT. In 1998 Bob and Barbara could have reduced their tax liability by their full personal credits of $1,500 (even though it would have resulted in a tax liability below the AMT). Without the special waiver, however, they would have been able to use only $942.50 ($8,404.50 – $7,462.00) of their HOPE scholarship credit—essentially lowering their tax liability to the point where the RIT equals the AMT. This limit on the use of tax credits applies to all taxpayers and will apply in the future if Congress does not extend the waiver.
Although the limitations apply to business credits, a taxpayer can carry those credits back and forward to other tax years. Personal credits are permanently lost if they are not used. The limitations have increasing importance because they put at risk the new personal credits such as the child, lifetime learning and HOPE scholarship credits enacted with the Taxpayer Relief Act of 1997. The Joint Committee on Taxation estimates that waiving the limit on personal credits cost the Treasury $474 million in tax revenue for 1998 alone. Many taxpayers will be affected in the future should Congress not extend the waiver beyond 1998. As a result, the AICPA AMT proposal advocates that Congress examine not only the potential revenue impact of any new legislation but also the number of taxpayers affected by the interaction between the newly available personal credits and the AMT.
AMT TAX PLANNING
Tax planning in the presence of the AMT becomes more complex. Under most circumstances, taxpayers prefer a tax deduction this year to one next year. The AMT, however, can catch people off guard, such as those who accelerate state and local taxes or miscellaneous itemized deductions. If these deductions are large enough, they can trigger the AMT and cause personal deductions to be permanently lost.
Example 6. Debra and Donald have $152,000 of taxable income and three dependent children. Debra has $6,000 of unreimbursed business expenses after considering the 2% miscellaneous itemized deduction floor. They have paid $12,000 of state and local taxes during the year and are considering paying an additional $2,000 toward their state tax liability in December. Accelerating this payment would lower their federal taxable income to $150,000. Exhibit 3 shows that the break-even point for $150,000 of taxable income is $26,753. Debra and Donald's adjustments and preferences are currently $26,250 ($6,000 + $12,000 + [3 x 2,750]). If they accelerate their state tax payment, their adjustments and preferences would increase to $28,250—exceeding the break-even point. They would permanently lose the $1,497 excess ($28,250 – $26,753) over the break-even point.
CPAs need to take extra care about advising clients to accelerate certain deductions into the current tax year. If a client is close to his or her adjustment and preference break-even point, accelerating a deduction that is an AMT preference or adjustment may not result in the anticipated reduction of tax liability. A deduction of a personal nature, such as state and local taxes or miscellaneous itemized deduction, may cause clients to lose part of their deduction permanently. To be safe, CPAs should make both regular and AMT computations before recommending that deductions be accelerated.
on AMT |
In testimony before Congress, the AICPA has proposed several changes to the alternative minimum tax (AMT). The changes would
Given the increased complexity, compliance problems and a perceived lack of fairness, the AICPA also recommended that Congress consider eliminating the individual AMT entirely.
AN EXPANDING TRAP
Unless Congress makes a major legislative correction, the number of taxpayers subject to the AMT will increase substantially over the next several years. Taxpayers with a large number of personal exemptions, high miscellaneous itemized deductions or those living in high-tax states are particularly vulnerable, and inflation adjustments will only exacerbate the trend in the coming years. Unless Congress changes the law, many taxpayers not subject to the AMT will find their personal tax credits unusable because of limitations resulting from AMT calculations. The AICPA AMT proposal offers several suggestions for Congress to consider. Without major legislation, the AMT is an expanding trap waiting to ensnare far more—and poorer—taxpayers than it was intended to when it was enacted.