With the growing threat of the alternative minimum tax (AMT), many unsuspecting individuals may face an unpleasant surprise when they file their 2004 returns, cautions John Battaglia, a director in the Private Client Advisors practice of Deloitte Tax LLP, one of the nation’s leading professional services firm.
The AMT, originally established to ensure that wealthy taxpayers could not escape the income tax through means of special loopholes, now affects taxpayers that it was never intended for – families that earn middle- to upper-income salaries and reside in states with high income taxes. While the tax, at its inception, affected just a small number of taxpayers, its reach has grown over the years, particularly since the AMT exemptions and tax bracket amounts are not indexed for inflation.
“The reduction of marginal rates under the 2003 tax act, as well as inflation adjustments in the regular tax system, has further bolstered the number of taxpayers subject to the AMT,” Battaglia says. “If you were subject to the AMT in 2003 – or even close to it – you will more than likely owe it this year,” he advises.
Circumstances Triggering AMT
Certain transactions or events, such as significant miscellaneous itemized deductions, long-term capital gains or dividends qualifying for lower tax rates, paying income tax in a state with a high state income tax, and exercising incentive stock options, may trigger the AMT, Battaglia says.
"It is best to know whether you’ll pay the AMT as soon as possible, so you can plan before year-end to make the most of your tax situation," advises Battaglia.
For 2005, the AMT exemption will not change from the 2004 amounts – $58,000 for married couples filing jointly and $40,250 for single filers. High-income taxpayers may not be able to take advantage of the exemption since it is phased out as income increases. While the increased exemption amount will help some taxpayers, the reduction of marginal rates has exacerbated the AMT problem, especially for high earners who do not benefit from the exemption.
Deloitte Tax suggests the following tax planning strategies to help individuals counter the AMT and plan successfully for their financial future:
- Individuals who expect to owe AMT in 2004, but will owe regular tax next year, should consider accelerating ordinary and short-term capital gain income into 2004 and deferring 2004 deductions to 2005. Possible deductions to defer include state and local income taxes, real estate taxes and miscellaneous itemized deductions subject to the two percent floor, which are not deductible under the AMT system. This planning technique is contrary to typical advice, but it may lower the ultimate tax bill.
- Individuals who are not subject to the AMT in 2004, but who will be in 2005, should accelerate expenses that are not deductible for AMT purposes into 2004. Also, they should consider selling private activity bonds and or paying off home equity debt if the interest expense is not deductible for AMT purposes.
- Some of the differences between the AMT and regular tax systems are merely matters of the timing when deductions are taken. For instance, the AMT generally requires slower depreciation than is permitted for regular tax purposes. Other differences are permanent; for example, state income taxes can never be deducted under the AMT system, while under the regular system, they are deductible when paid. Paying AMT in one year may generate a credit against a future year's regular tax, particularly when adjustments are due to timing differences. Overall, an individual may be better off if AMT is paid in a previous year in order to gain a credit in a later year. Perform a multi-year analysis to anticipate the effect of planning techniques used in 2004 on future years.
- Consider whether any exercised incentive stock options should be disqualified (a disqualified disposition) before year-end to minimize the AMT liability, especially if the stock has dropped in value.
- Watch out for other AMT traps, such as income from private activity (municipal) bonds, which is taxable under the AMT. In addition, certain mortgage interest, such as from a home equity loan, is subject to AMT if the funds from the loan are not used to buy, build, or substantially improve a primary or second home.
- Taking advantage of lower capital gains rates can produce AMT implications in several situations, so be careful to consider the overall tax situation before taking any action. For example, the bargain element associated with the exercise of an incentive stock option is subject to AMT. Similarly, any large capital gain may raise your state and local taxes to a level that would trigger AMT. The resulting AMT could wipe out some or all of the benefit expected from the lower capital gains rate. This makes it particularly important to plan on a multiyear basis for transactions that could trigger the AMT.
- Perform an AMT “self diagnosis.” Falling victim to the AMT has many possible causes, but individuals may be particularly prone to AMT if any of the following issues exist:
- Large state and local tax deductions
- Large long-term capital gains
- Large deductions for accelerated depreciation
- Large miscellaneous itemized deductions
- Mineral investments generating percentage depletion and intangible drilling costs
- Research and development expenses
- An exercise of incentive stock options
- Tax-exempt income from private activity bonds
If one or more of these conditions affects you, you should discuss your AMT situation with your tax adviser, as soon as possible. “Planning now will help net savings today,” Battaglia says, “and it will best position individuals for the future.”