Alternative minimum tax

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Alternative Minimum Tax (AMT) is part of the Federal income tax system of the United States. There is an AMT for those who owe personal income tax, and another for corporations owing corporate income tax. Only the AMT for those owing personal income tax is described here.

The AMT operates as a parallel tax system to the regular tax system with its own definition of taxable income, exemptions, and tax rates. It was originally called the "millionaire's tax", in that it targeted only the wealthiest households. The income triggers were not indexed for inflation so as incomes rose the AMT touched more of the middle class. Without periodic Congressional action to temporarily raise the income limits that trigger the AMT, almost a quarter of the United States' 90 million taxpayers could be required to pay the tax.

In practice, taxpayers must compute tax owed under the "regular" and AMT systems and are liable for whichever is higher. The AMT system has in general a broader definition of taxable income, a larger exemption, and lower tax rates than the regular system. For taxpayers subject to the AMT, it means that a portion of their itemized deductions are effectively eliminated, and thereby increases the tax they owe the federal government vs. the regular tax system.

Each year a taxpayer must pay the greater of an Alternative Minimum Tax (AMT) or regular tax.^[1] The AMT is a nearly flat tax on taxable income as modified for AMT. As with regular Federal income tax, rates and exemptions vary by filing status. The lower rate and the exemption are phased out above certain income levels at 25% of AMT income. A lower rate applies (through 2010) on capital gains (and qualifying dividends). These amounts for 2009 are reflected in the following table:^[2]

Status	Single	Married Joint	Married Separate	Trust	Corporation
Tax Rate: Low	26%	26%	26%	26%	20%
Tax Rate: High	28%	28%	28%	28%	20%
High Rate Starts	$175,000	$175,000	$87,500	$87,500	n/a
Exemption	$46,700	$70,950	$35,475	$22,500	$40,000
Exemption phase out starts at	$112,500	$150,000	$75,00	$75,000	$150,000
Zero exemption at	$299,300	$433,800	$216,000	$165,000	$310,000
Capital gain rate	25%	25%	25%	25%	20%

In addition, corporations with average annual gross receipts less than $7,500,000 for the prior three years are exempt from AMT, but only so long as they continue to meet this test.^[3] Further, a corporation is exempt from AMT during its first year as a corporation. Affiliated corporations are treated as if they were a single corporation for all three exemptions ($40,000, $7.5 million, and first year).^[4]

To the extent AMT exceeds regular Federal income tax, a future credit is provided which can offset future regular tax to the extent AMT does not apply in a future year.^[5] Regular tax for computing AMT is individual Form 1040 Line 44 or corporate Form 1120 Schedule J line 2 less foreign tax credit.^[6]

Under the AMT, no deduction is allowed for personal exemptions, nor is the standard deduction.^[7] State, local, and foreign taxes are not deductible. However, most other itemized deductions apply at least in part. Significant other adjustments to income and deductions apply.

Individuals must file IRS Form 6251 and corporations must file Form 4626 if they have any net AMT due. The form is also filed to claim the credit for prior year AMT.

Other individual adjustments in computing AMT include:^[8]

• Miscellaneous itemized deductions are not allowed. These include all items subject to the 2% "floor", such as employee business expenses, tax preparation fees, etc.
• The deduction for charitable contributions of property is limited to the basis of the property.
• The home mortgage interest deduction is limited to interest on purchase money mortgages for a first and second residence.
• Medical expenses may be deducted only if they exceed 10% of Adjusted Gross Income, as compared to 7.5% for regular tax.

Many AMT adjustments apply to businesses operated by individuals or corporations.^[9] The adjustments tend to have the effect of deferring certain deductions or recognizing income sooner. These adjustments include:

• Depreciation deductions must be computed using the straight line method and longer lives than may be used for regular tax. (See MACRS)
• Deductions for certain "preferences" are limited. These include deductions elated to:
  • incentive stock options,
  • circulation costs,
  • mining costs,
  • research and experimentation costs,
  • intangible drilling costs, and
  • certain amortization.
• Certain income must be recognized earlier, including:
  • long term contracts and
  • installment sales.

Certain other adjustments apply. Corporations are also subject to an adjustment (up or down) for adjusted current earnings.^[10] In addition, a partner or sharehlolder's share of AMT income and adjustments flow through to the partner or shareholder from the partnership^[11] or S corporation.^[12]

AMT is reduced by a foreign tax credit, limited based on AMT income rather than regular taxable income.^[13] Other tax credits are not allowed.

The AMT was introduced by the Tax Reform Act of 1969^[14] and became operative in 1970. It was intended to target 155 high-income households that had been eligible for so many tax benefits that they owed little or no income tax under the tax code of the time.^[15] However, the AMT has evolved significantly in many ways since then, with substantial changes in 1978, 1982, 1986, 1990, and 1993, among others. According to the Congressional Joint Committee on Taxation, the AMT provisions enacted in the Tax Equity and Fiscal Responsibility Act of 1982 are the foundation for the present individual alternative minimum tax: these provisions included the disallowal of state and local taxes, the deduction for personal exemptions, the standard deduction, and the deduction for interest on home equity loans.^[16]

"In 1986, when President Ronald Reagan and both parties on Capitol Hill agreed to a major change in the tax system, the law was subtly changed to aim at a wholly different set of deductions, the ones that everyone gets, like the personal exemption, state and local taxes, the standard deduction, certain expenses like union dues and even some medical costs for the seriously ill. At the same time it removed and revised some of the exotic investment deductions. A law for untaxed rich investors was refocused on families who own their homes in high tax states."^[17]

A further shift, involving many definitional changes and extensive reorganization, occurred with the Tax Reform Act of 1986.

However both participation and revenues from the AMT temporarily plummeted after the 1986 changes.^[18] Further significant changes occurred as a result of the Omnibus Budget Reconciliation Acts of 1990 and 1993, which raised the AMT rate to 24%, and to 26%/28% respectively, from the prior level of 21%.^[19] Now many taxpayers who do not have high incomes or participate in any special tax shelter activities have to pay AMT.^[20]

The AMT is imposed under 26 U.S.C. § 55 and disallows many deductions and exemptions allowable in computing "regular" tax liability. (Regular tax liability is defined in 26 U.S.C. § 55(c)(1), with reference to 26 U.S.C. § 26(b), and does not include AMT and various other categories of taxes imposed under Chapter 1 of Subtitle A of the Internal Revenue Code.) The AMT currently sets a minimum tax rate of either 26% or 28% (depending on the amount of the taxpayer's "alternative minimum taxable income," as adjusted) on amounts above a large exemption so that taxpayers cannot use certain types of deductions to lower their tax below a certain minimum. Affected taxpayers are those who have what are known as "tax preference items". These include state and local income, sales and property taxes, accelerated depreciation, a portion of otherwise deductible medical expenses, miscellaneous itemized deductions, the bargain element in exercised incentive stock options, percentage depletion, certain tax-exempt income, certain credits, personal exemptions and the standard deduction. In addition, due to a different system of exemption phaseouts, items such as long-term capital gains may result in AMT.^[21]

In recent years, the AMT has been under increased attention. Because the AMT is not indexed to inflation and because of recent tax cuts,^[15][22] an increasing number of middle-income taxpayers have been finding themselves subject to this tax. The lack of indexing produces bracket creep. The recent tax cuts in the regular tax have the effect of causing many taxpayers to pay some AMT, reducing or eliminating the benefit from the reduction in regular rates. (In all such cases, however, the overall tax payable will not increase.^[23]) In 2006, the IRS's National Taxpayer Advocate's report highlighted the AMT as the single most serious problem with the tax code. The Advocate noted that the AMT punishes taxpayers for having children or living in a high-tax state and that the complexity of the AMT leads to most taxpayers who owe AMT not realizing it until preparing their returns or being notified by the IRS.^[24]

A brief issued by the Congressional Budget Office (CBO) (No. 4, April 15, 2004), concludes:

"Over the coming decade, a growing number of taxpayers will become liable for the AMT. In 2010, if nothing is changed, one in five taxpayers will have AMT liability and nearly every married taxpayer with income between $100,000 and $500,000 will owe the alternative tax. Rather than affecting only high-income taxpayers who would otherwise pay no tax, the AMT has extended its reach to many upper-middle-income households. As an increasing number of taxpayers incur the AMT, pressures to reduce or eliminate the tax are likely to grow."^[25]

However, CBO's rules^[26] state that it must use current law in its analysis, and at the time the above text was written, the AMT threshold was set to expire in 2006 and be reset to far lower values.^[27]

For years, Congress has passed one-year patches aimed at minimizing the impact of the tax. For the 2007 tax year, a patch was passed on 12/20/2007, but only after the IRS had already designed its forms for 2007. The IRS had to reprogram its forms to accommodate the law change.^[28]

In addition to the normal tax code calculations, the AMT system uses a different set of rules for determining taxable income and allowable deductions. The "tax preference items" are added back, then an AMT Exemption is subtracted to compute AMT Taxable Income (AMTI). The AMT Exemption is phased out at 25 cents per dollar of AMTI above $150,000 on joint returns. Criticism often focuses on the fact that the $150,000 phase-out threshold has never been adjusted for inflation since its enactment in 1986. AMT Exemption has been changed by a series of short-term legislative "patches" over the years, as shown in the table below. The most recent "patch" was extended through 2009.

AMT Exemption Amounts

	1986-1992	1993-2000	2001-2002	2003-2005	2006	2007	2008	2009 only
Married Filing Jointly	40000	45000	49000	58000	62550	66250	69950	70950
Single or Head of Household	30000	33750	35750	40250	42500	44350	46200	46700

Applying a 26/28% rate schedule to the AMTI gives the "Tentative Minimum Tax" (TMT). TMT is 26% of AMTI up to $175,000, plus 28% of the rest of the AMTI, if any. The TMT is compared to the income-tax amount calculated for the taxpayer. If the regular income-tax amount is greater than the TMT, no special action is required. If the TMT is greater than the tax calculated using the regular rules, the difference between the TMT and the regular tax is added to the regular tax amount, so the taxpayer pays the full amount of the TMT. In effect, the tax liability (before application of credits) is the greater of the regular income tax amount and the TMT.

For 2007, the AMT Exemption is not fully phased out until AMTI surpasses $415,000 for joint returns. Like any deduction that phases out with income, the AMT Exemption increases the effective marginal tax rate within the phase out range. Within the $150,000 to $415,000 range, the TMT rates of 26% and 28% are effectively multiplied by 1.25^[how?], becoming 32.5% and 35% (See note below)^{[which note?]}. The TMT rate for capital gains becomes 21.5% to 22% rather than 15%, because each dollar of capital gain causes 25 cents more of ordinary income to be taxed at 26% or 28%. These are the true marginal federal tax rates for most taxpayers owing AMT. These marginal rates for TMT exceed regular tax rates at the lower end of this income range. Therefore AMT liability (the excess of TMT over regular tax) typically increases as income increases above $150,000. Non-deductibility of state income tax under the TMT exacerbates this problem. Advice to accelerate income when you will be liable for AMT is therefore exactly backwards for most taxpayers.

A portion of the tax that is considered AMT may be available in later years as a "Minimum Tax Credit", reducing the tax due in later years, but usually not below the taxpayer's TMT level in those later years. A full description of the AMT Credit is The Fairmark web site has a guide to AMT Credit.^[29]

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Critics of the AMT argue that various features are flaws, though others defend some of these features:

• The AMT exemption and AMT exemption phaseout threshold are not indexed for inflation so that over time, the real values decline and the fraction of taxpayers subject to the AMT rises. This is known as fiscal drag or bracket creep.
• The AMT eliminates state and local tax deductions. (Arguments have been produced for and against deducting such taxes. For example, an argument against a deduction is that if taxes are viewed as a payment for government services, they should not be treated differently from other consumption.^[30])
• The AMT disallows a portion of the foreign tax credit, creating some degree of double taxation for the more than 8 million American citizens living abroad. Some modest income families owe AMT solely because of currency fluctuations.^{[citation needed]}
• Businesses and individuals have to do twice the amount of tax planning when considering whether to sell an asset or start a business. They must first consider whether a particular path of action will increase their regular income tax and then also must calculate if alternative tax will increase.
• Taxes are often owed in the year that an exercise of ISO stock options occurs, even if no stock is sold. Although many taxpayers believe that in such a case no actual income exists, the bargain element of the exercise is considered income under the AMT system. In extreme cases, if the stock is private or the value drops, it may be impossible to realize the money the AMT demands.^[31]

Determining whether one is subject to the AMT can be difficult. According to the IRS's taxpayer advocate, determining whether someone owes the AMT can require reading 9 pages of instructions, and completing a 16 line worksheet and a 55 line form.^[32]

The AMT is a tax of roughly 28% on adjusted gross income over $175,000 plus 26% of amounts less than $175,000 minus an exemption depending on filing status after adding back in most deductions. However, taxpayers must also perform all of the paperwork for a regular tax return and then all of the paperwork for Form 6251. Furthermore, affected taxpayers may have to calculate AMT versions of all carryforwards since the AMT carryforwards may be different than regular tax carryforwards. Once a taxpayer qualifies for AMT, he or she may have to calculate AMT versions of carryforward losses and AMT carryforward credits until they are used up in future years. The definitions of taxable income, deductible expenses, and exemptions differ on Form 6251 from those on Form 1040.

The AMT's lack of indexation is widely conceded across the political spectrum as a flaw. In 2005, the Urban-Brookings Tax Policy Center and the Treasury Department estimated that around 15% of households with incomes between $75,000 and $100,000 must pay the AMT, up from only 2-3% in 2000, with the percentage increasing at high incomes. That percentage is set to increase quickly over the coming years if no change is made such as indexing for inflation. Currently, households with incomes below $75,000 are subject to the AMT only very rarely (and thus most tax advisors do not recommend computing AMT for such households). That is set to change in only a few years, however, if the AMT remains unindexed.^[33]

The median household income in the United States was $44,389 in 2005, and households making over $75,000 per year made up the top quartile of household incomes. Because those are the households generally required to compute the AMT (though only a fraction currently have to pay), some argue that the AMT still hits only the wealthy or the upper middle class. However, some counties, such as Fairfax County, Virginia ($102,460),^[34] and some cities, such as San Jose, California ($76,354),^[35] have local median incomes that are considerably higher than the national median, and approach or exceed the typical AMT threshold. The cost-of-living index is generally higher in such areas, which leads to families who are "middle class" in that area having to pay the AMT, while in poorer locales with lower costs of living, only the "locally wealthy" pay the AMT. In other words, many who pay the AMT have incomes that would place them among the wealthy when considering the United States as a whole, but who think of themselves as "middle class" because of the cost of living in their locale.

As early as the first Tax Reform study in 1984, arguments were made for eliminating the deduction for state and local taxes ^[36]

The current deduction for State and local taxes in effect provides a Federal subsidy for the public services provided by State and local governments, such as public education, road construction and repair, and sanitary services. When taxpayers acquire similar services by private purchase (for example, when taxpayers pay for water or sewer services), no deduction is allowed for the expenditure. Allowing a deduction for State and local taxes simply permits taxpayers to finance personal consumption expenditures with pre-tax dollars.

Proponents of eliminating the state and local tax deduction lost out in the 1986 Tax Reform, but they won a concession by eliminating these deductions in the TMT computation. That, coupled with the non-indexation of the TMT, created a slow-motion repeal of the deduction for state and local income taxes.

The AMT's partial disallowance of the foreign tax credit disadvantages even low-paid American citizens and green card holders who work abroad or who are otherwise paid in foreign currency. Particularly as the dollar falls around the world, those working abroad see their incomes (when reported to the IRS in terms of US dollars) sky-rocket even if their actual incomes fall from year to year and even if their foreign tax liabilities increase. They are in effect being taxed solely on changes in exchange rates, from which they do not benefit because their household expenses are all in foreign currency.

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For many taxpayers, the common question is, "How do I avoid AMT"? The first step in answering this question is to recognize that AMT is not a simple add-on tax that is calculated independently of other taxes on the return. Some strategies that reduce or eliminate AMT do so by increasing the regular tax, and so do not reduce the taxpayer's overall tax liability.

A more relevant question is therefore "How do I minimize Tentative Minimum Tax (TMT)?" The simple answer is to have fewer AMT preferences. The biggest of these are normally state income taxes and local real estate taxes. In any given year, if a taxpayer's TMT is substantially greater than his or her regular tax, the taxpayer may want to push the last real estate tax payment or state estimated taxes into the upcoming year. Conversely, if the TMT is much lower than the regular tax, prepayment of state and local taxes may help avoid AMT liability in the following year.

The standard deduction is an AMT tax preference. It is zeroed out when computing TMT. If an AMT liability appears when the standard deduction is claimed, it may decrease or disappear when itemizing deductions, even though the itemized deductions are less than the standard deduction. Even if the AMT liability decreases, the total tax liability might either increase or decrease when changing from the standard deduction to itemized deductions. There is no simple rule to follow when the AMT is involved. The computation must be done both ways to be sure.

Another way to avoid AMT liability is to stay out of the $150,000 to $415,000 income range.^[37] For example, a taxpayer might be better off realizing a $1 million capital gain all in one year rather than dividing it into two or three years.

For taxpayers who owe AMT, charitable deductions and home mortgage interest (but not "hard money" refinancing interest) are especially valuable. They reduce tax liability by the full TMT effective marginal rate of 32.5% or 35% plus the full state income tax marginal rate.^[38] This may be quite a bit better than under the regular tax.^[39]

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While many parties agree that the AMT needs to be changed, some argue against its outright repeal.

• More than half of the AMT is paid by those having current annual income over $200,000.^[40]
• The AMT could be amended so as to have little or no effect on those with lower incomes.
• The reduction in tax revenues from repeal is relatively large. The loss is expected to be between $800 billion and $1.5 trillion in federal revenues over 10 years.^[41] According to the Washington Post, "By 2008, it would cost the Treasury considerably less to repeal the ordinary income tax system than the alternative minimum tax, according to the Tax Policy Center, jointly run by the Brookings Institution and Urban Institute." ^[42] In 2007, an analysis in the New York Times claimed that; (1) Annual cost of repealing the AMT, and maintaining the regular income tax, would be $70 billion, while (2) Annual cost of making everyone pay the AMT, and repealing the regular income tax, would be the lesser amount of $63 billion.^[43]

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Policy analysts are divided over the best way to address the criticisms of the AMT. Len Burman and Greg Leiserson of The Tax Policy Center, a joint program of the Urban Institute and Brookings Institution, have proposed a revenue-neutral, highly progressive replacement for the AMT. They suggest an "option [that] would repeal the AMT and replace it with an add-on tax of four percent of adjusted gross income above $100,000 for singles and $200,000 for couples. The thresholds would be indexed for inflation after 2007." This plan, the authors contend, would share the original goal of the AMT—that is, to ensure a certain level of taxation for high earners.^[44]

Other groups advocate repealing the AMT rather than attempting to reform it. One such group, the Cato Institute, notes that:

• Many tax loopholes the AMT was designed to address have since been closed;
• The AMT is needlessly complex and burdensome to taxpayers;
• A full repeal would leave Federal revenues as a fraction of GDP at about 18%, its average value in recent decades.^[45]

The National Taxpayers Union also supports repeal. "It is wholly unfair for policymakers to promote certain social and fiscal ideas through exemptions, credits, and deductions, only to take these incentives away when a taxpayer takes advantage of them too well."^[46]

The Tax Foundation says that the AMT could be effectively repealed simply by correcting the deficiencies in the regular tax code. Economist Patrick Fleenor argues that "it is usually the unjustifiable limitations on taxable income…that cause the AMT backstop to kick in. If income were taxed comprehensively by the regular tax code, there would be no way of legally avoiding taxation, and not one taxpayer would have to file the AMT form even if the law were still on the books."^[47]

Some have proposed abolishing the regular tax and modifying and indexing the AMT. A proposal to the 2005 President's Advisory Panel on Federal Tax Reform advocated increasing the AMT exemption to $100,000 ($50,000 for singles) and indexing it thereafter, applying a flat 25% rate, and allowing appropriate exemptions for income-producing activities, in addition to repeal of the regular tax.^[48]

Standard tax texts

• Willis, Eugene, Hoffman, William H. Jr., et al, South-Western Federal Taxation, published annually. 2009 edition (cited above as Willis|Hoffman 2009) included ISBN 973-0-324-66060-0 (student) and ISBN 978-0-324-66208-5 (instructor).
• Pratt, James W., Kulsrud, William N., et al, Federal Taxation, updated periodically. 2010 edition ISBN 978-1424069866 (cited above as Pratt & Kulsrud).

IRS AMT Assistant application (online software)

• Fairmark.com provide comprehensive practical information on the AMT applicable to even the most complex of situations.