Understanding The Alternative Minimum Tax vs The Standard Tax System

by Kosmo on 2012-05-291

Usually, when people talk about the alternative minimum tax, they say that the problem is that it is affecting people it was never intended to affect.

Whom, then, WAS the AMT intended to affect?

A Brief History Of The Alternative Minimum Tax

A precursor to the AMT was enacted in 1969, and the current AMT was enacted in 1982. In a nutshell, the AMT was supposed to act like an earlier version of the Buffet Rule. Many wealthy citizens were taking advantage of various loopholes in the tax law in order to pay very little in federal income tax. The AMT, true to its name, levied an alternative minimum tax on these people. The AMT tax system disallowed many deductions and exemptions and changed how other deductions were calculated. To compensate for the loss of these deductions, the AMT uses a much larger standard deduction than does the standard tax structure.

The bottom line: after computing taxes under both the standard and AMT methods, a taxpayer must pay whichever amount is larger.

Over the past thirty years, there have been a number of tax reforms that have closed many of the loopholes that existed in 1982, making it much more difficult for wealthy tax payers to avoid taxes. The AMT, however, is still around. While the standard deduction and exemptions in the standard tax system are automatically adjusted for inflation, the exemption for AMT can only be adjusted by congress. But note that the AMT rate has also increased over the years. In 1986 it was 21%. Currently, the AMT begins at 26% and climbs to 28% for income above $175,000. Capital gains under AMT are taxed at a rate of 25%, compared to the 15% under the standard tax system. As a result, the AMT has begun to affect more people (and companies) each year.

In 1969, the precursor to the AMT was focused on 155 wealthy families who paid no federal income tax. In 2011, 4 million taxpayers were affected by the AMT.

Are You Affected By The AMT?

For tax year 2011, the AMT exemption amount is $48,450 for single taxpayers and heads of household and $74,450 for married filing jointly. If you want to do a quick “back of the envelope” calculation, take your total income, subtract these amounts, and multiply by .26. If this amount is close to (or greater than) the amount of taxes you paid under the standard tax system, you need to take a closer look at your situation as you might be affected.

Standard Tax System vs The AMT: What Are The Differences?

  • Deductions — Many deductions are treated differently by the AMT. Some, such as deductions for state and local income taxes, are completely disallowed. Others, such as medical expenses and mortgage interest, are restricted.
  • Depreciation — Assets must be depreciated under a straight line method rather than the accelerated depreciation allowed under the standard tax system. With the MACRS (modified accelerated cost recovery system) depreciation that is used under the standard tax system, a significant chunk of an asset’s cost is depreciated in the earlier years of ownership and less during the later years. This makes some sense. If you buy an asset with a 10 year life, does it lose more value in the first year or the tenth year? Obviously, it takes the biggest hit in year one. However, under the AMT, an equal amount of depreciation is allocated to each year.
  • Stock Options — The AMT treats the bargain element of a stock option – the difference between fair market value and the price the stock is purchased at – as an AMT adjustment to income. For example, let’s say that a stock is trading at $100 per share and you exercise an option to purchase 1000 shares at $10 per share. You save $90,000 via the stock option, and this gets added to your income for the year. Note that you’ve only made money on paper. It’s quite possible that the stock will tank and that you’ll need to eventually sell at a loss — but you need to pay taxes on the $90,000 in the current tax year. If you don’t actually fork over the cash to pay the taxes on the $90,000, you’ll probably be forced to sell a big chunk of your shares in order to pay the tax bills.

    This brings to mind a problematic scenario that arose more often during the dot com bubble and subsequent downturn. Back then there were many employees who were caught by twin whammies that were triggered by the tax system and a sliding stock market. They were caught in the AMT trap as they exercised stock options while their stocks suffered tremendous losses. Adding insult to injury, these employees saw themselves owing money to the IRS while the value of their holdings deflated.

    Here’s more on the decision to sell or keep employee stock options. More on this matter is also discussed here.

Another AMT Gotcha

The AMT exemption is phased out at higher income levels. The exemption begins to be phased out at $112,500 for single/head of household and $150,000 for married filing jointly. For each $4 in income above these amounts, the exemption is reduced by $1, until it is finally exhausted. This has the effect of pushing the highest marginal rate from the official marginal rate of 28% to an effective marginal rate of 35% (equivalent to 28 X 1.25) because for each $4 in income at the higher level, the taxpayer is paying taxes on $5 (the $4 in actual income plus $1 due to the effect of losing the exemption).

So this has been a brief introduction to the AMT. If you think you may be affected by the AMT, you may want to contact a tax professional. The AMT typically starts affecting people when they reach about $200,000 in income, but everyone’s situation is different.

Copyright © 2012 The Digerati Life. All Rights Reserved.

{ 1 comment… read it below or add one }

Charlotte@EverythingFinance May 29, 2012 at 7:23 pm

Thanks for this information. Glad I have someone to do my taxes. I’ll have to ask my tax man before I file next year.

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