Why You Need to Be Aware of the Alternative Minimum Tax (AMT)


The AMT – that is, the alternative minimum tax – is fast becoming the federal income tax most people pay.  While the tax originally was intended to be a tax for the “rich,” more and more of the middle class (as well as, of course, many wealthy taxpayers) now find themselves AMT taxpayers.  And if you are a business owner in New York State/City, the recently enacted increases in NYS and NYC tax rates, together with the AMT, may well result in a higher overall tax bill despite the highly published rate reductions in the regular federal income tax.

In broadest overview, the AMT is a fully separate, parallel tax system; a kind of shadow tax system lurking next to, and independently of, the so-called regular tax.  Calculating the amount of income tax payable to the federal government takes two fully separate procedures.  First, the regular tax must be calculated, taking into account all available deductions and exclusions.  Then, the AMT must be calculated.  In calculating income subject to the AMT, various deductions are eliminated and certain types of excluded income are added back in.  The actual tax owed is the higher of the regular tax or AMT.[1]  (Note that “alternative” in alternative minimum tax does NOT mean that there is a choice in whether or not you pay the AMT.)

The highest federal regular tax rate is 35% (lowered from 38.6% by the 2003 tax act).  The maximum AMT rate imposed on most types of income is only 28%. [2]  However, the amount of income subject to the AMT – alternative minimum taxable income or AMTI (the AMT, like so much of tax, is a jargon-laden quagmire) – can be significantly greater than the amount of income subject to the regular tax. [3] 

AMT will have tremendous impact on individuals in the New York area who own businesses as sole proprietors, LLC members, partners and S corporation shareholders, thus making the tax life of entrepreneurs more and more complicated and expensive.  For these individuals, all business income and associated deductions generally are reported on their personal Form 1040s.  Interestingly, a person who owns a business through a C corporation, and who takes only a modest salary from the corporation, may be able to escape the brunt of the AMT storm by keeping his or her income and deductions at a low level.

So why are so many taxpayers, particularly business owners, in the metropolitan New York area, now AMT taxpayers?  As stated above, many deductions that are permitted for the regular tax are not permitted when computing AMT.  The most significant for those living in “high tax states” like New York (and New Jersey) is the disallowance of any deduction for state and local taxes.  Recent tax rate changes have exacerbated the AMT problem.  In particular, the decrease in the top federal tax rates to 35% without any corresponding adjustment to the AMT rates makes it more likely that AMT at a lower rate on a broader base will result in a higher tax than the regular tax.  This year's increases in New York State and City personal income tax rates (the maximum NYS rate increased from 6.85% to 7.7% and the maximum NYC rate increased from 3.64% to 4.45%) worsen the AMT problem (because the increased itemized deduction lowers the amount that would be payable under the regular tax).

In addition, no miscellaneous deductions are allowed (including unreimbursed employee business expenses and investment expenses).  As if these disallowances were not enough, no personal exemptions are allowed, interest on home equity loans is disallowed and medical expenses are allowed for AMT purposes only to the extent that such expenses exceed 10% of adjusted gross income (compared with 7.5% for regular tax purposes).  The only itemized deduction of any importance that survives unscathed in the AMT context is the deduction for charitable contributions.  Finally, most personal credits (including various educational credits, the dependent care credit and the child tax credit) do not reduce AMT.  The fact that most credits may not be used to offset AMT is another reason why more and more low and middle-income taxpayers are subject to AMT.  The AMT adjustments to itemized deductions, combined with the increases in New York State and  City tax rates will throw almost all New York area residents with incomes much over $100,000 into the AMT.

Somewhat counter-intuitively, the reduction in the regular tax on dividends to 15% will make it more likely that investors will become AMT taxpayers, even though the AMT rate on dividends is also 15%.  This is because less income is taxed at the highest regular tax rates, making it more likely that AMT will exceed regular tax.

Another bit of AMT complexity (and seeming unfairness to those affected), is that the combination of the taxpayer's net operating loss ("NOL") carryover and foreign tax credits cannot reduce the taxpayer's AMT liability by more than 90% of the AMT that would have been determined without these items.  Thus, a taxpayer with business losses in prior years likely may pay AMT when his or her NOL zeros out the regular tax.

In certain circumstances, a tax credit for the excess of AMT over regular tax is available in years subsequent to the year in which AMT is paid.  The AMT credit is available only where AMT is payable by reason of timing differences.  For example, a credit is available for AMT payable in the case where NOL carryovers eliminate regular tax but, for AMT purposes, offset only 90% of AMTI.  No AMT credit is available for AMT paid by reason of adjustments that are not in the nature of timing differences, such as the disallowance of personal exemptions or itemized deductions (including state and local taxes).

Can Anything Be Done?

The short answer to the question of what you can do about AMT is … not a whole lot, aside from being aware of AMT and accepting it as part of your tax life.  One thing you can do, however, is call your accountant or tax preparer early and often, because projections of AMT and regular tax liability will help in whatever AMT planning can be done.  As this article shows, AMT is neither simple nor intuitive.  It's best to rely on an accountant or tax professional (who will rely on computer software to do the AMT calculations).

The main traditional planning for AMT is through the timing of state and local tax payments.  A December estimated tax payment will be worthless as a deduction if the taxpayer owes AMT.  Deferring the payment to January may allow some benefit in the following year.  In this regard, the New York legislature recently threw a real curveball at nonresident business owners; New York now requires S corporations and partnerships (including LLCs that elected to be treated like partnerships for tax purposes) to withhold 100% of the New York State tax due on nonresident owners, thus taking some AMT planning opportunities out of their hands.

Further AMT planning involves avoiding miscellaneous itemized deductions, particularly unreimbursed employee business expenses.  Given the 2% floor on these deductions for regular tax purposes, it generally makes sense to avoid these deductions.  The full AMT disallowance of these deductions makes it even more important to try to figure some way not to have these types of unreimbursed expenses.

Conclusion

The long and short of it is, AMT has become the tax payable by most middle and upper income taxpayers in the New York area, with business owners of flow-through entities paying AMT on their business income.  Cries for legislative relief no doubt will be made.  Whether these screams for help fall on deaf ears remains to be seen.  One thing is certain, tax life for 2003 and years to come will be complicated by AMT.

END NOTES

[1]   Technically, the tax owed is the regular tax plus the excess of the AMT over the regular tax.

[2]   The exception is capital gains and dividends, which are taxed at the same maximum 15% for both AMT and regular tax purposes.

[3]   There is also a corporate AMT, imposed at a 20% rate, compared with the 35% maximum regular corporate income tax rate.  This article does not discuss the corporate AMT.