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AMT Planning Strategies In the absence of indexing, more and more taxpayers are subject to the alternative minimum tax (AMT) each year. Until Congress decides to address this issue, tax advisers need to know how to minimize the AMT for their clients who may be subject to it. This article examines AMT liability for a hypothetical married couple, and offers planning strategies to minimize AMT exposure. John
O. Everett Cherie
J. O'Neil
For more information about this article, contact Dr. Everett at jeverett@erols.com or Dr. O'Neil at (970) 491-6114.
Executive Summary
Historically, the AMT was designed to require taxpayers who owe little or no RT—through the use of various tax incentives—to pay some minimum amount of tax. (The abbreviations used in this article are listed in the box on p. 789.) Although Congress occasionally discusses a gradual repeal of the AMT, perceived equity considerations virtually guarantee its continuance for years to come. As more and more individuals become subject to the AMT, they and their tax advisers need to understand how it works and how to avoid or minimize its effect. A recent Joint Committee on Taxation study noted that, while only 140,000 individual returns reported AMT in 1987, 823,000 were expected to report some AMT liability in 1999; approximately 9.043 million are expected to report some AMT liability by 2009.1 The following example serves as a starting point for discussing strategies either to avoid or minimize AMT.
Individual AMT Computation Exhibit 1 on and Exhibit 2 display the 2000 RT and AMT computations for H and W, who are married filing jointly. H is an employee; W is self-employed. Exhibit 1 displays the RT computation; Exhibit 2 displays the AMT computation.
Exhibit 2's two columns of computations facilitate the explanation of the AMT credit. Instead of receiving a small refund, H and W had a significant tax liability not covered by their estimated tax payments and withholding. Several observations about AMT can be made from this example.
RT vs. AMT TI Starting Point Although AMT is technically a second tax computation (with its own set of income and deduction rules), normally it is computed by converting TI to AMTI, by isolating those items whose treatment differs for RT and AMT purposes. The first adjustment to TI in Exhibit 2 is a reduction by the itemized deductions subject to the RT phaseout rules. The AMT rules do not require such a phaseout; thus, H and W initially benefit from this adjustment.
AMT Adjustments The AMT adjustments contained in Secs. 56 and 58 modify RT treatment. In general, most of the adjustments shown in Exhibit 2 (1) accelerate income recognition, (2) decelerate expense recognition or (3) deny certain deductions altogether. These items are designed to ensure that a taxpayer with substantial economic income cannot avoid tax through the use of special RT exclusions, deductions and credits. The following adjustments—unlike "preferences"— may be positive or negative:
AMT Preferences Preferences are somewhat similar to adjustments, with one major difference; they are taken into account only when positive (i.e., negative preference items are ignored). With the exception of tax-exempt interest on certain private activity bonds ($7,000 in the example), the preference items specified in Sec. 57 represent a few holdovers from the add-on minimum tax that preceded the AMT computation enacted in 1978. This is the case for the $3,000 depreciation adjustment for real estate shown in the example.
AMT Exemption Under Sec. 55(d), individuals are allowed an initial AMT exemption of $45,000 on a joint return, $33,750 on a single return or $22,500 on a married filing separately return. The exemption is reduced by 25% of the amount by which AMTI exceeds $150,000 (joint), $112,500 (single) or $75,000 (married filing separately). Thus, for H and W, the exemption is reduced by 25% of AMTI exceeding $150,000, for a $20,625 ($45,000 + [0.25 x ($247,500 + $150,000)]) AMT exemption.
TMT Under Sec. 55(b)(1)(A)(i), a two-tier AMT rate structure applies to noncorporate taxpayers. The first $175,000 of AMTI (for joint filers) is taxed at 26%; excess AMTI is taxed at 28%. Long-term capital gains included in AMTI are taxed at RT rates (20%, 25% or 28%). In the example, the $20,000 long-term capital gain is taxed at a 20% rate for both RT and AMT purposes.
AMT The AMT is the excess of TMT over RT. If such excess exists, the assumption is that the taxpayer has unfairly benefited from various tax-favored treatments in the Code and must increase RT. The AMT is added to the RT; in effect, the taxpayer pays the larger of RT or TMT. Thus, H's and W's 2000 tax liability increased from $33,827 to $58,425, because of the $24,598 AMT.
AMT Credit When Congress lowered the RT rates for individuals in the Tax Reform Act of 1986, the RT rates and the AMT tax rates were not substantially different. This led to concerns that the AMT would create double taxation on the same items—once as part of AMT and later as part of RT when items were reported for RT purposes. For example, gain on ISO exercise was reported at the date of exercise for AMT purposes, then again for RT purposes when the stock was sold. To reduce the possibility of double taxation, Congress created the minimum tax credit under Sec. 53. The theory is that a portion (or all) of the AMT paid during a tax year may be used in future years as a credit against RT. However, the credit cannot reduce the carryover year's RT below the TMT for that year. An AMT credit may be carried forward indefinitely. For individuals, only the portion of the current year's AMT that relates to "timing differences" (deferral items of adjustment and preference) can be carried forward as an AMT credit; any portion of the AMT related to "permanent differences" (exclusion items of adjustment and preference) is not eligible for an AMT credit. To apportion the AMT between timing and permanent differences, the normal procedure is to compute the AMT including both timing and permanent differences (the normal AMT computation), then recompute the AMT with only permanent differences. The difference in the two AMT figures is the AMT credit, which relates solely to timing differences. The permanent adjustments are listed in Sec. 56(b)(1); the permanent preferences are listed in Sec. 57(a)(1), (5) and (7). All other items of adjustment and preference are presumed to be timing items. Thus, the $18,513 AMT credit in Exhibit 2 may be used in future years to offset RT (but not TMT). Understanding the nature of the AMT credit is critical to applying some of the planning strategies discussed below.
Credits Against TMT The example does not show any credits as allowable against TMT. Traditionally, only the FTC is allowed as a credit against TMT; other credits (including all personal credits) are not part of the AMT computation. Stated differently, personal credits offset RT only to the point that the net tax liability equals TMT. The various child and education credits enacted in recent years may subject a significant number of taxpayers to the AMT. To remove these taxpayers from possible imposition of the AMT, Congress granted a one-year waiver (under Sec. 26(a)) in the Tax and Trade Relief Extension Act of 1998, Section 2001(a), on the prohibition against the use of nonrefundable credits against TMT. Section 501 of the Tax Relief Extension Act of 1999 extended this waiver for 1999; it also provides that personal nonrefundable credits may offset both RT and TMT in 2000 and 2001.
Tax Planning Strategies General Concepts Before discussing potential AMT planning ideas for individuals, several overall observations are warranted. AMT is a separate tax system: As illustrated in the example, the AMT is generally computed by starting with RT and modifying it for applicable adjustments and preferences. However, the AMT is a second, separate tax system, with its own rules. Using a short-cut computational approach does not result in paying more AMT than required. For example, it is possible, when making item adjustments, to inadvertently double-count (e.g., an adjustment for depreciation on property used in a passive activity). Care should be taken not to duplicate that adjustment when including the results of the passive activity in the AMT. Reducing AMT may increase RT: Some of the strategies discussed below are designed to reduce the incidence of the AMT; however, such strategies often result in increased RT. It is helpful to know rough "breakeven" or "crossover" points at which RT and AMT are approximately equal. Such computations are somewhat complicated for individuals, but rough estimates are possible (discussed below). Understanding the AMT credit: When the AMT credit was introduced in 1986, many AMT planning strategies had to be altered. If the AMT credit can be completely used in the following tax year, AMT problems are reduced to a time-value-of-money issue. The AMT paid this year may be returned next year as a reduction of RT. The longer the period needed to recover the AMT credit, the more detrimental the incidence of the AMT. Taxpayers in a constant AMT situation will view certain strategies (such as income acceleration) differently from other taxpayers. The analysis of the effects of the AMT credit is complicated for individual taxpayers, because only timing (deferral) adjustments and preferences can create an AMT credit. It is extremely important to determine the mix of timing and permanent items in the AMT; as discussed below, this can have a significant effect on individual tax planning strategies. The following discussion reveals general individual AMT planning ideas; these strategies can be divided into (1) business items, (2) investment items and (3) personal items. When possible, the strategies are related to the H and W example.
AMT Planning for Business Items Income acceleration/expense deceleration: In certain cases, individuals may want to consider accelerating income (or decelerating expenses) when faced with AMT in the current tax year. For example, taxpayers with little or no AMT credit may seek this strategy, because most (or all) of the preferences/adjustments are permanent. Such a taxpayer who accelerates income (or defers expenses) would pay an effective tax rate of 26% or 28% on the additional income, rather than RT rates as high as 39.6%. For H and W, income acceleration makes little sense, because their marginal RT rate is 31% and their marginal AMT rate is 28%. Also, a portion of their AMT credit can be used in the following year, arguing against income acceleration (or expense deceleration). Even for taxpayers in the highest RT brackets, with little or no AMT credits, caution is in order. First, tax is being prepaid; thus, the time value of money should be considered. Also, if the taxpayer's AMTI is in the phaseout range for the AMT exemption, an additional $1 of income will cause a $0.25 loss in the exemption (in effect, increasing the marginal AMT tax rate on each additional dollar of AMTI by 25%, from 28% to 35%). More importantly, if an AMT credit is generated, it makes little sense to accelerate income, because tax liability is also being accelerated. Exhibit 3 provides a two-year comparison of the income acceleration issue for a 39.6%-rate taxpayer (married filing jointly) when an AMT credit is or is not available.
Exhibit 3 assumes that timing or permanent adjustments occur only in the first year; the taxpayer is subject to the RT in the second year. If present value factors are ignored, the total taxes paid over the two years when a credit is generated are the same, whether or not income is accelerated (see Exhibit 4).
In the above example, a taxpayer with timing adjustments is actually worse off with income acceleration only in a present-value sense; tax is needlessly paid one year in advance. Taxes are saved only when no AMT credit is present (e.g., a taxpayer having only permanent adjustments). Determining the RT/AMT break-even point: At some point, the additional RT generated by accelerated income will overtake the additional TMT generated; from that point on, any additional income will be taxed at the higher RT rates. To determine the amount of additional income that will roughly equate the two taxes, AMT must be divided by the difference in the marginal RT and AMT rates. This approximation is fairly accurate if the additional income does not change the marginal tax bracket and the exemption phaseout does not apply. The bottom portion of Exhibit 3 provides an illustration of these computations based on the example. If the taxpayer recognizes $653,724 of additional income in Year 1, the RT and AMT will be the same ($627,543).
Cost Recovery Issues AMT problems caused by positive depreciation adjustments can be minimized by slowing the RT cost recovery deductions for depreciable assets. However, because depreciation is a timing item (and if the resulting AMT credit can be used in the following year), the only tax "cost" of accelerated depreciation is one year of interest. On the other hand, if a taxpayer is likely to be in an AMT situation for the foreseeable future, the following steps should be taken so that accumulated AMT credits can be used against RT: Electing straight-line or ADS recovery: A taxpayer can elect the AMT recovery method for RT purposes, or straight-line recovery over the MACRS period or ADS (which generally uses asset class life). Sec. 168(b)(5) provides that such elections are made annually on a class-by-class basis. Thus, it may be possible to use a mix of accelerated and "decelerated" recovery methods on new asset acquisitions to minimize the AMT threat, while maximizing current deductions. (For H and W, the depreciation adjustment was relatively minor in comparison to other adjustments and preferences, and may not pose a significant problem for them.) Leasing, not owning, property: The AMT depreciation adjustment is avoided when property is leased rather than purchased, because such lease deductions are allowed for both RT and AMT purposes. Lease pricing policies probably build in this consideration; with the recent narrowing of cost recovery differences between RT and AMT (i.e., the same recovery period is used for both computations), all economic factors should be considered when leasing alternatives exist. Weighing the positive aspects of negative adjustments: Negative AMT adjustments always result when property is sold, exchanged or abandoned before the end of its recovery life (because its adjusted basis is higher for AMT purposes). If H and W sold a business asset near the end of its useful life, a negative adjustment (equal to the sum of all prior net positive depreciation adjustments on the asset) would reduce AMTI. This factor encourages a judicious choice of timing asset dispositions and abandonments. Specifically, such actions may be accelerated to a year when the taxpayer is already in an AMT position. The resulting negative adjustments will offset (or possibly eliminate) AMT liability. (One advantage of abandonment is that such transactions are not sales or exchanges; any recognized loss is reported as ordinary, not Sec. 1231.)
Credits vs. Deductions Taxpayers have the option of deducting expenses, rather than taking a Sec. 41 research credit, a Sec. 51 targeted jobs credit or a Sec. 28 orphan drug credit. Such credits cannot be used to reduce TMT; however, if reported as expenses, such amounts are deductible for both RT and AMT purposes. If a taxpayer has a potential AMT problem, it may make sense to elect expensing. A taxpayer may also consider an election to forgo R&E expense reduction for research credits taken. R&E expenditures meeting the Sec. 174 definition may be deducted in the year incurred; however, such deduction must be reduced for any Sec. 41 research credit allowed on the expenditures. As an option, a taxpayer may elect to reduce the credit and avoid a reduction in the expense deduction. If the taxpayer is already subject to the AMT, this election may make sense, because the deduction is allowed for both RT and AMT purposes, while the credit is allowed only for RT purposes.
NOL Issues Sec. 172 requires RT and AMT consistency on the issue of forgoing a NOL carryback period. Taxpayers should carefully consider the effects on both RT and TMT in the carryback years if no AMT benefit is derived in the carryback years (i.e., if there is no AMT liability in those years). Electing to forgo the carryback would preserve the AMTNOL benefits for carryforward years. Because an AMTNOL carryback must offset any AMTI in a carryback year, even if the taxpayer did not owe any AMT for that year, the tax benefit of the AMTNOL may be lost.
AMT Planning for Investment Items Private activity bond interest: Taxpayers should be aware of the negative AMT consequences of private activity bond interest. Such interest, although not subject to RT, is subject to AMT. More importantly, this is a "permanent" preference item; no AMT credit is generated. Thus, for H and W, the $7,000 private activity bond interest is effectively taxed at 28% (the AMT rate), with no prospect of recovering such taxes through an AMT credit in future years. If the bond paid 6%, this would decline to only 4.32% in the current year, when the AMT applies. If the $7,000 is treated as marginal income, the effective tax rate is 35% (28% x 1.25%), because H and W are in the phaseout range of the AMT exemption. This lowers the effective rate on the 6% bond to 3.9%. If interest income is generated in an AMT year, care should be taken to ensure that any related expenses are deducted for AMT purposes. Because such interest is investment income for purposes of the investment interest limits, the ceiling on the AMT investment interest expense deduction is increased. Thus, H and W can deduct $3,000 additional interest disallowed for RT purposes. Evaluating the effect of capital gains: As mentioned earlier, the AMT rate applicable to long-term capital gains cannot exceed the preferential RT rate applicable to such gains (20%, 25% or 28%). Although this somewhat lessens the AMT exposure, another potential problem is that such gain may be subject to state income taxes (which do not generate AMT credit). The combination of large amounts of additional income from capital gains and the loss of the state tax deduction for AMT purposes may create an AMT problem, especially if state law does not recognize the Sec. 121 personal residence sale exclusion. The possible effect of the interplay of capital gains income and the state income tax deduction on the AMT should be examined before large capital gains are recognized. Problems may be avoided by spreading the gain over more than one year. The same considerations also apply to Sec. 1202 sales of qualified small business stock, with another problem—42% of the excluded gain (50% exclusion x 42% = 21% of total gain) is a tax preference item for AMT purposes. For stock acquired after 2000, the amount of excluded gain subject to tax preference is 28%. This preference amount has greatly reduced the attractiveness of using Sec. 1202 stock. The state tax effects may not be disastrous in states that follow the Federal tax inclusion rules for such capital gains, because only half of the gain is includible in income. One planning strategy is to make sales across several years to minimize AMT. Another possibility would be to roll over the stock tax-free into other Sec. 1202 stock under Sec. 1045. For H and W, the $6,000 long-term capital gain is taxed at the same 20% rate for both RT and AMT purposes. However, the gain is probably subject to state taxes, which increased the permanent adjustment for tax expense. ISO exercise: For H and W, the largest adjustment was for the bargain element in the stock option at exercise. In effect, the AMT rules accelerate recognition of such gain. For RT purposes, gain is recognized only when the stock is sold. Because this is a timing adjustment, an AMT credit is available in the following year to offset the negative current-year effects; once again, the analysis is simplified to time value of money. Thus, if this year's AMT is a one-time event, H and W will recover most of the tax benefit in the following year (when the AMT credit offsets RT). What if H and W reasonably anticipate more AMT situations in the future? It may make sense to limit the number of stock options exercised. For example, a breakeven analysis can be used to determine the number of options that could be exercised to equate RT and AMT. In H's and W's case, AMT would exist even if no options were exercised. One strategy would be to sell the optioned shares in the same year as exercise. Although this accelerates ordinary income recognition for RT purposes, it does remove the adjustment item from the AMT computation (Sec. 56(b)(1)(3)). If this leaves the taxpayer in an RT situation for the current year, accumulated AMT credits from prior years might be usable. Capital gains election for investment interest expense: For purposes of determining the Sec. 163(d) limit on investment interest expense, the definition of "investment income" does not include long-term capital gains. However, Sec. 163(d)(4)(B) permits a taxpayer to include such gains in the determination of investment income, at the expense of forgoing any lower capital gains rates otherwise applicable to such gain. An election to treat such gains as investment income may help minimize AMT exposure. The additional investment interest expense deductible at the higher level of net investment income would be a deduction against both RT and AMT; the long-term capital gain, now reportable as ordinary income in both computations, would further narrow the difference between RT and AMT. However, time-value-of-money considerations should factor into this analysis, as excess investment interest expense in one year may be carried forward indefinitely as a potential deduction in future years. Deducting foreign taxes paid: The FTC is different from other tax credits, in that it may offset TMT. However, the credit is limited in any one year to 90% of AMTI. If the limit is likely to apply, the deduction election may be a more attractive alternative for lessening AMT exposure, if it is anticipated that the credit will not be fully used in the foreseeable future.
AMT Planning for Nonbusiness Items Postponing property tax and miscellaneous itemized deductions: Property tax and miscellaneous itemized deductions offer no benefits to a taxpayer in a year that AMT applies; such deductions are not allowed for AMT purposes. Thus, it may make sense for a taxpayer (such as H and W) to postpone these deductions until a year they can be used to offset RT. Because they are in an AMT situation, the property tax and miscellaneous itemized deductions are wasted in 2000. If a portion of either expenditure could be postponed to 2001, they may be fully used against RT. Changing the character of unreimbursed employee expenses: Miscellaneous itemized deductions exceeding 2% of AGI are deductible for RT, but not for AMT, purposes. For many taxpayers (and H and W), unreimbursed employee expenses comprise the bulk of this potential deduction. Employees may prefer an employer-sponsored accountable reimbursement plan, so that such expenses would not fall into this category. Evaluating home-equity loans: H and W incurred $3,000 interest expense on a home-equity loan used to buy an automobile. This interest is not deductible for AMT purposes and is a permanent adjustment in computing AMT. Thus, the tax deductibility of a home-equity loan is negated for any year that a taxpayer is in an AMT position. Electing out of installment method: Electing out of the installment method does not provide any real advantage for AMT purposes, because only capital gain can be reported as installment-sale gain. Any ordinary income due to depreciation recapture is taxed in the year of sale. Thus, capital gain is taxed at the same rate for both RT and AMT purposes. If a taxpayer sells depreciable property on an installment basis, Sec. 453(i) provides that any depreciation recapture must be reported in the year of sale. This may not necessarily be bad for a taxpayer in a constant AMT situation, because the recapture income is taxed at ordinary income rates. In effect, a taxpayer in an AMT situation pays, at most, 26% or 28% on the ordinary income. Also, the installment-sale method is no longer available for accrual-basis taxpayers,2 under Secs. 453(a) and 453A(d)(4). Because most taxpayers use the cash method of accounting, this change is likely to have little effect on AMT planning.
Conclusion Many commentators refer to the AMT as a largely symbolic tax, in that its existence gives the impression that all taxpayers pay some amount of income tax. However, the AMT is also a politically expedient way for Congress to require taxpayers to pay some (or more) tax without having to address the tax incentives that give rise to AMT. Because it is unlikely that the AMT will be repealed, it is important for taxpayers and tax professionals to be aware of strategies for avoiding or minimizing its effect. This article has proposed a number of ideas for implementing these strategies. |
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