June 9, 2014

In 1969, Treasury Secretary Joseph W. Barr had some shocking news to share with Congress. It wasn’t a report on the cost of having 543,400 soldiers posted in South Vietnam, the peak of the entire war. It was something much more shocking. His minions had discovered that 155 individual taxpayers with incomes exceeding $200,000 (around $2 million in 2014 dollars) were so good at milking tax loopholes they were not paying any federal income tax.

The report created a political fireball. More people wrote to members of Congress complaining about the 155 taxpayers than about the Vietnam War. That was just after 1968, the bloodiest year in the conflict, which had seen 16,589 military casualties and $77.4 billion spent in military costs.

Congress reacted with unparalleled speed. Before the end of the year, Congress had passed the Alternative Minimum Tax, a law specifically designed to stop wealthy individuals from abusing tax deductions. Congress didn’t move quite so fast on Vietnam, which dragged on for another 6 years, but at least those 155 freeloaders were stopped in their tracks.

What is the Alternative Minimum Tax?

The AMT is a parallel tax system that has its own methods and rules for calculating tax liability. Put simply, AMT eliminates many of the exemptions, tax credits, and deductions taxpayers use to reduce their tax bills under “normal” tax rules. The AMT system is much simpler; it has only two tax brackets: the 26% tax bracket and the 28% tax bracket. The result is that more income may be taxable under AMT rules than with “normal” tax rules.

Both tax systems, the AMT and the regular tax system, work in tandem. Taxpayers have the responsibility of using both systems to calculate their tax liability and using whichever system generates the most expensive tax bill. In lower income brackets, the regular tax liability is usually higher because of AMT exemption amounts. In 2014, the first $52,800 for single filers and the first $82,100 for married people filing jointly were exempt from the AMT. At higher income levels, the AMT is not so forgiving.

Who Is at Risk?

What started as a patch to stop 155 wealthy taxpayers from completely avoiding taxes now is now a tax behemoth that affects around 3.8 million taxpayers, according to a report by the Urban-Brookings Tax Policy Center.

According to figures published by the Tax Policy Center, in 1970, the AMT collected just $122 million, barely 0.1% of all individual income tax revenue for that year. Fast-forward to 2010, the AMT generated $102 billion, over 10% of all individual income tax revenue.

The rules that determine when AMT rules apply are complex and there’s no single item that triggers it, but any of these scenarios could trip AMT liability:

  • Having a large family.
  • A gross income of more than $100,000.
  • Holding or exercising incentive stock options.
  • Receiving a large capital gain, such as selling real estate.
  • Earning passive income, such as profits from stock dividends, business investments, rent or commissions and royalties.
  • Excessive itemized deductions, such as state and local taxes, home-equity loan interest and medical expenses.

Damage Control

So, what happens if you are hit with the AMT? What can you do to minimize the impact on your tax liability?
Walking the fine line between tax mitigation and tax evasion is hard enough under the IRS’s normal rules. Add the complexity of AMT and it starts to get crazy. If you suspect you may be hit with the AMT, you really should consider hiring a tax professional before taking any specific actions.

With that disclaimer in place, here a few steps you can take to minimize the damage of ATM rules.

1. Invest in Your Retirement

Reduce your adjusted gross income by investing as much as you can into tax-deferred accounts, such as a 401(k), a 403(b), a 457(b) plan or an IRA.

2. Invest in Pre-Tax Healthcare

Instead of including medical expenses as an itemized deduction, which are harder to claim under AMT, sign up for a pre-tax medical deduction plan. This will reduce your salary and help both the AMT and your regular tax.

3. Spread Gains and Losses

Reduce the impact of large, one-time gains and deductions by delaying the sale of an asset. If delay is not practical you can also spreading out big gain or losses by structuring payments into several installments.

4. Exercise Stock Options Strategically

If you know you are going to be subject to AMT, sell incentive stock options the same year you exercise them. If you exercise and sell in the same year, you have to pay regular tax on the income but not AMT. Even the AMT has a silver lining. If you decide to hold incentive stock options, wait to sell them in years when you don’t face AMT tax brackets.

5. Business Expenses Refunds are Your Friend

Ask your employer to pay you back for business expenses you incurred as an employee. Under AMT rules this is a tax-free event. Under regular tax rules, claiming for unpaid business expenses as an employee is smart because it reduces your taxable income. With AMT, any unpaid business expenses you claim for as an employee are added back to your income.

6. Take Bare-Minimum Deductions

Minimize your state and local tax deductions, a deadly AMT trigger, by only paying property taxes when they are due. Prepaying for state and local taxes is great when you claim them as a tax deduction, but under AMT rules they come back to bite you.

You May Need A Pro

Mitigating your taxes under the alternative minimum tax system can feel like someone moved the goalposts or changed the rules half way through a game, because most deductions and tax breaks no longer apply. Previously effective tax mitigation measures can become expensive tax traps and the most tax-efficient moves may feel counter-intuitive or even foolish. So, if you’re playing under AMT rules this year, you may want to consider hiring a tax professional who is used to the AMT playbook, even if you normally file your own taxes.