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Chapter 26: Alternative minimum tax planning.

WHAT IS IT?

As discussed in Chapter 18, the alternative minimum tax ("AMT") system is a second income tax system that is imposed on most taxpayers. A taxpayer must compare his or her income tax liability under the regular tax system to the AMT system and essentially pay the higher of the two amounts.

Let us start with the basic premise that income tax planning in general is difficult. With all of the various code sections, regulations, interpretations, explanations, rulings, etc., professionals in the area spend a lifetime just trying to understand one aspect well enough to be considered an expert. By adding a second layer of potential tax to consider, the planning becomes that much more difficult, but also, that much more important.

To make matters more complex, the AMT potentially generates a minimum tax credit ("MTC") in certain situations where the extra tax is caused by timing adjustments or preferences.

AMT planning is not for the faint of heart. At a minimum, proper planning involves multiple year tax projections that must consider the interaction of the AMT and regular income tax systems along with any potential benefits created by the MTC.

Further complicating matters is the fact that more people will be subject to the individual AMT in the future than ever before. In fact, the number of AMT taxpayers is projected to balloon to 33 million (3 in 10 taxpayers) by 2010. (1)

The underlying reasons that so many taxpayers are caught in the AMT trap are straightforward enough.

* Tax rate reductions in 2001 and 2003 tax laws (slightly exacerbated further for married couples due to the marriage penalty relief provisions)

* No corresponding AMT rate reduction

* AMT exemption and brackets are not adjusted for inflation

* Expiring tax provisions including the allowance of personal credits to offset the AMT and the higher AMT exemption (for 2000-2009).

Example: Ross and Dorothy North earn $200,000 of compensation each year and have four children (all under age 7). They contribute $5,000 per year to charities, pay mortgage interest of $20,000 (all acquisition indebtedness), real estate taxes of $6,000 and $10,000 of state income taxes.

Assuming that the tax bracket schedules increase by 3% each year after 2009 and the tax cuts enacted by the Bush administration are allowed to expire at the end of 2010, the North's tax situation from 2008 through 2011 is summarized in Figure 26.1.

BRIEF OVERVIEW OF THE AMT

Recall from Chapter 18 that the tentative minimum tax for individuals is assessed at a rate of 26% of alternative minimum taxable income ("AMTI") in excess of the AMT exclusion amount, up to $175,000 ($87,500 for married taxpayers filing separately) and 28% of AMTI exceeding that amount. (2) Preferential tax rates used to determine regular tax liabilities for long-term capital gains and qualifying dividends are also used in determining an individual's tentative minimum tax. (3)

AMTI is computed as follows:

(1.) Taxable income (before subtracting personal exemptions) as computed on Form 1040 (4)

PLUS OR MINUS

(2.) Adjustments to taxable income (alternative methods, discussed below, to calculate certain gains, losses, and deductions) (5)

PLUS

(3.) The amount of "preference items" (specified items, discussed below, on which the taxpayer is receiving preferential tax treatment) (6)

EQUALS

(4.) Alternative Minimum Taxable Income

The tentative minimum tax is calculated by applying the AMT system tax rates to the AMTI in excess of the exemption amount. An exemption of up to (a) $70,950 for a married couple filing jointly, (b) $46,200 for a single taxpayer, or (c) $35,475 for a married couple filing separately. (7) These exemption amounts were issued as part of the American Recovery and Reinvestment Act of 2009 and are in effect for 2009 only. Without future tax legislation, the exemption amounts for 2010 and beyond will revert to the 2000 amounts ($45,000, $33,750, and $22,500, respectively). These exemption amounts are not indexed for inflation, which is the primary reason why an increasing number of taxpayers are expected to be pulled under the AMT umbrella.

The allowable exemption is reduced by 25% of the amount by which AMTI exceeds $150,000 for married taxpayers filing jointly, $112,500 for single taxpayers, and $75,000 for married taxpayers filing separately. (8) Thus, the exemption is completely phased out for joint filers with AMTI in excess of $433,800. The complete phase-out amount for single filers is AMTI over $297,300 and for married couples filing separately is $216,900.

If the tentative minimum tax computed under this formula does not exceed the taxpayer's regular tax, the AMT does not apply. If the computed tentative minimum tax exceeds the taxpayer's regular tax, the excess of the tentative minimum tax over the regular tax is the AMT that is added to the regular tax liability.

For a more detailed discussion of the AMT and the related adjustments and preferences, please refer to Chapter 18.

IDENTIFYING THE AMT TRAPS

Before any AMT planning can be effectively started, an understanding of what items of AMT adjustment or preference might be creating the AMT in the taxpayer's situation is essential.

As covered in Chapter 18, most individual taxpayers who itemize deductions (whether they know it or not) are required to add back certain of these deductions when determining their AMTI. Deductions for charitable contributions, casualty losses, and wagering losses to the extent of reportable winnings are allowed in full for both regular tax and AMT purposes. For all other itemized deductions, the taxpayer must be diligent to ensure that he/she correctly follows the rules to determine what adjustments are applied in computing AMTI. Figure 26.2 describes some of the issues that can arise based on itemized deductions.

Of course, AMT traps are not limited to itemized deductions alone. There are also income-based adjustment and preference items that have traps for the unwary. These are discussed in Figure 26.3.

Certain deductions are also impacted by the AMT. There are some solutions to minimizing the impact of the AMT, although most involve making annual elections to slow down the deduction that is creating the problem. These issues are discussed in Figure 26.4.

The last set of traps to be aware of relate to the utilization of credits. There are a number of credits that are available to reduce a taxpayer's regular tax liability. However, a taxpayer may be limited in the amount of credits that may be used to offset his/her regular tax liability based on the AMT for the year.

In 2009, an individual taxpayer's nonrefundable personal tax credits are allowed to offset both regular tax and AMT. (10) Nonrefundable personal credits are those that are defined under Internal Revenue Code Sections 21 through 26, which include:

1. Child tax credit

2. Education credits (Hope and Lifetime Learning Credits)

3. Child and dependent care credit

4. Adoption credit

5. Credit for interest paid on certain home mortgages

6. Retirement savings contribution credit

7. Residential energy efficient property credit

After 2009, only the adoption credit, child tax credit and the retirement savings contribution credit may be used to offset both a taxpayer's regular tax and AMT. The other credits may offset regular tax only.

A taxpayer that has business tax credits may not use the credits to offset his/her AMT in a given year. The general business credit of a taxpayer is limited to the taxpayer's net regular tax (net of nonrefundable personal credits, foreign tax credit, and certain other rarely used credits) plus AMT, less the larger of (1) tentative minimum tax or (2) 25% of the amount by which the net regular tax exceeds $25,000. (11)

Example: Jessica Nelson's net regular tax liability for 2009 was $50,000. Her tentative minimum tax was $47,000. She also received a $5,000 general business credit from one of her partnership investments. She is permitted to claim $3,000 of the credit against her 2009 tax liability and thereby reduce her regular tax to $47,000. The remaining $2,000 may be carried forward to future years subject to carry-forward limitations.

AMT PLANNING TECHNIQUES

Rarely can one consider the impact of the AMT system in one particular year. Even when a taxpayer is expecting an unusually high amount of income that creates an AMT liability for that year, the planning ideas will typically include an analysis of accelerating or deferring income or deductions which will force a multiple year projection of the taxpayer's liabilities.

Once a taxpayer is subject to the AMT under the current rules, it is likely the taxpayer will continue to be caught in that trap if the taxpayer's income, deductions, adjustments and preferences in future years continue at the same level or increase.

Unfortunately, there is no overall planning strategy that can be implemented in order to avoid the imposition of the AMT. Each taxpayer's situation is very different--the items creating an AMT liability need to be identified before any planning can begin. For example, a married couple may have an AMT liability because they have six children and the AMT does not allow personal exemptions, while another couple with the same amount of income may be paying the AMT because of high medical expenses or investment expenses (a miscellaneous itemized deduction).

In order to create a complete AMT planning analysis, one must begin with a multiple year projection of the taxpayer's regular tax liability, AMT liability and expected MTC. From this point there are a number of general planning strategies that can be considered, including:

1. Moving income into an AMT year

2. Moving deductions into a non-AMT year

3. Timing the recognition of adjustment or preference items

4. Making elections to minimize the AMT

5. Utilizing alternative tax net operating losses ("ATNOL")

A multiple year projection is essential to completing the AMT planning process. Most (if not all) of the general planning strategies listed above involve issues of timing. For example, deductions for real estate taxes and income (or sales) taxes must be added back when taxpayers determines their AMTI. It is not a matter of whether taxpayers are going to pay these taxes, it is simply a matter of when. If taxpayers are able to control when certain items of income are earned or when certain (deductible) expenses are paid, much more flexibility exists for creative AMT planning.

Moving Income into an AMT Year

Timing the recognition of income can be advantageous to a taxpayer who may be subject to the AMT in one year but not another. Accelerating income into an AMT year works best for a taxpayer when the following conditions exist:

1. the AMT is primarily due to the add-back of exclusion-type adjustments or preferences, and

2. the taxpayer's marginal tax bracket in future years will exceed 28%, the top tax bracket of the AMT system.

To the extent the AMT is generated by exclusion items, there is no MTC involved and the AMT represents a pure permanent tax increase under the AMT system. As a result, any additional income that is recognized in the AMT year is taxed at a maximum marginal rate of 28% instead of a potentially higher marginal tax rate under the regular tax system (e.g., 30%, 33%, or 35%).

However, due to the nature of the AMT system, taxpayers in this situation will not be able to accelerate an unlimited amount of income into the AMT year at a 28% tax rate. Since the AMT system is a parallel tax system, as one adds income subject to the AMT, the regular tax liability will also increase--and eventually it will increase at a faster rate (as the marginal tax rate under the regular tax system exceeds 28%). Therefore, there will sooner or later be some point at which the regular tax liability will equal the AMT liability, any future increases in income will increase the total tax liability at the higher regular tax system marginal rate, and the marginal tax savings will have been completely absorbed.

Recall from Chapter 18 that adjustment and preference items that are treated as exclusions include (12):

1. Taxes

2. Medical expenses

3. Certain residential interest expense

4. Miscellaneous itemized deductions

5. Standard deduction

6. Personal exemptions

7. Excess depletion

8. Tax-exempt interest from private activity bonds

9. Applicable add back for the Section 1202 exclusion for gain from the sale of small business stock

Moving Deductions into a Non-AMT Year

Since itemized deductions such as taxes, medical expenses and investment expenses increase a taxpayer's exposure to the AMT without the generation of a corresponding MTC, it would be prudent for a taxpayer to attempt to pay these expenses in a year in which the AMT does not apply. Otherwise, no tax benefit would be generated from the payment of these expenses due to the imposition of the AMT.

Example: Nicholas and Amanda Wright earn compensation of $100,000 per year and have no children. They always give $5,000 per year to charities, spend $6,000 on real estate taxes and pay $20,000 in mortgage interest. Five percent of their compensation is withheld for state income tax purposes. In 2007, the Wrights sold some of their stock holdings and recognized a $400,000 gain (taxable at a maximum rate of 15%). They immediately set aside $20,000 to cover the state income tax on the gain (they live in a 5% flat tax state) but are unsure if they should pay the amount before the end of 2007 to claim the deduction or wait until April 15, 2008. A multiple-year analysis would show that they would save $1,509 by paying their state tax liability in 2007.
                   Pay State Tax             Pay State Tax
                      in 2007                   in 2008

                 2007         2008         2007         2008

Regular Tax     65,002       7,748        70,004       4,748
AMT             12,989          52         9,496       3,052
Total Tax       77,991       7,800        79,500       7,800


Timing of Adjustments and Preferences

A certain degree of planning can be undertaken with respect to adjustment and preference items that are in the complete control of the taxpayer and only impact the AMT. This section of the chapter will discuss two items in particular:

1. Incentive Stock Options (ISOs)

2. Tax-Exempt Interest from Private Activity Bonds

This book dedicates an entire chapter to planning with stock options. The adjustment for AMT purposes of the excess of the fair market value over the exercise cost for ISOs is one of the more common adjustments that has been creating a great deal of anguish for taxpayers.

Taxpayers may defer regular tax on income resulting from the exercise of an ISO as defined in IRC Sec. 422. (13) Unlike nonqualified stock options ("NQSO"), which are taxed to the extent of the value of the stock over the exercise cost, the taxation of an ISO occurs only when the stock acquired by exercise of the ISO is sold or otherwise disposed. At that time, the difference between the selling price and the amount paid for the stock when the ISO was exercised is taxed as a capital gain.

The capital gains treatment at the time of the exercise of the ISO does not apply if the taxpayer disposes of the stock within two years from the grant date of the ISO or within one year of the exercise date of the option. (14) If the taxpayer makes a disqualifying disposition, he/ she realizes gain as ordinary income in the taxable year of the disposition.

For AMT purposes, the ISO does not receive the deferral treatment at the time of exercise. Instead the ISO is treated like a NQSO. (15) This means that the value of the stock acquired at the time of exercise in excess of the exercise cost creates a positive AMT adjustment in that year.

Taxpayers who exercise ISOs must keep accurate dual records of the basis of their stock. For regular tax purposes, the basis will equal their exercise cost plus any transaction costs. For AMT purposes, the basis will equal the value of the stock on the date of exercise plus any transaction costs. When the stock acquired by ISO is ultimately sold, the taxpayer will reduce the AMTI in that year by the amount of the basis difference.

Taxpayers with stock options can manage the exercise and sale of such options by using such timing techniques as:

1. Exercising only the amount of ISOs that can be done without triggering the AMT in a given year;

2. Coordinating the timing of the sale or exchange of stock acquired by ISO with the exercise of newer ISOs;

3. Accelerating the exercise of NQSOs to a year in which the AMT applies to benefit from the lower marginal tax rate (see "Moving Income into an AMT year" above).

Each of these planning techniques is fully discussed in Chapter 27, Stock Option Planning.

Example: Kevin Peterson is an unmarried executive for a major corporation. He lives in Florida (no state income tax) and has not yet left the apartment that he rents in South Beach. In 2006, he expects to earn $500,000 in compensation. He has no other source of earnings and does not itemize deductions. He has 10,000 incentive stock options with an exercise price of $10. The stock is currently trading at $30 per share. Since he expects to hold the stock for some time into the future and believes he will likely receive more ISOs in the future, he wants to exercise as many ISOs as possible without triggering the AMT in 2006.
                            No ISO           Exercise
                           Exercises        2,888 ISOs

Taxable Income                $493,750          $493,750
Standard Deduction/
Personal Exemptions              6,250             6,250
ISO AMT Adjustment                   0            57,760

AMTI                          $500,000          $557,760

Tentative Minimum Tax         $136,500          $152,673
Regular Tax                   $152,673          $152,673
AMT                                  0                 0

Total Tax                     $152,673          $152,673


By exercising 2,888 ISOs at an exercise purchase cost of $28,880, Kevin will generate an AMT adjustment of $57,760 ([$30--$10] x 2,888). At $557,760 of AMTI, Kevin's regular tax (where ISO excess gain is deferred) and tentative minimum tax (where ISO excess gain is recognized) are both $152,673.

Example: Kevin then decides he wants to know the impact of exercising all of the ISOs this year. The results are summarized as follows:
                          No ISO      Exercise
                        Exercises    2,888 ISOs

Taxable Income           $493,750     $493,750
Standard Deduction          6,250        6,250
ISO AMT Adjustment              0      200,000

AMTI                     $500,000     $700,000

Tentative Minimum Tax    $136,500     $192,500
Regular Tax              $152,673     $152,673
AMT                             0       39,827

Total Tax                $152,673     $192,500


By exercising all 10,000 ISOs at an exercise purchase cost of $100,000, Kevin will generate an AMT adjustment of $200,000 ([$30-$10] x 10,000). At $700,000 of AMTI, Kevin's regular tentative minimum tax exceeds his regular tax by $39,827--which becomes the additional amount of tax he must pay under this scenario.

Note: Since all of Kevin's 2006 alternative minimum tax is generated by a deferral adjustment, the entire amount of his AMT becomes a minimum tax credit, eligible to offset regular tax in future years.

Example: In 2007, Kevin has the same amount of income but did not exercise any ISOs or sell any of the stock he acquired in 2006. He calculates his regular tax liability to be $152,006. The MTC is available to offset his regular tax liability dollar for dollar down to his tentative minimum tax. His tentative minimum tax liability is $136,500, allowing him to utilize $15,506 of the MTC generated in 2006. His remaining unused minimum tax credit is carried forward to future tax years.

Note that beginning in 2007, long-term unused minimum tax credits may be used to offset a taxpayer's liability. Please see Chapter 18--Alternative Minimum Tax for further information.

Most municipal bond issues that are tax-exempt for federal income tax purposes are also tax-exempt for the AMT. However, the interest earned on "specified private activity bonds" must be added to AMTI. The amount of interest to be added back is reduced by any deductions (e.g., investment interest or other investment expense attributable to the bonds) which would have been allowable if the tax-exempt interest was includible in gross income for regular tax purposes. (16)

A specified private activity bond is any private activity bond which is issued after August 7, 1986. (17) Private activity bonds are covered by IRC Sec. 141 and include any bonds that meet either (1) the "private business use" test and the "private security or payment" test or (2) the "private loan financing" test.

A bond is identified as a private activity bond at the time of its issue. Because the inclusion of the interest paid on such bonds in the AMTI of its holders makes them undesirable (or at least less desirable), the market for these municipal bonds is slightly smaller and issuers must offer a slightly higher yield to successfully issue the bonds. It is notable that the increased yield on these bonds is almost never enough to make the (AMTI-based) after-tax yield on the bonds as high as municipal bonds not subject to AMT. Thus, for investors subject to the AMT, private activity bonds are generally not optimal investments on an after-tax basis. However, for taxpayers not subject to the AMT, this offers an opportunity to benefit from the extra yield available when purchasing and/ or holding a private activity bond instead of a normal tax-free municipal bond. The extra amount of income, if it does not trigger the AMT, could be significant to a number of taxpayers.

Example: Early-retirees Sam and Lydia Costello receive $100,000 of pension income per year and have a $500,000 portfolio of municipal bonds. The municipal bonds have a coupon yield of 4.25% ($21,250 of tax-exempt income per year). They understand that similarly-rated private activity municipal bonds are yielding 4.50% ($22,500 of regular tax-exempt income per year). Should Sam and Lydia invest in the AMT bonds, or will they generate an AMT liability that completely offsets (or even exceeds) their increased yield?
                              Without        With
                             AMT Bonds    AMT Bonds

Taxable Income                 $83,100      $83,100
Standard Deduction              10,300       10,300
Personal Exemptions              6,600        6,600
Private Activity Bond Int.           0       22,500

AMTI                          $100,000     $122,500

Tentative Minimum Tax           $9,737      $15,587
Regular Tax                    $13,890      $13,890
AMT                                  0        1,697

Total Tax                      $13,890      $15,587


By converting all of their municipal bonds to private activity bonds, the Costellos create a $1,697 AMT liability, but enjoy only an extra $1,250 of bond interest income. Consequently, their after-tax yield would decrease from 4.25% to 4.16% ([$22,500--$1,697] -h $500,000). They should not invest in the private activity bonds unless they could get a higher spread than .25% between the regular municipal bonds and the private activity bonds.

Making Elections to Minimize the AMT

There are certain elections that can be made by a taxpayer or a taxpayer's business to help mitigate the potential impact of the AMT. However, these elections typically serve to slow down deductible items for regular tax purposes as well. Consequently, it can be particularly important to create multiple year projections of tax liabilities to properly evaluate the potential costs or benefits of these elections. In addition, it is important to bear in mind that if these elections are not made and the taxpayer is subject to alternative minimum tax, a minimum tax credit may be created.

Please note that some of these elections may need to be made by the taxpayer that owns the asset, as opposed to an individual investor who holds a partnership or shareholder interest.

Depreciation of Property Placed in Service After 1986--Recall from Chapter 18, Alternative Minimum Tax, that property placed in service after 1986 is depreciated using MACRS, which is typically the 200-percent declining balance method over a specified life, depending on the type of asset. For assets placed in service prior to 1999, taxpayers were required to re-compute depreciation for AMT purposes using the 150-percent declining balance method with a longer recovery period. Taxpayers could elect either of the following two methods for regular tax purposes on the assets placed in service for that year to avoid future AMT depreciation adjustment(s):

* IRC Section 168(g)(7)--Straight-line depreciation method using the AMT recovery period. This is an annual election that is made by the entity that purchased and used the asset. With this election, no AMT adjustment is required.

* IRC Section 168(b)(2)--150-percent declining balance method using the AMT recovery period. This is also an annual election that is made by the asset purchasing entity. However, since the depreciation method is still somewhat accelerated (150-percent versus straight-line), higher depreciation deductions will be realized for regular tax purposes in the earlier years (and lower depreciation deductions will be realized in the later years) than would be generated using the IRC Section 168(g)(7) election. Again, with this election no AMT adjustment is required.

After 1998, taxpayers could use the same recovery period that is used for determining their regular tax depreciation. However, the depreciation method still may be no faster than the 150 percent declining balance method. (18) Thus, the elections that may currently be used to reduce the impact of the AMT depreciation adjustments are:

* IRC Section 168(b)(3)--Straight-line depreciation method with no adjustment to the recovery period. Note that this annual election needs only to be made on personal property since real property is already being depreciated using the straight-line method and the recovery periods are the same for regular tax and AMT purposes. No AMT adjustment is required.

* IRC Section 168(b)(2)--150-percent declining balance method using the same recovery period as would be used for regular tax purposes. This is also an annual election that is made by the asset purchasing entity. However, since the depreciation method is still somewhat accelerated (150-percent versus straight-line), higher depreciation deductions will be realized for regular tax purposes in the earlier years (and lower depreciation deductions will be realized in the later years) than would be generated using the IRC Section 168(b)(3) election. Again, with this election no AMT adjustment is required.

Although the size and number of AMT depreciation adjustments has been reduced after 1998 due to the change in recovery period requirements, assets placed in service prior to 1999 can still have sizeable and/or important AMT adjustments to consider--especially given the fact that we are getting to the point when some of the depreciation adjustments will turn around (become negative) and begin to reduce the taxpayers' AMTI.

Research and Experimental Expenditures Paid or Incurred After 1986- IRC Section 174(a) allows taxpayers to deduct research and experimental expenses incurred in connection with a trade or business. Alternatively, the taxpayer may elect to capitalize and amortize such expenditures over 60 months for regular tax purposes. (19)

For AMT purposes, if research and experimental expenditures are deducted, an adjustment must be made in computing a non-corporate taxpayer's AMTI. The amount of the adjustment is equal to the difference between the current year expense and the amount that would have been deducted had the expenditures been capitalized and amortized over ten years. (20) However, if the taxpayer materially participates (as defined in the passive activity rules) in the business activities of the entity than incurred the expenditures, no AMT adjustment is required if the expenditures are deducted under IRC Section 174(a). (21)

An election may be made under IRC Section 59(e) to capitalize and amortize research and experimental expenditures over ten years for regular tax purposes. If this election is made, no AMT adjustment is required. This election can be made in any year expenditures are incurred. The taxpayer may elect to capitalize all, or any portion, of the research and experimental expenditures. Again, it is notable that if the election is not made and an AMT liability is created, a minimum tax credit may be available.

Intangible Drilling Costs--Most taxpayers will only see intangible drilling costs ("IDC") as an investor in an oil and gas venture. In general, these costs must be capitalized and depleted over the life of the mineral property. However, there is the opportunity to deduct such expenditures when paid or incurred. (22)

If the taxpayer makes the election to expense IDC, an AMT preference item may be created. The preference is equal to the amount by which the "excess IDC" exceeds 65% of the taxpayer's net income from oil, gas and geothermal properties for the year. (23) Excess IDC is the IDC deduction amount from productive wells less the amount that would have been deductible if the productive IDC were capitalized and either (1) amortized over ten years beginning in the first month of production or (b) depleted using cost depletion.

A taxpayer may make an election under IRC Section 59(e) to capitalize IDC and amortize it over 60 months beginning in the month the expenditure is paid or incurred. Like the election for research and experimental expenditures, this election can be made for all, or any portion, of current year IDC expenditures. If the election is made, no AMT preference item should be reported by the taxpayer.

These elections must be used with caution. If the elections are being considered because the taxpayer is currently paying the AMT due to deferral or timing adjustments, the AMT will likely be generating a MTC that can offset tax in future years. Increasing current income by slowing down depreciation or amortization and giving up the credit may not be a wise decision. If, on the other hand, the taxpayer is paying the AMT due to permanent adjustments, these elections could preserve deductions for use in future years when the AMT does not apply to the taxpayer. Either way, the need for multiple year projections of tax liability should be clear.

For non-AMT reasons, the elections may also be beneficial if the taxpayer has expiring net operating losses in the near future.

Utilizing Alternative Tax Net Operating Losses

A taxpayer that has a net operating loss ("NOL") in a year may also, but not necessarily, have an alternative tax net operating loss ("ATNOL"). For this reason, a separate calculation must be performed to determine a taxpayer's ATNOL. This is done by starting with the NOL for regular tax purposes and increasing or decreasing this amount by the AMT adjustments and preferences in the year of the loss. (24)

Example: Jack Sprat determined that he had a NOL of $175,000 as a result of his business falling on hard times. His only AMT adjustment in that year was a $15,000 positive depreciation adjustment. Since the positive depreciation adjustment increases his AMTI, it reduces his NOL by that amount to yield an ATNOL of $160,000.

The ATNOL must be carried to the same tax year as the NOL. (25) Therefore, care must be taken before a decision is made whether to use the automatic carryback period, or instead elect to carry forward the regular NOL. The ATNOL is used to offset AMTI in the carryover year even if the taxpayer did not have an AMT liability for that year. In general, taxpayers may carryback NOLs and ATNOLs two years and forward 20 years. (26)

The amount of ATNOL that can be claimed as a reduction to AMTI is limited to 90% of the taxpayers AMTI determined without regard to the ATNOL. (27) An exception was added by the Job Creation and Worker Assistance Act of 2002 for ATNOL carrybacks arising in and ATNOL carryforwards to tax years ending in 2001 and 2002. For such losses, the 90% limitation is increased to 100%. Note that an ATNOL must be initially carried to the same year as the regular tax NOL.

Example: Using the facts as above and assuming the loss year and carryback years were not 2001 or 2002, Jack carries back the loss two years to a year in which his AMTI was $100,000 but did not have an AMT liability. Jack could utilize $90,000 of his ATNOL in that year and carry forward the remaining $70,000 to the next year.

Since the regular tax NOL is permitted to offset 100% of a taxpayer's income in a carryover year and the ATNOL is limited to 90% of the taxpayer's AMTI, the carry back of a loss to a prior year may actually trigger an AMT liability for the taxpayer. The NOL may wipe out all of the taxpayer's income but leave a sufficient amount of AMTI for some AMT to be assessed. Therefore, taxpayers must compute the benefit of carrying back the NOL and ATNOL to prior years by reviewing the impact under both tax systems.

questions and answers

Question--Do individual states have their own version of an AMT?

Answer--Currently, nine states have some form of alternative minimum tax system, including California, Colorado, Connecticut, Iowa, Minnesota, New York, Rhode Island, West Virginia, and Wisconsin. The specifics of the state-level AMT system vary by state, but most are not indexed for inflation like the Federal system, and thus will increasingly affect taxpayers in their states in the coming years. Taxpayers in the above states should carefully review if they may be affected by their state-level AMT in addition to the Federal system.

CHAPTER ENDNOTES

(1.) Urban-Brookings Tax Policy Center, Burman, Gale, & Rohaly. "The AMT: Projections and Problems", July 7, 2003 www.brook. edu/views/articles/gale/20030707.htm.

(2.) IRC Sec. 55(b)(1)(A).

(3.) IRC Sec. 55(b)(3).

(4.) IRC Sec. 55(b)(2).

(5.) IRC Sec. 55(b)(2)(A).

(6.) IRC Sec. 55(b)(2)(B).

(7.) IRC Sec. 55(d)(1).

(8.) IRC Sec. 55(d)(3).

(9.) Note: This planning idea will save both regular tax and AMT. A reimbursed expense is always better than a deductible one.

(10.) IRC Sec. 26(a)(2).

(11.) IRC Sec. 38(c).

(12.) IRC Sec. 53(d)(1)(B)(ii).

(13.) IRC Sec. 421(a).

(14.) IRC Sec. 422(a)(1).

(15.) IRC Sec. 56(b)(3).

(16.) IRC Sec. 57(a)(5)(A).

(17.) IRC Sec. 57(a)(5)(C)(i).

(18.) IRC Sec. 56(a)(1)(A).

(19.) IRC Sec. 174(b).

(20.) IRC Sec. 56(b)(2).

(21.) IRC Sec. 56(b)(2)(D).

(22.) IRC Sec. 263(c).

(23.) IRC Sec. 57(a)(2).

(24.) IRC Sec. 56(d)(2).

(25.) Rev. Rul. 87-44, 1987-1 CB 3.

(26.) NOLs incurred prior to 1998 were permitted to be carried back three years and forward 15 years.

(27.) IRC Sec. 56(d)(1)(A).
Figure 26.1

                          2008        2009        2010        2011

Adjusted Gross Income    200,000     200,000     200,000     200,000
Personal Exemptions     (21,000)    (21,900)    (22,500)    (23,100)
Itemized Deductions     (40,599)    (40,668)    (41,000)    (40,308)

Taxable Income           138,401     137,432     136,500     136,592

Regular Tax Liability    27,496      26,744      26,275      30,426
Tentative Minimum Tax    28,938      35,425      35,425      35,425

AMT                       1,442       8,681       9,150       4,999

Tax Liability            28,938      35,425      35,425      35,425

AMT as % of Total         4.98%      24.51%      25.83%      14.11%

Figure 26.2

ITEMIZED DEDUCTION-BASED AMT TRAPS AND ESCAPES

 Itemized Deduction     AMT Treatment (Trap)        Planning Idea
                                                      (Escape)

Medical                 Deductible for AMT      Utilize employer
                        only to extent the      provide pre-tax
                        expenses exceed 10%     medical deduction or
                        of AGI.                 cafeteria plan. Funds
                                                are set aside from
                                                paycheck on a pre-
                                                tax basis and
                                                recovered in full
                                                with substantiated
                                                medical receipts. (9)

Taxes (Real estate,     Must be added to AMTI   Determine if real
state, local, etc.)     in year of payment.     estate taxes can be
                                                claimed as a business
                                                expense (e.g. home
                                                office or rental
                                                property), which is
                                                not added back for
                                                AMT purposes. Also,
                                                see "Moving
                                                Deductions Into a
                                                Non-AMT Year" below.

Mortgage Interest       Not deductible for      Watch the use of home
                        AMT unless used to      equity loans to
                        acquire, construct,     finance non-home
                        or substantially        expenditures
                        improve a principal     (consider other
                        residence or            financing
                        qualified dwelling      alternatives for car
                        (not a boat treated     purchases, tuition,
                        as a second home).      etc.). If the
                                                expenditure is for
                                                business property,
                                                determine if the
                                                interest should be
                                                claimed as other than
                                                an itemized deduction
                                                for mortgage interest
                                                (e.g. home office,
                                                rental property,
                                                interest expense on
                                                business property,
                                                investment interest).

Investment Interest     Recalculate deduction   Determine the impact
                        using interest from     investments in
                        private activity        private activity
                        bonds as an addition    bonds and investment
                        to investment income    expenses is having on
                        and excluding all       after-tax yield and
                        investment expenses.    consider investment
                                                alternatives, if
                                                appropriate.

Miscellaneous           Must be added to        Always try to have
Itemized Deductions     AMTI. Typically         expenses fully
                        created by large        reimbursed by
                        unreimbursed business   employer through an
                        expenses or             accountable plan (one
                        investment-related      in which expenses are
                        expenses.               substantiated).
                                                Alternatively,
                                                negotiate a reduction
                                                of salary and a
                                                payment of your
                                                expenses.

Figure 26.3

INCOME-BASED AMT TRAPS AND ESCAPES

    Income          AMT Treatment (Trap)      Planning Idea (Escape)

State /Local      Although refunds may be    Since taxpayers are not
Tax Refunds       taxable for regular tax    allowed to deduct state
                  purposes, these refunds    and local taxes when
                  are always excluded from   computing AMTI, it is
                  AMTI.                      only fair that taxpayers
                                             are not required to
                                             report the corresponding
                                             refunds.

Tax-Exempt        Tax-exempt interest from   Determine the impact of
Interest          private activity bonds     investments in private
                  must be included in the    activity bonds
                  determination of AMT.      (including the adjusted
                  Interest from bonds        rules regarding
                  issued during 2009 or      investment expenses) on
                  2010 is not included.      after-tax yield.
                                             Consider investment
                                             alternatives, if
                                             appropriate. See "Timing
                                             of Adjustments and
                                             Preferences" below.

Section 1202      7% of the excluded gain    With the enactment of
Gain              on qualified small         JGTRRA 2003, this
                  business stock must be     preference item is not
                  included in AMTI. (Prior   as damaging as it was
                  to the 2003 Tax Act, the   before. Consider
                  applicable percentage to   deferring other
                  be added to AMTI was 42%   deductions which may
                  of the excluded gain.)     cause the imposition of
                                             the AMT in the year of
                                             the gain. See "Timing of
                                             Adjustments and
                                             Preferences" below.

Incentive Stock   The excess of the fair     The timing of the
Options (ISOs)    market value of the        exercise of ISOs is
                  stock over the exercise    essential in maximizing
                  cost of the option is an   the after-tax return to
                  adjustment for AMT.        the taxpayer. This
                                             adjustment item can
                                             single-handedly create a
                                             taxpayer's AMT
                                             liability, but will also
                                             typically create a MTC
                                             for the future. Also, do
                                             not forget that negative
                                             adjustments are allowed,
                                             so when the stock
                                             acquired by ISO is sold,
                                             a large portion of the
                                             MTC may be realized
                                             against regular tax. See
                                             "Timing of Adjustments
                                             and Preferences" below
                                             and Chapter 27--Stock
                                             Option Planning.

Adjusted Gain     The difference between     Maintain meticulous
or Loss           an asset's regular tax     records detailing not
                  and AMT basis. This        only the regular tax
                  adjustment can be          basis of assets but also
                  sizeable depending on      the AMT basis. (For
                  the nature of the asset.   example, as mentioned
                                             above, the exercise of
                                             ISOs could create a
                                             large difference between
                                             the tax basis for
                                             regular tax and AMT.)

Capital Gains     Although capital gains     Evaluate the potential
                  continue to receive        impact of large capital
                  preferential treatment     gains on the total tax
                  under the AMT system,      bill under both tax
                  the increase in AMTI can   systems, and consider
                  trigger an AMT liability   moving a portion of
                  and cause other income     capital gains into a
                  to be taxed under the      non-AMT year to avoid
                  higher marginal AMT        increased taxes on non-
                  rates.                     capital-gains income.

Figure 26.4

DEDUCTION-BASED AMT TRAPS AND ESCAPES

    Deduction         AMT Treatment (Trap)          Planning Idea
                                                      (Escape)

Standard             If taxpayer does not      Most taxpayers who
Deduction            itemize, this must be     claim the standard
                     added back to AMTI.       deduction are not
                                               paying the AMT because
                                               of this adjustment
                                               alone.

Personal             The deduction for         Carefully determine if
Exemptions           personal exemptions is    all of the individuals
                     not permitted for AMT     being claimed as
                     purposes. Large           dependents qualify as
                     families are sometimes    such. It may be more
                     subject to the AMT just   beneficial for
                     because of the number     dependents to claim
                     of dependents (e.g.,      themselves on their own
                     children).                tax returns if they
                                               somehow fail the
                                               dependency rules.
                                               Consider the family's
                                               overall tax liability
                                               in this case.

Depletion,           All of these items are    Each of these items
Depreciation,        business related          have a corresponding
Passive              deductions which are      election which may be
Activities,          more accelerated for      made in order to treat
Circulation,         regular tax purposes      the deduction for
Expenditures, and    than they are for AMT     regular tax purposes
Research and         purposes.                 identically as the
Development                                    treatment for AMT
Expenditures                                   purposes. See "Making
                                               Elections to Minimize
                                               the AMT" below.

Alternative Tax      A taxpayer's ATNOL will   In the year an ATNOL is
Net Operating Loss   almost always be          created, carefully
(ATNOL)              different than their      consider the impact of
                     regular NOL. Depending    carrying the NOLs back
                     on the year of the loss   to previous years
                     and the current tax       instead of forward to
                     year, the ATNOL may       future years. There may
                     only be allowed to        be more regular income
                     offset 90% of a           tax saved by carrying
                     taxpayer's AMTI.          the loss back, but more
                                               AMT savings (and thus
                                               total tax savings) by
                                               carrying the NOLs
                                               forward.
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Publication:Tools & Techniques of Income Tax Planning, 3rd ed.
Date:Jan 1, 2009
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