By Kenneth H. Bridges, CPA, PFS March 2011
As mentioned earlier in this newsletter, one of the hot-button issues today is the alternative minimum tax (“AMT”). The alternative minimum tax is a separate but parallel system to the regular income tax. You must compute your tax under both systems, and pay the greater of the two. If the AMT is higher than the regular tax then this excess shows up on your return as an additional tax.
The AMT applies for both corporations and individuals. However, for S-corps (and also partnerships and LLCs) the adjustments flow through to the owners for computation on their personal returns, and small C-corps (generally those with average annual revenue of less than $7.5 million) are exempt from the AMT. Larger C-corps generally incur the AMT only if they are capital-asset intensive and thus have big depreciation adjustments. Further, the AMT rate is lower for C-corps (only 20%). Accordingly, the AMT is mostly an issue for individuals.
For individuals, the AMT is computed largely like the regular tax, except that you don’t get certain deductions (e.g. real estate taxes, state income tax, interest on home equity line of credit proceeds used for something other than home improvements, and miscellaneous itemized deductions) and you have to adjust for accelerated depreciation taken and for the gain on any ISOs exercised and held. Whereas for the regular tax you have a progressive rate bracket system (with Federal rates up to 35%), the AMT is pretty much a flat 28% (except that for dividends and long-term capital gains it is 15% like the regular tax; and a 26% flat rate applies to lower income amounts). Any AMT that you pay as a result of “timing differences” (e.g. depreciation differences or ISO adjustments) becomes a credit carryforward that you can use in any future year in which your regular tax exceeds your AMT, but only to the extent of such excess.
Anyone can potentially be subject to the AMT, but there are certain criteria that make you a more likely candidate:
- Incentive stock options – If you exercise and hold ISOs with a significant in-the-money value, you will almost certainly be in the AMT. Fortunately, AMT incurred as a result of ISO exercise becomes a credit that you may be able to use in future years. An article in an upcoming issue of this newsletter will discuss strategies with respect to ISOs.
- Significant capital gain – If you live in a state with a state income tax and realize a substantial long-term capital gain, you will most likely be in the AMT posture; either in the year of the capital gain or the following year (or both), depending on when you pay your state income tax. The reason is that your marginal tax rate both for regular and AMT purposes will likely be 15%, but you will get no deduction against AMT income for the significant state income tax you pay on the capital gain. Careful planning as to the timing of payment of your state income tax can often minimize the amount of your deduction for such that is effectively lost.
- Income between $150,000 and $500,000 – For those with income below $150,000, usually the AMT exemption will enable them to avoid it. For those with ordinary income above $500,000, generally enough of their income is subject to the highest rate bracket (35%) that the AMT (which caps out at 28%) does not come into play. For anyone with ordinary income between these two amounts, however, if you live in a state with a state income tax you will likely be in or very near the AMT.
- Investors – Individuals who derive most of their income from investments generally enjoy a very favorable Federal regular rate on most of their income (e.g. the 15% rate on dividends and long-term capital gains). This, coupled with the addbacks for state income taxes, real estate taxes, and investment expenses, makes investors likely candidates for the AMT almost regardless of income level.
- Capital intensive businesses – If you enjoy the benefits of accelerated depreciation on fixed assets, you may find much of that benefit taken back by the slower depreciation methods and periods required under the AMT.
The upside of incurring AMT is that it means your marginal Federal rate is at most 28% (versus potentially 35%). However, it does mean that you are losing the benefit of some of your deductions. The key is to plan properly in order to minimize the negative impact of the AMT.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.