The Alternative Minimum Tax (AMT)

Throughout my years as an advisor, I have been asked by clients many times to decipher the AMT system by explaining it in simple terms. While “AMT” and “simple” mix like oil and water, I hope the explanations and the observations below make the topic a little less mysterious.

What is the AMT?

The AMT was first introduced in 1969 to prevent taxpayers with very high incomes from using special tax benefits to pay little to no federal income tax. It is essentially a separate federal income tax system with its own tax rates and set of rules governing the recognition and timing of income and expenses. If you’re subject to the AMT, you must calculate your taxes twice – once under the regular tax system and again under the AMT system. If your income tax liability under the AMT is greater than your liability under the regular tax system, the difference is reported as an additional tax on your federal income tax return.

Am I subject to the AMT?

Part of the problem with the AMT is that, without doing some calculations, there’s no easy way to determine whether or not you’re subject to the tax. Key AMT “triggers” include the number of personal exemptions you claim, your miscellaneous itemized deductions and your state and local tax deductions. Thus, for example, large families living in high-tax states often have to contend with the AMT. IRS Form 1040 instructions include a worksheet that may help you determine whether you’re subject to the AMT, but you might need to complete IRS Form 6251 to know for sure.

Common AMT adjustments

It’s no easy task to calculate the AMT, in part because of the number and seemingly disparate nature of the adjustments that need to be made. Here are some of the more common AMT adjustments:

  • Standard deduction and personal exemptions: The federal standard deduction, generally available under the regular tax system if you don’t itemize deductions, is not allowed for purposes of calculating the AMT. Nor can you take a deduction for personal exemptions.
  • Itemized deductions: Under the AMT calculation, no deduction is allowed for state and local taxes paid. Your deduction for medical expenses may also be reduced, and you can only deduct mortgage interest to the extent loan proceeds are used to purchase, construct, or improve a principal residence.
  • Exercise of incentive stock options (ISOs): Under the regular tax system, tax is generally deferred until you sell the acquired stock. But for AMT purposes, when you exercise an ISO, income is generally recognized to the extent that the fair market value of the acquired shares exceeds the grant price.

AMT exemption amounts and uncertainty

While the AMT takes away personal exemptions and a number of deductions, it provides specific AMT exemptions. The amount of AMT exemption that you’re entitled to depends on your filing status. For taxpayers who are married filing jointly, the exemption is $74,450 for 2011, but drops to only $45,000 for 2012.

The exemption is not adjusted for inflation – it only changes through legislation. Over the past ten years Congress has “patched” the AMT exemption eight times, temporarily delaying dramatic increases in the number of individuals affected by the tax. The latest two-year patch, included as part of 2010 tax legislation, was effective through December 31, 2011. As the exemption remains “unpatched” for 2012, an election year, you should expect more eleventh-hour legislation dealing with this issue. If Congress fails to act, the number of taxpayers subject to AMT could rise from 4 million in 2011 to over 30 million in 2012!

It also is important to note that the exemption amount begins to phase out once taxable income exceeds a certain threshold ($150,000 for married individuals filing jointly). The phaseout thresholds are not indexed for inflation.

AMT rates

Under the AMT, the first $175,000 of taxable income is taxed at a rate of 26%. Taxable income above this amount is taxed at a flat rate of 28%. The lower long-term capital gain rates (typically 15%) exist under the AMT calculation as well. However, long- term capital gain and qualifying dividends are part of your taxable income under the AMT system. That means large capital gains and qualifying dividends can push you into the phaseout range for the AMT exemption, indirectly increasing your AMT.

Summing up

Owing AMT isn’t the end of the world, but it can be a very unpleasant surprise. It also turns a number of traditional tax planning strategies (e.g., accelerating deductions) on their heads, so it’s a good idea to factor AMT into your tax planning. If you think you might be subject to the AMT, consider discussing your situation with your advisor or tax professional.

If you are not currently a client but would like to learn more about Truepoint’s services, please contact Lisa Reynolds. If you are a client and would like more assistance with this process, please contact your lead advisor.

Truepoint Wealth Counsel is a fee-only Registered Investment Adviser. Registration as an adviser does not connote a specific level of skill or training. More detail, including forms ADV Part 2A & 2B filed with the SEC, can be found at TruepointWealth.com. Neither the information, nor any opinion expressed, is to be construed as personalized investment, tax or legal advice. The accuracy and completeness of information presented from third-party sources cannot be guaranteed.

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