To better understand the alternative minimum tax (AMT), you must first understand how the tax originated. In 1969, Congress established a minimum tax calculation for 155 (out of about 70 million filers) high-income earners who, despite earning $200,000 or more, paid no federal income tax in 1966. The situation caused some public outrage. Legislation was subsequently introduced and enacted to ensure an adequate level of minimum tax payments from individuals who benefitted from those loopholes.
Fast forward to 2017 and the AMT continues to sit squarely in the sights of lawmakers, albeit for different reasons. The Trump administration has targeted a repeal of the tax, perhaps partially due to the report that the current POTUS himself allegedly paid $31 million or 25% of $153 million in 2005. Without the AMT in place, Trump would have owed about 4% on that bundle, or approximately $25 million less. Nonetheless, both political parties as well as the National Taxpayer Advocate, a taxpayer watchdog within the IRS, see inherent flaws in the AMT.
However, until such time when Congress decides to act on Trump’s loosely conceived tax overhaul, the AMT still applies. In 2016, approximately 4.7 million Americans paid the tax. In the interim, it behooves certain U.S. taxpayers to understand the mechanics of the law and how the AMT, if applicable, might impact your own taxable earnings.
How AMT Works
When completing your IRS Form 1040 each year using software, two separate calculations are being performed as you enter earned income and deductions. One calculation applies regular income tax rules and the other calculation applies AMT rules. Regular income tax rules allow certain deductions and exemptions to reduce the amount of your income that is subject to taxation. The personal exemption for you and each dependent, for instance, is $4,050 in 2017. Under regular tax rules, that personal exemption reduces taxable income by the number of dependents claimed. Thus, if you’re married with two children and filing jointly, you could claim four personal exemptions totaling $16,200. Say you earn gross or pre-tax household income of $150,000 in 2017. Those personal exemptions would reduce your taxable income to $133,800 and subsequently shrink the amount of tax owed to the federal government. AMT calculations disregard the personal exemption deduction. That disallowance stands as one reason why large families who hover around the cusp of qualifying income levels find themselves subject to AMT.
While certain deductions must be thrown out for AMT calculations, the IRS has established an exemption that can be subtracted from taxable income once the qualifying amounts have been reached. In 2017, those exemptions, which are annually adjusted for inflation, remained the same as in 2016: $54,300 for individuals and $84,500 for married couples filing jointly. So taxpayers beneath the exemption amounts don’t need to worry about AMT.
There are two AMT brackets. The first $187,800 of income over qualifying thresholds is taxed at a 26% rate and income exceeding that amount falls into a 28% bracket. Income earned or deductions received from certain scenarios don’t apply to total dollar amounts in regular tax calculations. IRS Form 6251, which must be completed if you’re doing taxes manually, lists items subject to AMT rules. Most of these situations don’t apply to the average taxpayer. However, some of the more common items include state and local income tax deductions and interest from home equity loans, if those proceeds were used for something other than buying, building or improving a residence. Of the 4.7 million taxpayers who shelled out AMT in 2017, about 4.2 million would have avoided the payments had both personal exemptions and state and local tax deductions been allowed.
AMT exemptions for 2017 begin to phase out for married couples at $160,900 and for single filers at $120,700. As such, most people toward the bottom of the spectrum don’t pay AMT. Since the income thresholds weren’t adjusted for inflation until 2013, many middle-income earners owe AMT tax even though their earnings might not be considered on the “high” side. Yet after all relevant data for 2014 was examined, the IRS reported that only three in 100 taxpayers paid the AMT.
Investments and AMT Calculations
Municipal bond investors would be wise to examine how income from these investments affect their tax situations. Individual tax-exempt bond or municipal bond fund owners may receive interest payments through the purchase of private activity bonds. These bond issues finance projects such as stadiums that benefit the public and still escape federal taxation. Despite that qualification, interest from those bonds must be added into the AMT tax equation. If an individual filer earns $100,000 and receives $10,000 in interest payments from private activity bonds, that investment income must be added to total income considered for AMT. Effectively, that taxpayer’s gross income becomes $110,000 for AMT purposes.
Example of AMT:
|W-2 adjusted gross income||$100,000|
|ISO imputed income||$5,000|
|Minimum taxable income||$110,000|
|AMT taxable income||$56,900|
|AMT tax @ 26% rate||$14,586|
|Regular tax due||$13,200|
In this example, the taxpayer would owe the greater amount between the AMT and regular tax or $14,586.
Employees who receive incentive stock options (ISO) as part of total compensation packages must also be aware of how those perks affect their taxable bottom lines. ISO plans generally extend to employees who may purchase company stock presently and in future years for a fixed or “grant price”. That grant price might be $10. If the market value of the stock increases to $25, the employee can exercise the option to purchase the stock at $10 per share. No tax is due on the gain between the grant price and the exercise price per share. If the employee decides to sell the stock after a required waiting period, capital gains taxes will be owed on the difference between the exercise price of $25 in this case, and an assumed sale price of $50. As you might expect, AMT rules require the $15 difference between the grant and the market value be factored into earned income in the year the options were exercised. Thus, if a single filer earned $150,000 and exercised options on 500 share of company stock at $10 per share ($5,000 cost basis), then a market price of $25 at the time of exercise means that $7,500 (500 shares @ a market value of $12,500 minus the basis of $5,000) be computed in earned income for that year, increasing total taxable income to $157,500.
When looking for ways to mitigate or plan for AMT, it’s important for taxpayers to assess where they’ve been and where they’re headed. Individuals who paid AMT in a prior year could receive a tax credit to offset liability in a current year. In certain circumstances, unrealized income from exercising ISOs may trigger an AMT payment, but could also create a credit to reduce a future liability. The credit amount calculates on Form 8801, which records deferral items that can be carried forward to future tax years. By contrast, exclusion items such as miscellaneous deductions or unreimbursed employee business expenses are considered lost and not applicable to subsequent years.
Filers who have concerns that AMT may be due in a current year can look back at lines 34 and line 35 on Form 6251. These lines compare the tentative minimum or regular tax calculation with the AMT amount derived. If ISOs were exercised or other situations apply, filers can estimate whether that imputed income might result in a current AMT liability.
Summing It Up
Of the approximately 148 million tax returns the IRS expected to receive in 2016, paper returns projected to number about 15% or 23 million. Manually arriving at AMT requires attention to the twists and turns of the law as well as a fair amount of patience. The balance of filers won’t have to wrestle with AMT calculations as ubiquitous software programs figure AMT alongside regular tax computations. Taxpayers concerned about AMT liabilities would do well to leverage automated solutions when completing their tax returns. As always, despite the method of preparation, the safest course of action involves seeking advice from a qualified tax professional.