Gregory S. DuPont
Planning Ahead to Avoid the AMT
The alternative minimum tax (AMT) is a parallel tax system that was introduced in the 1960s to ensure that wealthy taxpayers who claim substantial deductions pay at least a minimum amount in Federal taxes. But because the exemption amounts are now relatively modest, the AMT is hitting a large number of middle- to upper-middle-income taxpayers, especially those who live in areas with high state and local taxes, have larger families, and claim itemized deductions. But by planning ahead, you may be able to avoid triggering the AMT, or to reduce the amount you owe in years when you are subject to the AMT.
Most tax preparation software will help you assess your potential AMT liability, or you can use a worksheet in the instructions for Form 1040 to determine if you should fill out Form 6251 to calculate your AMT. If the tax calculated on Form 6251 is higher than the tax on your regular tax return, you must pay the difference as AMT.
The AMT has an alternative set of rules for calculating the amount of tax owed. When figuring your regular tax liability, you add up your total income, subtract all deductions and personal exemptions, add in various tax credits, and then calculate the tax. By contrast, the AMT does not allow the standard deduction, personal exemptions, or certain itemized deductions; and some income not subject to the regular tax is added back for AMT purposes. Having to pay the AMT eliminates most or all of the regular tax savings from these deductions.
An AMT liability can be triggered in a number of ways. Taxpayers may get caught in the AMT trap when, for example, they have a large number of personal exemptions, itemized deductions for state and local taxes and miscellaneous expenses, deductions for mortgage interest on home equity debt, or deductions for investment expenses. Exercising, but not selling, incentive stock options can also result in an AMT liability, as can large long-term capital gains, deductions for passive income or losses, depreciation, or tax-exempt interest from private activity bonds.
Over the years, Congress had routinely “patched” the low AMT exemption amounts to prevent them from hitting taxpayers with more modest incomes. But the American Taxpayer Relief Act of 2012 (ATRA) provided a permanent solution to this problem by giving taxpayers higher AMT exemption amounts and other forms of relief starting in 2012, with the amounts adjusted for inflation going forward. The 2015 exemption amounts are $53,600 for unmarried individuals, $83,400 for married taxpayers filing jointly and surviving spouses, and $41,700 for married taxpayers filing separately.
Coming up with a strategy to avoid having to pay the AMT can be challenging, especially if the AMT liability mainly results from a combination of factors that cannot be easily altered. But by making adjustments where you can, you may be able to reduce your chances of moving into the AMT zone. One of the best ways to minimize the risk of paying the AMT is to reduce your adjusted gross income (AGI). If you are employed, consider making maximum salary deferrals to your employer’s 401(k) or other retirement plan, and participating in your workplace cafeteria plan. If you are self-employed, you should also contribute to tax-advantaged retirement accounts, and claim your business expenses directly against your self-employment income instead of as a miscellaneous itemized deduction. Doing this will lower your AGI, and ensure that you will retain these deductions even if you are subject to the AMT.
If you intend to exercise incentive stock options, plan to sell them in the same year. When you exercise and sell stock options in the same year, you will be subject to the regular tax on the income, but not the AMT. If, however, you exercise but do not sell, the difference between your exercise price and the fair market value of the stock on the date the options were exercised is counted as income for AMT purposes. Similarly, a large long-term capital gain could trigger the AMT. Therefore, before liquidating major assets, you should calculate the potential tax consequences. In some cases, you may be able to spread the sale of assets over several years.
If paying the AMT in a given year is unavoidable, there may still be some strategies you can use to lower your tax burden, including timing your deductions and tax payments. If for, example, you have business expenses incurred as an employee, ask your employer to reimburse you for those expenses, rather than claiming them as miscellaneous itemized deductions, which are not deductible for AMT purposes. If this is not an option, try to pay these expenses in a year when you do not owe the AMT.
Because state, local, and other taxes paid and claimed as itemized deductions are not allowed as deductions for AMT purposes, you should try to defer payment of state and local taxes to years when you will not face the AMT. Although this can lead to underpayment penalties at the state and local level, these penalties may be small relative to the tax savings. If you expect to pay the AMT in the coming year, but not the current year, you may want to consider accelerating payments for state and local income taxes using estimated advance payments.
In addition, you should review the types of interest income you receive, and consider adjusting your portfolio to minimize the risk of having to pay the AMT. For example, the interest on tax-free bonds used to pay for private activities, such as the construction of hospitals or industrial parks, is subject to the AMT; while interest income generated by most state and local municipal bonds is exempt from all Federal income taxes, including the AMT.