The Alternative Minimum Tax (AMT)

If you aren't already familiar with the individual alternative minimum tax (AMT), there's a good chance that you soon will be. Because its key figures aren't indexed for inflation, the AMT reachesfurther into the ranks of middle-income Americans each year. And, since temporary legislative band-aids expired at the end of 2006, the stage is set for a dramatic rise in the number of individuals who are affected.

What is the AMT?

The AMT is essentially a separate federal income tax system with its own tax rates, and its own set of rules governing the recognition and timing of income and expenses. If you're subject to the AMT, you have to calculate your taxes twice--once under the regular tax system and again under the AMT system. If your income tax liability under the AMT is greater than your liability under the regular tax system, the difference is reported as an additional tax on your federal income tax return. If you're subject to the AMT in one year, you may be entitled to a credit that can be applied against regular tax liability in future years.

How do you know if you're subject to the AMT?

Part of the problem with the AMT is that, withoutdoing some calculations, there's no easy way to determine whether or not you're subject to the tax. Key AMT "triggers" include the number of personal exemptions you claim, your miscellaneous itemized deductions, and your state and local tax deductions. So, for example, if you have a large family and live in a high-tax state, there's a good possibility you might have to contend with the AMT.

IRS Form 1040 instructions include a worksheet that may help you determine whether you're subject to the AMT (an electronic version of this worksheet is also available on the IRS website), but you might need to complete IRS Form 6251 to know for sure.

Common AMT adjustments

It's no easy task to calculate the AMT, in part because of the number and seemingly disparate nature of the adjustments that need to be made. Here are some of the more common AMT adjustments:

• Standard deduction and personal exemptions: The federal standard deduction, generally available under the regular tax system if you don't itemize deductions, is not allowed for purposes of calculating the AMT. Nor can you take a deduction for personal exemptions.
• Itemized deductions: Under the AMT calculation, no deduction is allowed for state and local taxes paid, or for certain miscellaneous itemized deductions. Your deduction for medical expenses may also be reduced, and you can only deduct qualifying residence interest (e.g., mortgage or home equity loan interest) to the extent the loan proceeds are used to purchase, construct, or improve a principal residence.
• Exercise of incentive stock options (ISOs): Under the regular tax system, tax is generally deferred until you sell the acquired stock. But for AMT purposes, when you exercise an ISO, income is generally recognized to the extent that the fair market value of the acquired shares exceeds the option price. This means that a significant ISO exercise in a year can trigger AMT liability. If ISOs are exercised and sold in the same year, however, no AMT adjustment is needed, since any income would be recognized for regular tax purposes as well.
• Depreciation: If you're depreciating assets (for example, if you're a sole proprietor and own an asset for business use), you'll have to calculate depreciation twice--once under regular income tax rules and once under AMT rules.

AMT exemption amounts

While the AMT takes away personal exemptions and a number of deductions, it provides specific AMT exemptions. The amount of AMT exemption that you're entitled to depends on your filing status. Your exemption amount, however, begins to phase out once your income exceeds a certain threshold ($150,000 for married individuals filing jointly, $112,500 for single individuals, and $75,000 for married individuals filing separately).

Caution: AMT exemption amounts are not adjusted for inflation--they only change through legislation. This is one of the principal reasons that more people are subject to the AMT each year. Temporary increases to the AMT exemption amounts expired at the end of 2006. Unless Congress passes new legislation, 2007 AMT exemption amounts will return to pre-2001 levels.

AMT rates

Under the AMT, the first $175,000 of your taxable income is taxed at a rate of 26%. (If your filing status is married filing separately, the 26% rate applies to your first $87,500 in taxable income.) Taxable income above this amount is taxed at a flat rate of 28%.

Tip: The lower maximum tax rates that apply to long-term capital gain and qualifying dividends apply to the AMT calculation as well. So, even under AMT rules, a maximum rate of 15% (5% for individuals in the lower two tax brackets) applies. However, long-term capital gain and qualifying dividends are included when you determine your taxable income under the AMT system. That means large capital gains and qualifying dividends can push you into the phaseout range for AMT exemptions, and can indirectly increase AMT exposure.

Summing up

Owing AMT isn't the end of the world, but it can be a very unpleasant surprise. It also turns a number of traditional tax planning strategies (e.g., accelerating deductions) on their heads, so it's a good idea to factor in the AMT before the end of the year, while there's still time to plan.

If you think you might be subject to the AMT, it may be worth sitting down to discuss your situation with a tax professional.