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THE (NOT REALLY) ALTERNATIVE MINIMUM TAX: COMING TO A RETURN NEAR YOU

October 11, 2002

We recently noted a peculiar feature of the tax law: while the tax brackets and standard deductions for the regular income tax are indexed for inflation, the alternative minimum tax (AMT) is not indexed.

The AMT is of course only an "alternative" for the taxpayer in the way keeping your wallet is really an "alternative� offered by the stickup man; taxpayers compute their tax under both the regular rules and the AMT rules and pay the higher tax. The top individual AMT rate is only 28%, compared to the top regular tax rate of 38.6%. While the AMT rate is lower, many regular tax deductions are not allowed for AMT � most importantly, the deduction for state and local taxes. The regular rate is slated to decline to 35% over the next few years, but no changes are in store for AMT.

Even without doing a lot of math, it is obvious that a tax that is not indexed for inflation will eventually become higher than an indexed tax, everything else being equal. With the scheduled decline in regular tax rates, �eventually� is sooner than you might think. In 1999, one million taxpayers paid AMT. According to the think tank Tax Policy Center, 36 million taxpayers will pay AMT by 2010 if the system isn�t changed. These proud 36 million will include 95% of all households with income between $150,000 and $500,000, according to the Center.

WHO PAYS AMT NOW? Inflation has yet to do its work on most taxpayers, but AMT returns are becoming more common every year. Certain sets of circumstances are most likely to produce AMT:

TAXPAYERS WITH LARGE CAPITAL GAINS. OK, this category is only theoretical this year, but it could happen. The top long-term capital gain rate is 20% for both regular tax and AMT. Think of the arithmetic here: a tax with few deductions will be higher than a tax at the same rate with many deductions. This situation is especially true in high-tax states like Iowa; the state tax imposed on a big capital gain is non-deductible for AMT.
TAXPAYERS WITH INCOME SPIKES. Taxpayers who follow a high-income year with a lower-income year often get a nasty AMT surprise. If they wait until the due date of their return for the high-income year to pay their state taxes, the deduction may wipe out their regular tax entirely, without lowering the AMT computation at all. Owners of businesses operated as S corporations or partnerships (including limited liability companies) often experience income fluctuations, with unpleasant AMT results.
BIG LAWSUIT WINNERS often share their awards with the IRS, which considers legal fees non-deductible for AMT.
FORMER DOT-COM MILLIONAIRES. The tax law has been even crueler than the stock market to many of these unfortunates. Taxpayers who exercise �Incentive Stock Options� (ISOs) must include in their AMT taxable income the exercise date �spread� � the amount the stock value exceeds the option exercise price. Many options exercised with multi-million dollar spreads in 2000 were worthless by the time taxes were due in April 2001. This has left many people in a hopeless tax situation.

WHAT TO DO? Year-end tax planning is often the key to avoiding AMT. A projection of current-year taxes can enable your tax advisor to spot AMT coming, and maybe to take steps to avoid it. The best way to avoid AMT is often to pay state taxes in the same year the income is earned � even though the tax payments can legally be delayed well into the following year. In many cases taxpayers can control the timing income is earned to minimize AMT � or even, sometimes, to take advantage of the lower AMT rates.

BUT BE CAREFUL. The AMT can, under some circumstances, generate an �AMT Credit� offsetting regular tax in future years. This credit, while welcome, can make AMT planning very complex; it can make the income acceleration strategy very foolish at times.

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