In filing your taxes this year, you may have been hit with a nasty surprise — Alternative Minimum Tax (AMT). That’s because more and more people are being affected by this once esoteric tax. The AMT is a parallel tax system created in 1969 to ensure that wealthy taxpayers could not fully shelter their income from taxation. Now, taxpayers earning as little as $75,000 per year could end up paying the tax. Only Congress can truly solve this problem. In the meantime, some advance tax planning can help.
What exactly is AMT?
AMT is a tax system with a different set of rules than our ordinary tax system. For example, under the AMT calculations, state and local income taxes are not deductible. There is no standard deduction, nor are there personal exemptions or exemptions for dependents, or miscellaneous itemized deductions. Also, the bargain element on employee incentive stock options is considered income. After calculating your taxes under the regular system, you must add these and other ‘preference items’ back into your income and calculate your AMT tax. You pay whichever tax is higher.
Why are more people getting hit with AMT?
It is estimated that 2.6 million people will owe AMT in 2003. By 2005, that number is expected to jump to 12.3 million. There are several factors contributing to this increase. Because AMT is a comparative tax, anything that lowers taxes under the regular tax system without an equivalent reduction under the AMT system will cause people to get hit by AMT tax. For example, unlike regular income tax rates, AMT rates are not indexed for inflation. Naturally, as incomes have risen since 1969 due to inflation, more people have fallen into AMT territory. Also, the 2003 federal tax cut reduced tax rates under the regular system but not under AMT. It did raise the AMT exemption to $58,000 ($40,250 for singles), but the exemption will drop to $45,000 ($33,750 for singles) in 2005 unless Congress does something. Increases in state and property taxes have added to the problem because, as mentioned earlier, these items are not deductible under AMT. A large enough state income tax deduction could cause someone to have to pay AMT.
Who is most likely to be affected?
Because so many people are being affected, some tax planners believe that anyone earning more than the exemption amount should calculate their AMT to see if it applies. The people most likely to be hit are residents of states with high income tax rates, employees who exercise incentive stock options, small business owners with equipment to depreciate, and anyone with substantial miscellaneous itemized deductions, capital gains, or dividend income.
What can you do?
Generally, there is only a two-year tax planning window for AMT — this year and the next. Normal tax planning involves accelerating deductions and deferring income, but that often gets turned around when planning for AMT. Planning opportunities are better for those who move in and out of AMT territory from one year to the next than for those who are subject to AMT every year. Some examples include:
– Try to pull more ordinary income into years that you will owe AMT.
– Capital gains are better taken in a year when you are not paying AMT.
– Time payments of state income taxes to get the most from the state tax deduction.
If you were hit by the AMT in 2003, you should take a look at what caused the tax and start planning for this year. We can devise an AMT strategy to help you minimize the tax. And write your congressman!