Written by Merry G. Broughton, EA

About one in five taxpayers will have to pay the Alternative Minimum Tax (AMT) by 2010, unless reforms are made.[1] Not only will taxpayers in the $100,000–$500,000 income range owe AMT, but taxpayers in the $50,000–$100,000 income range will be surprised to learn they owe it too.

Taxpayers who potentially owe AMT must recalculate their taxable income as defined by AMT, apply the AMT tax rates, allow for credits and other factors, and compare the result against their regular tax liability. In effect, taxes are calculated two different ways, and you have to pay the higher of the two.

The AMT was established by the Tax Reform Act of 1969. Its target was high-income households that got so many tax breaks—loopholes, exclusions, deductions—that, in the end, they owed little or no tax. The intent was to limit tax sheltering and ensure that high-income filers paid at least some tax.

AMT income brackets and exemptions do not adjust for inflation, and it threatens to affect more taxpayers every year. Inflation’s accumulative effect is expanding the reach of AMT. So more taxpayers will not only complete a regular tax return, they will also have to fill out AMT forms, which have very different definitions of taxable income, deductible expenses, and exemptions.

Some income items make it more likely that a taxpayer will pay AMT. Incentive stock options, long-term capital gains, tax-exempt interest, and tax shelters, for example, can create AMT.

AMT can even be triggered by claiming various miscellaneous itemized deductions or tax credits, because these do not count when AMT is calculated. Personal exemptions are not allowed, state taxes are not deductible, and the standard deduction will not provide any relief from AMT. Medical expenses cannot be deducted until they exceed 10% of the Adjusted Gross Income (AGI) when the tentative AMT is figured.

For tax year 2007, the Tax Increase Prevention Act of 2007 (TIPA) increases the exemption amounts for individuals as follows:

• Married Filing Jointly (MFJ) and Qualifying Widow(er) (QW) = $66,250 less 25% of Alternative Minimum Tax Income (AMTI) exceeding $150,000 (0 exemption when AMTI reaches $415,000)
• Single (S) and Head of Household (HOH) = $44,350 less 25% of AMTI exceeding $112,500 (0 exemption when AMTI reaches $289,000)
• Married Filing Separately (MFS) = $33,125 less 25% of AMTI exceeding $75,000 (0 exemption when AMTI reaches $207,500

However, for taxpayers filing MFS, AMTI is increased by the lesser of $33,125 or 25% of the excess of AMTI over $207,500, without regard to the exemption reduction.

AMT exemption amounts have been increased to stave off a rise in the number of taxpayers who have to pay AMT.  But unless new legislation is enacted, the 2008 AMT exemptions amounts will return to 2000 levels. At that point most tax authorities expect the number of taxpayers who have to pay AMT to skyrocket.

According to a table in the Joint Committee on Taxation’s “Present Law and Background Relating to the Individual Alternative Minimum Tax ,”[2] the number of taxpayers projected to be affected by AMT over the next 10 years is as follows:

To reduce the burden of the individual AMT, this report suggests some reform options, including:

1. Exemption amounts could be increased or indexed to inflation.
2. Deduction for personal exemptions and the standard deduction could be allowed in computing AMTI.
3. State and local taxes could be deductible.
4. Minimum tax rates could be reduced.
5. Phase-out of the minimum tax exemption could be eliminated.
6. All non-refundable personal credits could be allowed to offset the minimum tax after 2007.

Most dramatic of the reform options, the AMT could be repealed.

Calculating AMT is a five-step process:

1. Calculate regular income tax.
2. Determine whether AMT may apply. NOTE: Some taxpayers are automatically subject to AMT, because it applies to everyone who claims certain kinds of adjustments to income (for example, stock options not exercised in the same year received). Other taxpayers may be subject to AMT if their taxable income plus other items exceeds certain limits.
3. Recalculate taxable income using AMT rules on Form 6251.
4. Compare regular tax before credits to tentative AMT tax.
5. Pay whichever tax is the greater.

Here is another way of defining how AMT works:

1. Preference items and adjustments are added back to the taxpayer’s regular taxable income to arrive at AMT income. 
2. The AMT exemption is subtracted. 
3. The amount left is subject to a 26% tentative minimum tax on the first $175,000 and 28% on the excess.
4. The amount by which the tentative minimum tax exceeds ordinary income tax is the taxpayer’s AMT liability.

According to IRS Publication 17, Your Federal Income Tax, some of the most common tax preference items include:

• Personal and dependent exemptions
• The standard deduction (if claimed)
• A portion of the deduction for medical expenses
• Most miscellaneous expenses claimed
• State and local taxes
• Certain income from incentive stock options (called the “bargain element” of such options, it is the spread between the price paid for the stock and the market price when the option is exercised)
• Interest on mortgages and home equity loans not used to build, buy, or improve a qualifying residence
• Tax-exempt interest on certain private activity bonds, such as income from municipal bonds issued to finance a sports stadium

Kleinrock [3] lists adjustments as follows:

Adjustments applicable to all taxpayers:

• MACRS depreciation of property placed in service after 1986
• Mining exploration/development costs
• Long-term contracts
• Net operating losses
• Certified pollution control facilities
• Installment sales of certain property
• Passive activity losses (business/farming)

Adjustments applicable to individuals:

• Limits on deductions
• Circulation and research/experimental expenditures
• Incentive stock options

Tax preference items include:

• Tax-exempt interest from certain private activity bonds
• Accelerated depreciation of certain property placed in service before 1987
• Exclusion for gain on sale of certain small business stock

The biggest difference between AMT and regular taxable income is the number of items that must be added back and the adjustments that are not allowed when calculating the tentative AMT amount.

For example, to reach the tentative AMT amount the taxpayer must begin with the regular tax AGI and then add back items such as private activity bond income. Also, the taxpayer may not subtract personal exemptions or the standard deduction, and not all of the itemized deductions.

Deductions also differ for AMT purposes. For example, regular tax investment interest is not allowed as a deduction for AMT purposes, and the medical expense deductions are limited to the amount above 10% of the AGI, whereas regular tax limits it to only 7.5%.

Following is an example of how AMT might work for some taxpayers.

John and Mary Moses are married filing jointly with two children. They run a small family cattle ranch (for which they have a Net Operating Loss (NOL) carryover from 2006 of $45,000 but earned a modest $4,000 this year). They also work in the city and have $142,000 in wages between them. They have long-term capital gains of $25,000 coming from an S-Corporation in which they are shareholders.

The NOL amount of $45,000 is added back to the income under AMT rules. Since there are no itemized deductions, the standard deduction is taken on the regular tax but is not allowed on the AMT calculation.

By the time line 55 of Form 6251 is calculated (which is where the $25,000 long-term capital gains come into play) and added back to line 31, the taxpayer ends up with AMT of about $10,600.

John and Mary’s income range plus the NOL carryover from their farming venture and the long term capital gains will cause them to have to pay AMT.

Many authorities say the best way to avoid AMT is to reform the rules that govern it. One reform would be to index AMT tax rates for inflation. Others think the best move is to repeal AMT altogether. Some say that stop-gap measures enacted every year will suffice, while others believe that such measures are just a Band-Aid on a life-threatening wound.

For the layman taxpayer the question isn’t what legislation can be worked out for the future; it's what can be done now? The answer is complex. Some taxpayers will automatically fall under AMT because of certain income adjustments. The taxpayer could try to avoid AMT by taking fewer tax preference deductions on Schedule A. Of course, the taxpayer would have to be intimately familiar with what those tax preference items are. The taxpayer could try to figure out how much AMT would be owed by completing Form 6251; this, however, would entail reading, understanding, and applying 10 pages of IRS instructions. Perhaps the best suggestion is to consult with a tax professional for tax planning that adjusts for AMT.

Being surprised by AMT is an unpleasant experience, but consider the alternative. What happens if the IRS discovers that the taxpayer should have paid AMT? When the IRS comes knocking at the taxpayer’s door for payment of back taxes, it will want interest and penalties too.

[1] Fleenor, P. and Chamberlain, A. (2005, May 24). Backgrounder on the Individual Alternative Minimum Tax (AMT).

[2] The Staff of the Joint Committee on Taxation.(2007, June 27).  Present law and background relating to the individual alternative minimum tax.

[3] Kleinrock Publishing, a division of CCH. (2006). Kleinrock’s analysis and explanation, individuals, alternative minimum tax, checklist of AMT adjustments and tax preference items.

Merry G. Broughton, EA, is a division manager with Drake Software’s Support group. She has five years’ experience in Support and assists with the administration of Drake Software’s forums as well as writing articles for the Drake Software Knowledge Base. Originally from Indiana, Merry worked at a local university before coming to work for Drake Software in 2002.