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Alternative Minimum Tax Planning

The Tax Reform Act of 1986 changed the tax landscape in many ways. One of the most significant changes was the creation of a separate Alternative Minimum Tax (AMT) structure. Congress enacted a separate tax regime intending to achieve a high number of goals - not the least of which was to make sure that high income taxpayers paid their fair share of taxes. Using AMT, Congress has managed to extract taxes from many taxpayers who had not previously paid taxes and to increase the tax burdens of many others. Coincidentally Congress added a level of complexity to the tax laws that is truly beyond the grasp of virtually all taxpayers and most tax preparers. To the layman, the AMT rules defy comprehension. There are, however, a number of planning techniques available to minimize the harsh effects of the alternative minimum tax.

At the heart of the AMT system lie AMT adjustments and AMT preferences (IRC Sections 56, 57 and 58). These items generally increase alternative minimum taxable income resulting in taxing benefits that Congress considers potentially abusive (read: transactions that reduce regular income tax liability).

It is this writer's opinion that tax software currently available to the consumer market does not give a taxpayer bullet proof answers to correctly compute AMT liability. There are software weaknesses, but more importantly, it's the interpretation as what is to be added and subtracted as AMT preference items and/or AMT adjustment items which create most potential inaccuracies.

Below is a list of the adjustments and preferences which an individual, filing Form 6251, must consider in determining alternative minimum taxable income.

ADJUSTMENTS

• Exercise of incentive stock options
• Passive activity losses
• Tax shelter farm losses
• Certain itemized deductions
• Post-1986 depreciation
• Mining exploration and development costs
• AMT net operating loss
• Certain installment sales
• Circulation and research and experimental expenditures

PREFERENCES

• Oil and gas well depletion
• Intangible drilling costs
• One half of the gain excluded from gross income under IRC Section 202 on the sale of certain small business stock

Determining the amount of the taxpayer's alternative minimum taxable income therefore is a complicated matter. Like regular income taxes, AMT taxable income has an allowable exemption. But, similar to the regular income tax regime, the AMT exemption is phased out over certain income levels. High income taxpayers end up losing their exemptions for both regular income tax purposes as well as AMT tax purposes.

ALTERNATIVE MINIMUM TAX CREDITS

A little understood section of the alternative minimum tax system is a taxpayer's ability to recapture alternative minimum taxes previously paid. Despite its name, the minimum tax credit (MTC) can only be used to offset a taxpayer's regular income tax liability; it cannot be used to reduce a taxpayer's alternative minimum tax liability. The MTC was designed to reimburse a taxpayer for tax that is "prepaid" because of AMT. Thus, once AMT taxes are paid, a credit may be available to offset a subsequent regular income tax liability. It is this tax practitioner's view that the vast majority of tax preparers do not understand those instances in which a taxpayer can recapture prior AMT taxes paid.

When Congress enacted the Tax Reform Act of 1986, it recognized that some alternative minimum tax (AMT) preference items "reflected deferral, rather than the permanent avoidance of tax liability". See Senate Report 99-313, 99th Congress, Second Session 521.

For example, AMT taxes paid because of high itemized deductions are not subject to recapture as an alternative minimum tax credit. Itemized deductions are viewed as a permanent type of tax avoidance and therefore do not create MTC credits. Other AMT preference such as the exercise of incentive stock options reflect deferral considerations rather than permanent avoidance, and therefore, AMT taxes paid on account of the exercise of incentive stock options can be recaptured in later years. The exercise of an incentive stock option creates an AMT preference in the year of exercise and will often result in alternative minimum taxes even though the taxpayer is only paying for and receiving stock and is not selling the stock.

AMT created by deferral preference items such as the exercise of incentive stock options can result in minimum tax credit (MTC) which in later years can be utilized against regular income tax liability. This MTC credit is claimed in the year of the sale of ISO stock in question or in a year of high regular income tax liability. These rules are extremely complex and require careful planning. Without an understanding of AMT and careful planning, taxpayers can and do lose the benefits of minimum tax credits.

The AMT regime is not well understood by the Internal Revenue Service nor by tax practitioners. Taxpayers are increasingly finding themselves paying alternative minimum taxes and not understanding what caused AMT tax to rear its ugly head. There are no generalized strategies for the alternative minimum tax. There is no substitute for accurate tax projections on a multi-year basis. Only a tax professional competent in alternative minimum tax computations and the minimum tax credit can guide a client through the intricacies of the AMT maze.

The alternative minimum tax system is inherently unfair to high income individuals and, in this writer's opinion, should be repealed. But in the rush for revenue by the government, the AMT tax will continue to exact a toll not only in tax costs but also in tax compliance costs as well.