Navigating the AMT system.

The alternative minimum tax (AMT) is designed to apply to taxpayers with substantial economic income who use tax credits and other tax incentives to reduce their tax liabilities. Although Congress originally intended only the highest income taxpayers to be subject to AMT, many middle-income taxpayers are finding themselves subject to it. The Urban-Brookings Tax Policy Center estimates that, by 2010, the AMT will raise 52% of its revenue from households with less than $100,000 in income.

According to a Congressional Research Service (CRS) Report for Congress, The Alternative Minimum Tax for Individuals (RL30149), the effects of the legislative reductions in the regular income tax due to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) have caused more middle-income taxpayers to be subject to AMT. The CRS estimates that, if the EGTRRA provisions are made permanent, the number of taxpayers subject to AMT will increase to over 41 million by 2013. The CRS also cites inflation as another reason for the increase in AMT. According to the National Taxpayer Advocate, if the original 1969 $30,000 exemption had been indexed for inflation, it would currently be greater than $150,000. For 2005 the exemption is currently only $40,250 for single fliers and $58,000 for joint fliers. Absent legislative changes, it will revert back to $33,750 and $45,000 for 2006.

How to Plan for the AMT

First, taxpayers must understand the risk that AMT will apply. With the reduction of regular income tax rates and increased credits and allowances lowering regular tax liabilities of individuals in the recent past, an increasing number of taxpayers are liable for AMT. Certain taxpayers may be at greater risk than others. For example, the Tax Policy Center estimates that 48% of married couples are subject to AMT, Versus only 3% of single individuals. New for 2006, the IRS has released an online tool to help individual taxpayers determine whether they are at risk; see www. irs.gov/businesses/small/article/0,,id=1 50703,00.html.

Second, to the extent AMT is a risk, individual taxpayers should understand which items affect the determination of AMT. Certain preference items that were used to reduce the taxpayer's regular tax liability must be added back in determining AMT income. These preferences are listed specifically in Sec. 56. Alternatively, individual taxpayers can gain a summary of the items giving rise to AMT by reviewing Form 6251, Alternative Minimum Tax--Individuals, and its instructions. Once identified, they can determine whether these credits and incentives can be avoided or deferred in an effort to minimize AMT exposure.

Any good AMT management strategy should include a multiyear analysis of income. Taxpayers should have the ability to understand the relative amounts of regular tax and AMT liability over a number of years, to determine the lowest out-of-pocket tax cost in the long run. Once these projections are identified, the following strategies may be considered in minimizing the effects of AMT.

Postpone and prepay state income and property tax payments: Sec. 56(b) does not allow deductions for state, local or foreign income or property taxes. Consequently, the nondeductibility of state taxes is one cause of taxpayers becoming subject to AMT. Delaying the payment of state income taxes is a possible strategy to defer the AMT effect. Similarly, if taxpayers are likely to avoid AMT in the current year but are projected to be liable for AMT in the following year, they can consider prepaying some of next year's state income taxes in the current year. This strategy will help to manage next year's AMT exposure.

Postpone paying other itemized deduction: Similar to taxes, taxpayers may consider postponing or accelerating paying certain addback itemized deductions, such as nonqualified mortgage interest (discussed below). Even if late payment penalties may be involved, the benefit of avoiding AMT may likely outweigh the penalty fees.

Accelerate charitable gifts: Charitable deductions are deductible for both regular tax and AMT purposes. However, the lower AMT tax rate may make the contribution less tax efficient.

Postpone exercising or triggering a disqualifying disposition of incentive stock options (ISOs): Under Sec. 56(b)(3), an ISO exercise is a preference item for AMT purposes, to the extent of the difference between the stock's fair market value at exercise and the strike price. Taxpayers may want to postpone an ISO exercise until the following year if they are in danger of falling into AMT. On the other hand, if they will be paying regular tax anyway, consideration should be given to an acceleration of the ISO exercise. Another way of equalizing the negative impact of an ISO exercise is to engage in a controlled disqualifying disposition of ISO stock. The effect of the disposition would be to create more income for regular tax purposes.

Postpone sales of long-term capital gain assets until next year: The creation of long-term capital gains typically contributes to AMT problems. Taxpayers may want to plan the disposition of capital assets or business property to coincide with the smaller likelihood of AMT. However, they should consult with their investment adviser before implementing this decision. Further, they may want to recognize capital losses when capital gains are raising income above the AMT exemption phaseout amount.

Accelerate income: Income acceleration can be accomplished in a variety of ways, including negotiating with an employer for earlier payments of items that would be normally paid shortly Her year-end, such as bonuses. Taxpayers could also consider selling capital assets that would give rise to. short-term capital gains.

Sell assets with high AMT basis: Because of the differences in depreciation schedules between regular tax and AMT (Sec. 56(a)(1)), the underlying assets will typically have a higher AMT basis until fully depreciated for regular tax purposes. Taxpayers may want to consider disposing such assets to recognize a negative AMT basis adjustment.

Invest in corporate bonds rather than municipal bonds: By increasing regular taxable income, this strategy capitalizes on the spread between regular tax and AMT rates.

Pay off home equity loans when the proceeds were not used for home improvements: Under Sec. 56(e), the only mortgage interest eligible for AMT purposes is on a mortgage whose proceeds were actually used to build, buy or substantially improve an individual taxpayer's main or second home. While regular tax allows a deduction for the interest paid on a mortgage taken in an amount up to $100,000, regardless of whether the mortgage is used for home improvements, no such allowance exists for AMT purposes.

Legislative Developments

Discussions on AMT continue to be a hot topic for lawmakers. In November 2005, the Senate approved the Tax Relief Bill of 2005 (S 2020) at an estimated cost of $31 million, and in December 2005 the House approved a stand-alone bill, the Stealth Tax Relief Bill of 2005 (HR 4096), at an estimated cost of $30 million. Both the Senate and the House versions extend the higher AMT exemptions for one year and index the exemption for inflation. However, the House version does not address the use of nonrefundable tax credits to offset AMT.

So why not repeal the AMT altogether? According to the Congressional Budget Office, repeal of the AMT under the current taxing system would be extremely expensive. Treasury estimates that if the EGTRRA and the JGTRRA tax cuts are extended, repealing the AMT would reduce revenues by over a trillion dollars between fiscal-years 2006 and 2015, making it more expensive to repeal the AMT tax than the regular income tax by 2013.

FROM DARLA DECORE, CPA, AND AMY LEACH, CPA, SCHAUMBURG, IL