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Your deduction may be Schedule C, or it may be nothing at all

March 10, 2010

20100310-1.JPGOne of the first things people figure out about tax returns is that deductions on Schedule C are better than deductions on Schedule A. A legitimate Schedule C deduction is fully-deductible whether you itemize or not, for regular taxes or alternative minimum tax. If the deduction is instead an "unreimbursed employee business expense," it is only deductible if you itemize, only to the extent your "miscellaneous" deductions exceed 2% of your adjusted gross income, and it isn't deductible at all in computing your AMT.

A Montana investment advisor, a Mr. Purdy, figured out the difference. He worked for Merrill Lynch, where he received a W-2 and filed his returns as an employee for three years. Relationships soured and he sued Merrill Lynch, eventually getting a $393,000 settlement, $120,000 of which went to his attorney.

The taxpayer deducted the attorney fees as a Schedule C deduction for a new investment advisory business he set up. The IRS had other views. The Tax Court this week came down on the side of the IRS:

In addition, the parties treated Mr. Purdy as an employee. The two agreements Mr. Purdy signed consistently mentioned his employment with Merrill. Merrill paid Mr. Purdy a salary, withheld Federal and State taxes, and issued Mr. Purdy a W-2 every year. Mr. Purdy received benefits of the kinds an employee would receive, including health insurance and a retirement plan. Mr. Purdy reported the wages he earned as an employee consistently each year he was working at Merrill and even reported the settlement award as wages despite having been fired. At no time did he report any self-employment income from Merrill. Moreover, he claimed unreimbursed employee business expenses while he was working at Merrill. Mr. Purdy's tax returns during his tenure at Merrill never included a Schedule C related to his financial adviser activities and instead included his expenses related to his advising as unreimbursed employee business expenses...

Accordingly, we find that Mr. Purdy incurred these legal fees as an employee, not as an independent contractor, sole proprietor, or partner

This highlights a big problem that lawsuit winners often face. They are taxable on the whole lawsuit proceeds, but if the lawsuit arises from employment, the legal fees are a Schedule A deduction -- and if you have alternative minimum tax, that's often the same as non-deductible. After the lawyers and the IRS are done, the lawsuit winner may get the smallest cut of the awards. Moving the deduction to Schedule A cost Mr. Purdy about $42,000.

Cite: Purdy, T.C. Summ. Op. 2010-26.

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Well, the market crash was an education of sorts...

September 11, 2009

You can get a miscellaneous itemized deduction by cashing out an underwater Sec. 529 college savings plan, as William Perez explains. Remember, any deduction you get - and miscellaneous deductions only count to the extent they exceed 2% of adjusted gross income - doesn't count for alternative minimum tax.

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Stimulus conference bill has AMT patch

February 13, 2009

The conference version of the stimulus monstrosity "stimulates" us by including the alternative minimum tax "patch" for 2009 that was sure to pass eventually anyway. The bill (Section 1012) prevents the AMT from applying to 20 million or so new taxpayers by increasing the AMT exemption for 2009 to $70,950 for joint filers and $46,700 for unmarried taxpayers. Absent Congressional action, the exemption would fall to $45,000 for joint filers and $33,750 for unmarried folks.

The bill also extends the rule that allows a bunch of personal credits to apply in computing AMT, including the dependent care credit, the credit for the elderly and permanently disabled, the education credits, and the credit for "nonbusiness energy property."

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Long-term minimum tax credits: what are they?

October 10, 2008

Cash is king right now, and the new tax law turns "long-term minimum tax credits" into cash over the next two filing seasons. This prompts a reader question:

In your very informative article 10/6/08 I have a Question on terms; long-term unused minimum tax credits vs. long-term AMT credits. Are they the same under this new legislation? Are they the "minimum tax credit" on from 8801, LIne 28?

The minimum tax credit arises when taxpayers incur alternative minimum tax from items whose timing differs for computing regular tax and AMT. The most famous example of this is incentive stock options, which are taxable upon exercise for computing AMT, but not until the option stock is sold for regular tax. The credit can also be generated by differences in AMT depreciation, amongh other things. Minimum tax credit does not result when AMT is caused by itemized deductions, like state income taxes, miscellaneous deductions, or home equity loan interest.

Minimum tax credits carry forward to reduce regular tax, but only to the level of AMT in a subsequent year. As a practical matter, many minimum tax credits have languished unusable for years.

The new rules enacted in the bailoug bill treat mimimum tax credits that were generated by AMT more than three years before the current tax year as a refundable credit, like wage withholding; half of existing long-term credit can be claimed as a refund in 2008, and the rest in 2009. That means credits generated by AMT in 2004 and earlier will create refunds in 2008.

You may have a long-term mimimum tax credit if you have an amount on your 2007 Form 8801, line 28. To see whether you are eligible to cash out some minimum tax credit in 2008, you need to dig out your 2005 return and turn to Form 8801. If there is is a number on line 19, you may have a long-term minimum tax credit you can use in 2008. If the number doesn't get smaller on your 2006 8801 line 19 or your 2007 8801 line 19, and your 2007 form 8801 line 28 is at least as high as your 2005 8801 line 19, the 2005 amount is your long-term minimum tax credit carryforward. If your line 19 declined in any of the years after 2005, your smallest line 19 amount for the period should normally be your long-term mimimum tax credit carryforward.

So if you have a Form 8801 on your 2007 1040, it's time to dig out your old returns and see if the IRS might have some extra cash for you next April.

Related: How the refundable AMT credit works

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How the refundable AMT credit works

October 06, 2008

A reader asks a question that identifies a tricky issue in dealing with ISOs and the minimum tax credit under the new rules enacted last week. I have changed some of his numbers so it works better as an example.

I exercised some ISO's early in Jan at $180 but the stock has fallen to $80 now. My original intent was to hold until next year for capital gains benefit but knew I had the option of selling them by end of year to make the income regular and avoid AMT calc. With the change in ISO-AMT rules, does this mean that if I paid $420k in AMT for tax year 2008 that I can claim $210k cash back on my 2009 return?

The reader leaves out some important facts, so I will make some up. We will assume that the reader has ISOs for 10,000 shares, and that his exercise price was $30. If he holds the ISO stock for a year, he will have no 2008 regular taxable income on his exercise of incentive stock options, but he will have $150 per share added to his income in computing alternative minimum tax, - $1,500,000 in total. We will assume that this increases his AMT by $420,000: 28% of $1,500,000. This should generate a $420,000 minimum tax credit that may offset future regular tax, but not AMT.

The new tax law makes 50% of long-term unused minimum tax credits refundable, the same as if it were from wage withholding. "Long-term" unused credits are those over three years old. That means any credits generated by 2008 tax won't become "long-term" until 2012. So the taxpayer will not be able to get 50% back as a refundable credit until 2012; it will only be available to reduce regular tax, but only to the level of AMT. As the rule allowing refunds of long-term minimum tax credit expires after 2012, the remaining 1/2 would never generate a cash refund; it would only offset regular tax. That may not happen for many years.

If the taxpayer's $420,000 AMT credit had originated in 2003 instead, it would be "long-term" in 2008, and he would, under the new law, be refunded $210,000 in 2008 and $210,000 in 2009.

Disqualifying disposition: opting out of ISO treatment

If the reader sells the stock in 2008 at $80, the results differ. If he sells shares acquired by exercising an ISO within 12 months of exercise of the option, he in effect elects out of ISO treatment and the resulting AMT problems. He will have $1,500,000 of ordinary compensation income per share ($180 value - $30 exercise price = $150 x 10,000 shares = $1,500,000). Assuming a 35% rate, that means he will owe $525,000 to the IRS on the shares for 2008. He will also have a capital loss of $700,000, the difference between the $1,500,000 exercise price and the $800,000 sales price at $80 per share. But very importantly, he will have $800,000 cash available to pay the $525,000 tax. If he holds on to the shares that have already fallen in value from $180 to $80, he will be in a pickle if the shares decline more - and further stock declines are certainly possible in today's economy.

The ISO tax benefit benefit our reader would get by holding onto the shares for a year after exercise is that any gain would then be taxed then at capital gain rates. If the stock stays at $80, the reader will have $500,000 capital gain taxable at 15%, unless the next president and Congress raise capital gain rates for 2009. That would reduce his regular federal tax on the ISO income to $75,000. But he would still probably be unable to use much of the minimum tax credit generated by his 2008 exercise of the ISOs for a number of years, with the big benefit not available 2012.

The bottom line? Our reader has to do some thinking on whether the savings of having capital gain treatment of ISOs is worth both the market risk on his stock and the high possibility of having to wait until 2012 to recover taxes due in 2008 if he retains ISO treatment. If the stock goes to zero before he sells it, he has a $420,000 AMT liability and no cash.

Oh, and one more thing: Congress should fix the problem going forward by repealing the ISO rules entirely. They create a dangerous AMT trap for the unwary, and they encourage behavior - holding stock after exercising an option - that would normally not make economic sense.

UPDATE, 10/10/08: more at Long-term minimum tax credits: what are they?

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The bailout: more on the tax provisions

October 02, 2008

While most of the tax provisions attached to the bailout bill that passed the Senate yesterday were extensions of the "expiring" tax breaks that never actually seem to expire, there are a few new ones. The three original tax provisions of the failed House bill are in there, but there are also a few odd new provisions.

For example, the bill makes all machinery and equipment placed in service in a farming business in 2009 5-year property. Considering that farmers already qualify for the $125,000 Sec. 179 deduction for such property, this is a nice little spiff for an industry enjoying some of its most profitable times ever.

The bill also extends the Section 199 domestic production boondoggle to our strategic film and television production industry; this will enable the economy to pull itself up by its sitcoms.

Oddly, the bill caps the Section 199 deduction for domestic oil production at 3%, vs. the usual 6%, so as not to encourage too much of that; heaven knows we don't need any more domestically-produced oil.

ISO-AMT victims will get to claim as cash refunds up to 50% of their unused long-term AMT credits, starting in 2008. The bill also abates all interest and penalties attributable to unpaid taxes on ISOs, with a credit for those who have already paid such interest and penalties.

The bill imposes information reporting on brokers, requiring them to report on 1099s the basis and gain on securities trades, starting in 2011.

And perhaps most importantly, the bill exempts children's wooden practice arrows from the 39-cent-per-shaft excise tax otherwise imposed on arrows. And why shouldn't Congress shaft us a bit more?

A roundup of the provisions is below the fold. You can check with the TaxProf and the TaxGrrl for additional coverage.

Links:

Text of Senate Bill

Related: Saving the economy, one tax preparer at a time

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Lead the way, Senator!

October 02, 2008

20081001-1.jpg

One of the perks of being a Senator appears to be breathtaking self-righteousness. Consider this from Senator Grassley:

Grassley insisted that Wall Street itself had an important role in a crisis that has focused more on Congress in the past week.

"I've suggested that it wouldn't be a bad thing if the leadership of these investment banks and financial institutions and Fannie May and Freddie Mac would take a Japanese approach to corporate governance. And I'm not talking about going out and committing suicide," Grassley, a Republican, told reporters during a morning conference call.

"The CEOs go before the board of the directors, before the public and before the stockholders and bow deeply and apologize for their mismanagement," Grassley said.

That's a great idea, Senator. And as a supreme moral leader, it would only be fitting for you and your fellow Congresscritters to set the right example. Senator Dodd and Congressman Frank could start by standing on the mall and undergoing a Cultural Revolution-style self-criticism for enabling and encouraging Fannie and Freddie to insolvency, and for being silent while their well-connected executives took fabulous salaries while shoveling cash to their campaign funds. They should then resign and join a Trappist monestary, living out the rest of their days in silence while they contemplate and atone for their deeds while sparing us any further legislative mastery. In fact, all of Fannie's favorites could do some bowing and scraping.

Senator Grassley, a member of the taxwriting committees since the 1980s, could then step up to the platform to apologize, along with all of his taxwriting colleagues, for continuing to encourage overinvestment and overleveraging in the housing market through expansion of tax incentives for home ownership, home speculation, and mortgage borrowing.

Then, once the congresscritters who have made all of this possible stand up and take their own responsibility, then by all means bring on the executives. By then the crowd should be about out of eggs and tomatoes.

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Saving the economy, one tax preparer at a time

October 01, 2008

The text of the Senate version of the bailout is available, courtesy of The Wall Street Journal. It looks to be the House bill, with increased deposit insurance and the extension of expiring provisions, including the AMT patch.

It contains one provision dear to the hearts of tax preparers: it repeals the rule that subjected preparers to penalties for positions that would not be penalized if taken by taxpayers doing their own returns. Hey, it's a sacrifice we preparers are willing to make to save the financial system. We're just that nice.

It's pretty sad, actually. If the bailout is a good thing (I think it is, if only compared to the potential for disaster if nothing is done), you shouldn't have to bribe legislators to support it by attaching the extenders bill, which is a hodgepodge of largely bogus or silly tax breaks that are regularly re-enacted with a one or two year life to disguise their true cost, and to provoke regular visits from lobbyists bearing campaign money. Congress continues to earn it's 9% approval rating.

UPDATE: More on the tax provisions of the bailout.

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ISOS: THE TAXMAN TAKES A HOLIDAY

August 29, 2008

The TaxProf tells us that ISO-AMT victims will have a new reason to enjoy the long weekend:

Senate Finance Committee Ranking Member Charles Grassley today announced that he has secured a commitment from the IRS to suspend the collection of the AMT (including interest and penalties) arising out of employees’ exercise of incentive stock options. The suspension gives Congress time to enact legislation that would ease these burdens on affected taxpayers.

The entire ISO statute should be repealed - tax breaks and tax penalties alike. It's a relic of forgotten origins with no policy justification.

As for Senator Grassley's efforts to help the AMT-ISO victims - the good Senator has been on the Finance Committee since 1986 or so, and has had a hand in dozens of tax bills. It's good that he's working to fix a bad law, but it makes me think of this article.

Background here: TAX COURT TO MCLEOD AMT VICTIMS: SORRY, BUT YOU'RE STILL SCREWED

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FAIR OR NOT, AMT APPLIES

July 15, 2008

So the AMT can make your effective rate on capital gains higher than 15%? Tough, says the Tax Court:

Petitioners' first objection to the application of the AMT is that it contravenes a 2001 statutory enactment of a 15-percent tax rate on capital gains. Petitioners assert that the application of the AMT makes the effective rate on their capital gain income slightly more than 15 percent. In their own words, petitioners contend that the "application of AMT [is] * * * rendered null and void" because of this contravention.

If only it were that easy.

In computing the AMT there is a special computational provision for taxpayers with net capital gains. Generally speaking, the net capital gain income is multiplied by 15 percent and the result is added to the tax on other income which is computed in the manner described above. Sec. 55(b)(3). Following this computational provision, petitioners' AMT is computed at $7,007, which petitioners contend causes their net capital gain income to be taxed at an effective rate slightly greater than 15 percent because of the disallowance of the entire amount of the standard deduction and exemptions.

Petitioners' position would require a change to the statute that would apportion the disallowed items. Ultimately, however, respondent's computation is in accord with the statutes, and petitioners' argument fails.

The moral? The tax law is enforced based on what Congress actually did -- not on what you think they were trying to do.

Cite: Fritz, T.C. Summ. Op. 2008-81.

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IRS SNATCHES BACK ISO-AMT REFUND

May 16, 2008

Incentive Stock Options are a textbook case of grim unintended consequences from a tax break. Unlike regular "non-qualified" stock options, ISOs don't generate taxable salary income when they are exercised; if you hold on to them for one year after exercise and then sell them, any gain you have is long-term capital gain, taxed at preferential rates. This is supposed to be a tax break.

But there's a catch: the "bargain element" on the ISOs - the difference between their value and the price paid to exercise the options - IS taxable for alternative minimum tax in the year the option is exercised, even if the stock received on exercise isn't sold. If the stock becomes worthless between the exercise date and the sale date, the taxpayer pays AMT when the stock is exercised, but can only take the loss on the sale to the extent of other capital gains, plus $3,000 per year. Taxpayers have argued that there should be an AMT "net operating loss" rather than a capital loss, so that they could retroactively recover the AMT through an NOL carryback, but the Merlo decision rejected that argument.

The McLeod nightmare ISOs

This problem became all too real for many employees at McLeod Communications in Cedar Rapids -- perhaps most famously, Ronald Speltz.

Another McLeod employee, Bryce Nemitz, attempted to use the NOL carryback argument. Mr. Nemitz sold McLeod stock he had received from exercising ISOs in 2001. McLeod stock had tanked, so he had a huge loss compared to the amount he had to pay AMT on. On an amended 2001 return filed in November 2002, he computed an NOL that he carried back to 1999 and 2000. Things went well at first, as the IRS issued him carryback refunds of $53,942 for 1999 and $1,476,656 for 2000. Then the IRS realized what it had done and asked for the money back.

Did the IRS assess too late?

By the time the case reached Tax Court, the Merlo decision settled the issue of whether a loss on the sale of ISO shares could generate a net operating loss, rather than a capital loss ("no"). Mr. Nemitz tried to save the day by arguing that the IRS had asked for the money back too late, missing the three-year statute of limitations.

The IRS pointed out that assessments can be made on erroneous net operating loss carrybacks, the statute of limitations runs out three years after the filing of the return that generated the loss to be carried back - in this case, the 2001 return, under Code Sec. 6501(h).

Not really an NOL claim?

Mr. Nemitz argued that the refund was governed by Sec. 6501(a), the usual three-year statute of limitations for timely-filed returns, which would have expired for 1999 and 2000 by the time the deficiency notice was issued in 2005. He cleverly argued that since the amount carried back turned out not to qualify as an NOL under Merlo, it wasn't really an NOL, and so it didn't trigger the extended NOL statute of limitations. He also argued that the special NOL carryback statute applied only to regular NOLs, not AMT NOLs.

The Tax Court didn't go for either argument. Regarding the "it wasn't really an NOL" point, the court said:

The record establishes, and we have found, that petitioners claimed a net operating loss, and not a capital loss, for AMT purposes in the 2001 amended return and that they carried back that net operating loss for AMT purposes in the 1999 amended return and the 2000 amended return.

In other words: you claimed it as an NOL and the refund was erroneously issued as a result of the NOL claim, so the NOL statute applies.

Then the court addressed the claim that the special NOL statute only applies to "regular" losses:

As we understand it, petitioners are arguing that, because section 6501(h) refers only to a net operating loss carryback, and not to a net operating loss carryback for AMT purposes, that section does not apply to the deficiency for each of their taxable years 1999 and 2000 that is attributable to the carryback to each of those years of the net operating loss for AMT purposes that they claimed in the 2001 amended return.

Section 6501(h) applies in the case of a deficiency attributable to the application of a net operating loss carryback. The only provision in the Code that allows a net operating loss carryback is section 172(b). That section, which is entitled "Net Operating Loss Carrybacks and Carryovers", allows, inter alia, a taxpayer to carry back a net operating loss. Section 172(b) does not refer to, or distinguish between, a net operating loss for regular tax purposes and a net operating loss for AMT purposes. See Plumb v. Commissioner, 97 T.C. 632, 638 (1991). That section provides rules that apply to both the carryback of a net operating loss for regular tax purposes and the carryback of a net operating loss for AMT purposes. .

Like section 172(b), section 6501(h) does not refer to, or distinguish between, a net operating loss for regular tax purposes and a net operating loss for AMT purposes. If Congress had intended that section 6501(h) not apply with respect to the carryback of a net operating loss for AMT purposes, it would have so stated. It did not.

Bottom line: Mr. Nemitz has to pay back over $1.5 million to the IRS, in the hopes of getting some of it back over time under the relief provisions enacted in late 2006 for ISO victims.

The case has a sad note aside from the woeful consequence to the taxpayer; it was one of the last cases argued by our friend Burns Mossman, who died last year. It made me misty-eyed to see his name at the top of the opinion. If Burns couldn't pull it out, I'd say it was hopeless to start with.

Cite: Bryce E. and Michelle S. Nemitz, 130 T.C. No. 9.

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TAX PROCESSING TO START ON TIME FOR MOST TAXPAYERS

December 28, 2007

The IRS has announced that tax processing will start on time for most taxpayers, but that return processing will be delayed for some taxpayers affected by the belated enactment of the AMT patch. Processing won't start until around February 11 for taxpayers with the following forms in their returns:

* Form 8863, Education Credits.
* Form 5695, Residential Energy Credits.
* Form 1040A’s Schedule 2, Child and Dependent Care Expenses for Form 1040A Filers.
* Form 8396, Mortgage Interest Credit.
* Form 8859, District of Columbia First-Time Homebuyer Credit.

Kay Bell and Russ Fox have more.

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PAY EXTRA TAX THIS YEAR? ARE YOU CRAZY?

December 24, 2007

Tax advisors spend a lot of time looking for ways to punt income into the hereafter. It almost feels like heresy to suggest accelerating income. Yet in some narrow circumstances paying extra tax this year can save you money.

One example we see occasionally arises from the way the AMT exemption phases out. For 2007, the AMT exemption is $66,250 on joint returns, but it is reduced by 25 cents for each dollar adjusted gross income exceeds $150,000. This creates a hidden extra bracket for the AMT. While the stated top rate for AMT is 28%, the phase-out makes the real top rate 35% until the entire exemption is phased out (at AGI of $415,000 for joint filers). The phase-out also cause an extra hidden bracket on long-term capital gains, which are otherwise taxable at 15%.

If you have an item of taxable income that you can choose to take in either 2007 or 2008 (lucky you!), you might be better off taking the income this year and paying the tax sooner. It works if:

- Your 2007 income is already above the AMT exemption phase-out amount
- You will be subject to AMT in 2008, and
- Your 2008 income will be in the phase-out range.

A simplified example of an Iowa married couple illustrates this. The couple has $500,000 of 2007 income and will have $200,000 of 2008 income. They have another $100,000 of capital gain income they can choose to take in either year. They have two children, and their only itemized deduction is state income taxes.

If they take the $100,000 in 2007, their combined tax over the two years is reduced by over $6,000; if it is taxed in 2008, it is taxed in the hidden AMT phase-out bracket, while if it is taxed in 2007, it is only taxed at a the normal capital gain rate. The totals:

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Be careful! If you are going to accelerate your income, and your taxes, you'd better be pretty confident you know what your income will for both 2007 and 2008. Talk to your tax advisor before you start throwing your income around among your tax years.

This is another in our daily series of 2007 year-end tax planning posts. Look for a new post daily through December 31.

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THANKS, SANTA, BUT GO AWAY

December 20, 2007

If it's true that tax practitioners like new legislation adding complications so that our clients become even more dependent on us, well, our cup runneth over for the holidays. Congress is finishing up five bills to the president this week affecting the tax law in one way or another:

- The AMT Patch
- The mortgage debt forgiveness bill
- The energy bill
- A bill for military tax breaks, with attached technical corrections
- A bill with tax breaks for families receiving funds from the Virginia Tech shootings

The Congresscritters are also working on a farm bill with tax provisions larded in among the New-Deal subsidies that have outlasted the Depression by 67 years now. If they pass it, all tax geeks will need from Santa is a bigger stocking.

The only bad thing about these "gifts" is we can't return them for something useful.

AWFUL TAX POLICY IN SO MANY WAYS

There is so much bad tax policy in these bills, it's hard to know where to start. First, when you change the tax law constantly - six times just this month - that is bad policy by itself. When the law constantly changes, even the most diligent tax professional has trouble keeping up, and the poor taxpayr doesn't have a chance.

The AMT Patch is bad policy spawned by bad policy. The idea of having an "alternative" tax system as a "backup" for the regular system is just a way for politicians to have their cake while eating it. It gives away tax breaks with one hand to buy votes while taking them away with the other to show their concern for the "little guy" who isn't paying income taxes anyway. Rather than enacting a tax law that gets rid of the AMT and deals with the abuses it was supposed to address, the Patch just kicks the problem into next year, where Congress again will flail to deal with it ad-hoc.

The mortgage deadbeat relief bill has the bad policy of treating mortgage deadbeats better than other deadbeats just because they gambled on the real estate market, rather than, say, the stock market or the ponies. It does so temporarily, which is a bad idea, while making the exclusion for home sales (arguably a bad idea by itself) yet more complicated, which is never good. It also moves up part of a 2012 corporate estimated tax payment by one quarter, causing software and administrative complications to "pay for" the deadbeat relief by accelerating tax receipts that would be paid anyway by three months.

The energy bill limits itself to diddling with depreciation lives for some energy assets. The military bill makes the umpteenth change in military tax in the last 5 years, while fixing screw-ups from prior hyperactive tax legislative efforts. And the Farm Bill is just loaded with special interest tax subsidies, paid for by obscure traps and foot-faults and an "economic substance" provision that the IRS and Treasury have always opposed as bad and unecessary, but which the Congressional tax scorers call a "revenue raiser," making it an irresistable "pay-for."

Even the Virginia Tech thing is bad policy. Certainly the families of the victims deserve sympathy, but do they deserve it more than, say, the families Omaha Mall shooting victims? Or the family of the teenager who was stabbed in Des Moines this week? If Congress wants to help murder victims, they should write a tax law treating murder victims right to begin with, rather than narrow publicity stunts to ride the headlines.

IS THERE A SOLUTION?

Advocates of various tax elixirs say their plan will keep Congress from diddling with the tax law. That's fantasy. For example, a 30% national sales tax would make the lobbying game an even more high-stakes field than it is now.

Two things would help things get better. One would be an awareness that every tax break comes with a cost. Each tax break adds complexity and takes money out of the pockets of the majority of taxpayers who don't qualify. If politicians promising tax breaks were properly identified as picking your pockets on behalf of some lobbyist, maybe they'd keep their fingers to themselves.

The other thing that would help would be adults in key policy positions - Treasury Secretary, and chairmen and ranking members of the tax policy committees. If they did their jobs, they would be looking out for the interests of the rest of us against those who are constantly trying to take our money through targeted tax breaks. So much for any hope there.


BLOG COVERAGE OF THE AMT PATCH:

Tax Policy Blog (here and here)
Tax Grrrl
The Wandering Tax Pro
Taxable Talk
The TaxProf.

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HOUSE CAVES, AMT PATCH PASSES

December 19, 2007

The House of Representatives caved this afternoon and passed a an "AMT Patch" for 2007 with no offsetting tax increases. The President is expected to sign the bill.

The House apparently passed the version of HR 3996 passed by the Senate December 6. The bill increases the AMT exemption to $66,250 for a joint return and $44,350 for single filers. The amounts were $62,550 and $42,500 for 2006. If Congress had failed to pass a "patch," the exemptions would have reverted to $45,000 for joint returns and $33,750 for singles, adding an estimated 19 million additional taxpayers to the AMT rolls.

As the patch only covers 2007, it kicks the problem into 2008 - an election year. More fun awaits.

Link: Statement by Treasury Secretary

Related: HOUSE PASSES DOOMED AMT PATCH BILL

UPDATE: The TaxProf has a roundup.

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HOUSE PASSES DOOMED AMT PATCH BILL

December 13, 2007

The House of Representatives yesterday passed an "AMT patch" bill to keep 20 million or so new taxpayers from being hit with the alternative minimum tax. The bill is different from the Senate bill in that it has "pay-fors," or tax increases to generate the same revenue as the pre-patch AMT would. There's no telling how long it will take to reconcile the bills, so the beginning of the IRS 2007 1040 processing season recedes a little further into February 2008.

PAY-GO

The "pay-fors" are the sticking point. Congressional rules have for some years now required tax changes that reduce revenue to be "paid for" by additional revenues from somewhere else. These "Pay-as-you-go," or "Pay-go" rules have generated terrible tax policy and budgeteering chicanery great and small:

GREAT: The entire 2001 Bush tax cut legislation was warped into awful tax policy by the Pay-go" requirements. With enough votes to pass the bills, but without 60 Senate votes to waive the Pay-go rules, the Administration "paid" for its tax rate cuts by leaving the AMT alone. As taxpayers pay the greater of regular tax or AMT, a cut in regular taxes alone mathematically ensures that more people fall into AMT. Ever since then Congress has kicked the day of reckoning down the road one or two years at a time by increasing the AMT exemption amount.

The other great casualty of Pay-go in 2001 was the estate tax repeal. Lacking pay-fors, the 2001 bill increased the lifetime exemption over a period of years until the estate tax was repealed for one year, 2010. The estate tax then roars back in it's pre-2001 form, with top rates over 50%, in 2011. Whether or not you think the estate tax repeal is wise, it's hard to argue that what we have now is sound tax policy.

SMALL: The house-passed bill is full of the little budgeteering chicanery, and bad tax policy, generated by Pay-go. My favorite (via RIA):

Increase for large corporations the required installment of estimated tax which is otherwise due in July, August, or September of 2012 by 52.5 percentage points (with corresponding adjustments to the amount of the next required installment).

This is just a cheesy way to stuff tax revenue from the 2013 fiscal year, which begins in October 2013, into the 2012 fiscal year so they can say that the AMT patch is "paid for" under their through-the-looking-glass scoring rules. That's like "paying" a mortgage payment by taking a cash advance on your credit card.

Who is responsible for the mess? Bob Williams at Tax Vox argues persuasively that there is plenty of blame to go around. The TaxGrrrl just wants the mess cleaned up. And, of course, the TaxProf has a link-rich roundup.

Related: A LATE START TO TAX SEASON?

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A LATE START TO TAX SEASON?

December 03, 2007

The IRS might delay the start of 1040 processing at least two weeks because Congress hasn't passed an "AMT patch" for 2007 yet. Failure to pass the fix would throw 20 million new taxpayers into AMT this year.

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IRS OVERSIGHT BOARD: IRS CAN'T BAIL OUT DAWDLING CONGRESS

November 27, 2007

The IRS Oversight Board says that the IRS can't change it's systems based on what Congress might do to fix the alternative minimum tax. The IRS return processing systems can't be programmed for "what-ifs," according to the board:

These systems can only accommodate one programming option without introducing excessive risk to the filing season. Above all else, the IRS must ensure that its systems can process tax returns under current law. The IRS believes that implementing program changes into these systems that do not reflect current law could jeopardize this responsibility. The Board concurs.

The Oversight Board's views were stated in a letter to Senators Baucus and Grassley, the lead Senate taxwriters.

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PAULSON: PUNT AMT TO 2008

October 04, 2007

It's October. Do you know if you'll pay alternative minimum tax this year?

If you don't know, you're not alone. 23 million taxpayers may or may not be subject to AMT this year, depending on whether Congress enacts another one-year "patch" to put off the day of reckoning.

The 2001 Bush administration tax cuts lowered the regular tax rates for individuals, but not the AMT rates. Also, the AMT isn't indexed for inflation, unlike the regular tax rate system. As you pay the higher of regular tax or AMT, the reduction of regular rates and the effects of inflation have threatened to add millions of taxpayers to the AMT system.

Congress has put off the AMT day of reckoning by passing temporary "patches" that have increased the amount of income exempt from AMT. The most recent of these expired at the end of last year. Unless Congress acts, millions of taxpayers face higher tax bills for 2007.

Yesterday Treasury Secretary Paulson urged the House Ways and Means Committee to pass another patch, according to a story by Tax Analysts ($link). Ways and Means Chairman Rangel has been wanting to craft a bill to permanently fix the AMT by just raising the regular tax -- a proposal that would be certain to draw a veto.

What will happen? I'm guessing another one-year patch. The AMT hits Democratic states the hardest; they tend to have high state income taxes, which are a common cause of AMT. It's hard to imagine Congressional Democrats allowing a big tax increase that hits their own voters going into an election year.

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2008 MALIBU, AURA HYBRIDS QUALIFY FOR CREDIT

September 07, 2007

The IRS yesterday certified the 2008 Chevy Malibu and Saturn Aura hybrid cars for the Alternative Motor Vehicle Credit (IR-2007-156).

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Chevy Malibu Hybrid

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Saturn Aura hybrid

Both cars qualify for a $1,300 credit. Remember, this credit doesn't work for alternative minimum tax.

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FULL TAX COURT DENIES AMT NOL ON SALE OF ISO SHARES

August 16, 2007

20070816-3.jpegApparently seeking to be perfectly clear on an an issue that has provoked seemingly endless litigation, the full Tax Court ruled without dissent that a loss on a sale of shares acquired with incentive stock options is a capital loss in computing alternative minimum tax. Capital losses are limited to capital gains plus $3,000, which makes them much less useful than normal operating losses.

Yesterday's decision involved taxpayers who exercised incentive stock options in Veritas Software Corporation. Through March 2000 they paid $175,841 on the exercise to buy shares worth $5,922,522. In computing their regular tax, this generated no income, but the $5,746,681 excess of the stock's value over its purchase price was taxable income for AMT. As a result, the taxpayers paid over $1.6 million of AMT for 2000.

Their stock fared poorly in the subsequent months, and they unloaded 3/4 of their ISO shares for $2,756,758 less than they were worth when they were acquired. Because the acquisition value was used to compute their prior AMT, they had an AMT loss of that amount.

The taxpayers argued that their $2,756,758 loss should be treated as an ordinary loss, giving them a net operating loss for AMT purposes that could be carried back to reduce their 2000 AMT taxable income. The Tax Court instead ruled the loss a capital loss. Assuming that the taxpayer uses the AMT capital loss carryforwards to the tune of $3,000 per year, they should be about used up in a bit more than 900 years.

The result is unsurprising from a technical standpoint, as that is the obvious reading of the law; in fact, it has been reached from a slightly different angle in last year's reviewed Merlo decision (Merlo was affirmed by the Fifth Circuit last month).

The issuance of a fully-reviewed decision is unusual; this is only the fourth such decision this year. Perhaps the court is attempting to chase similar cases off its docket by making clear that further such efforts by AMT-ISO victims are futile.

Congress passed limited relief for AMT-ISO taxpayers last year.

Cite: Marcus, 129 T.C. No. 4

The TaxProf also has coverage.

Related Tax Update coverage:

MERLO AGES POORLY

YET ANOTHER AMT-ISO VICTIM LOSES IN TAX COURT

TAX COURT TO ISO-AMT VICTIMS: YOU'RE STILL SCREWED

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GRASSLEY V. PRIVATE EQUITY

August 10, 2007

Iowa's own Chuck Grassley is looking to private equity funds to fix the AMT mess. It appears that he wants to make public investment partnerships taxable as corporations. It also appears he wants to tax "carried interests" taxable as ordinary income. From the New York Post:

G000386.jpg

Iowa Senator Charles Grassley said he intends to link his proposal to boost taxes on publicly traded buyout firms to a fix of the alternative minimum tax, a pairing that may make it harder for opponents of the measure to vote against it.

"This is going to come when we deal with the alternative minimum tax," Grassley, a Republican, said in an interview yesterday. He said the bill deals with "issues of equity and fairness."

By going after carried interests, Senator Grassley and other congresscritters divert attention from their own negligence in managing the AMT. Their long-term budget projections assume AMT revenue that they never expect to collect. Increasing taxes on private equity can at best raise only a fraction of the trillion dollars needed to permanently the alternative minimum tax. By itself the annual "patch" to punt the projected expansion of AMT to 23 million more households back another year is now costing $45 billion annually.

If they really want to deal with the AMT, the only way to do so is as part of a broader reform that repeals tax breaks in exchange for lower rates. As it is so much easier to come out against hedge fund millionaires so it looks like you're doing something, that's the course we can expect Congress to take.

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BIG CREDIT, LITTLE CAR

July 26, 2007

The IRS has announced (IR 2007-133) that a $12,000 alternative vehicle credit is available for the hydrogen-powered 2005 and 2006 Honda FCX:

fcx06.jpg

There are only a few dozen of these critters in the wild, and only a few filling stations, so a $12,000 credit might be small consolation for a car that can't be used most places.

Now if hydrogen cars all look like the next version of this car, they might catch on:

fxcconcept08.jpg

Whether hydrogen cars have any real long term potential is another matter. And don't forget that the $12,000 tax credit does not apply for alternative minimum tax.

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SENATOR BROWNBACK AND THE LITTLE GOOD BOOK

July 19, 2007

Kansas Senator Sam Brownback floats a tax proposal as part of his foredoomed presidential campaign. It will land with a thud like a dull axe.

The candidate starts by declaring his undying hatred for the tax law:

People often laugh when I say on the campaign trail that the tax code should be taken behind the barn and killed with a dull axe. In fact, one man in Iowa was so excited by this proposal that he presented me with an axe before I finished my remarks (fittingly, I was speaking in a barn).

He goes on to say that he reads a trimmed-down version of the Bible:

Today's tax code -- which is sixteen times longer than the Bible -- is unpredictable, manipulative and hinders the economic growth that generates more prosperity for all Americans.

Um, no, the Code is not. Like the Bible, it can fit in one volume, but like the good book, it is often broken in two for convenience. That can only mean that the Senator goes with the Readers Digest version of the scriptures.

The Senator didn't come to praise the tax code, but it turns out he doesn't plan to bury it either:

That is why I propose an optional flat tax that would exist alongside the current code. This approach does not gore any of the tax code's sacred cows and it could actually be enacted into law. An optional flat tax would generate economic growth and be vastly more transparent, simple and family -- friendly than the current code.

We already have that. It's called the alternative minimum tax. Unfortunately, it's not optional.

It's hard to picture a less promising approach to tax reform than to start a brand new tax law on top of the old one. In real life, it would mean everybody would do their tax two ways (or three, if you count AMT, which you should).

The tax law needs reform sure enough. The way to do it is to broaden the base by eliminating special interest loopholes and credits, and to lower the rates so people will have less incentive to carve new loopholes. Adding a new code to the old code isn't going to break Senator Brownback from the pack of also-rans.

code.jpg
A recent edition of the Internal Revenue Code. Sam Brownback's version of the Bible is 1/16 as big.

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MERLO AGES POORLY

July 18, 2007

The unbroken string of courtroom frustration for AMT-ISO victims continued yesterday in the 5th Circuit Court of Appeals. The appellate panel upheld the Tax Court's ruling that Robert Merlo could not carry back a capital loss on the disposition of stock acquired by exercising incentive stock options.

When you exercise an incentive stock option, the excess of the stock's value over its exercise price is taxable income for computing alternative minimum tax, but not regular tax. If you hold onto the stock for a year after exercise, the excess of the sales price over the exercise price is capital gain for regular tax purposes, and excluded from AMT income to the extent it was recognized on exercise.

Unfortunately for many telecom employees, including Mr. Merlo, stock can decline drastically in value during that one-year period. Mr. Merlo sold his ISO-stock that was worth over $1 million on exercise for less than $10,000. He argued that he should be allowed to carry back his AMT-only capital loss to wipe out his AMT income for the year of exercise.

The Tax Court ruled that the tax law applies the same $3,000 annual deduction limit to AMT capital losses as it does to regular tax capital losses. The appellate panel agreed.

Cite: Merlo, CA-5, No. 06-60723

Link: Prior Tax Update coverage of Merlo.

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STILL ANOTHER AMT-ISO VICTIM LOSES IN COURT

June 05, 2007

The Court of Claims Federal Claims last week shot down yet another attempt to undo alternative minimum tax caused by incentive stock options.

In March of 2000, Hendy Lund exercised $30,000 shares of Redback Networks, Inc. stock at a cost of $1.1875 per share; at the time the shares traded at about $149.84 each. The $148.6565 per share difference between the market price and the exercise price - the "bargain element" - would be taxable in computing her 2000 alternative minimum tax, to the tune of $4,459,695.

Ms. Lund wisely protected herself by disposing of 11,000 shares of her stock in October 2000 for $1,540,006 ($140/share). By disposing of the shares, she made sure she had some cash to cover her taxes - even though disposing of ISO shares less than 12 months after exercising the option meant forgoing capital gain treatment on the disposition proceeds. Her October sale proved prescient; she dumped the remaining 19,000 shares in April 2001 for $303,984.87 - only $16 per share. Ms. Lund therefore had over $1.8 million available to pay her 2000 and 2001 taxes of about $1.3 million. In contrast, some AMT-ISO taxpayers let their ISO shares decline to almost zero, leaving them without cash to cover their taxes.

The Court of Federal Claims ruled that Ms. Lund could not carry back a capital loss for the 19,000 shares included in AMT income at the $148.68 "bargain element" and sold for $16.00 - a loss totaling over $2.5 million. The tax law limits capital loss deductions to capital gains, plus $3,000, and this limit applies to AMT losses as well as regular tax losses.

The futility of challenging the taxation of the "bargain element" of incentive stock options in the courts seems to have been abundantly established by now. Attempting to use more than $3,000 of AMT losses to offset taxable income is also a lost cause. We probably won't see too many more of these cases, especially now that Congress has enacted relief, however complex and incomplete, for AMT-ISO victims.

Cite: DANIEL D. PIERCE AND HENDY J. LUND, Ct. Claims No. 05-1071T

UPDATE: The TaxProf has more.

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HOW TO SOLVE AMT? FIX THE REGULAR TAX

May 21, 2007

The Tax Foundation has a new study on how to fix the alternative minimum tax. The solution? Fix the regular tax:

More than one quarter of personal income received during 2006 was entirely excluded from the federal individual income tax base. Untaxed government transfers, in-kind compensation of employees, and a plethora of other types of incomenone of these is included when the filer tallies his income on his tax form. Another 23.5 percent of personal income was included in the tax base but avoided taxation when filers claimed various deductions, exemptions, credits, and other provisions in the tax code.

If the special interests loopholes and credits (ethanol and biodiesel are only the newest) were repealed, the tax system would raise as much money as it does now with lower rates, less complexity, and without the AMT. Why is it so hard for politicians to do the right thing? From the study:

The logical, preferable alternative to such an administratively redundant tax system would be to repeal all or some of the offending tax breaks from the regular income tax. But each of those special tax breaks has a committed group of champions who fight like dogs to preserve and expand it. In effect, by enacting the AMT and keeping it in law for decades, Congress has recognized that it simply will not repeal tax preferences that benefit politically powerful groups no matter how unjustified those tax breaks are in principle.

That's just as true for special tax breaks at the state level.

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GEE, THANKS, CONGRESSMAN

March 23, 2007

It would be pretty depressing to be in, say, the Polk County Jail. You'd certainly be eager to hear somebody telling you that they could get you out of there. Even so, it's not likely that a transfer to the Warren County Jail would seem like a good solution.

Congressional taxwriters are considering a similar approach to the alternative minimum tax. The AMT is computed with fewer deductions and exemptions than the regular income tax, at a nominally lower rate. It applies when it exceeds the regular tax. As a result of accumulated legislative fudging, the AMT threatens to exceed regular tax for 23 million more taxpayers next year.

Congressman Richard Neal of Massachussets, a Democrat on the Ways and Means committee, has hit on a solution. He proposes raising the regular tax high enough to exceed AMT ($link):

House Ways and Means Select Revenue Measures Subcommittee Chair Richard E. Neal, D-Mass., told reporters March 22 that his efforts to reform the alternative minimum tax will likely involve adjusting tax rates instead of going after preferences in the tax code.

When asked whether an AMT reform proposal would be offset with repeal of tax code preferences or with an adjustment to federal tax rates, Neal replied, "I think that the latter is probably more realistic."

It's reasonably save to assume Congress won't approve this transfer between jails, and if it did, it would almost certainly be vetoed. Congress is instead likely to kick the AMT problem down the road one more year by increasing the AMT exemption temporarily, as they have done for the last several years. Real AMT reform probably requires a 1986-style major tax reform, which doesn't seem to be in the cards.

Related: AMT: THE INCONVENIENT TRUTH

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SATURN AURA QUALIFIES FOR HYBRID CREDIT

March 19, 2007

The IRS announced today that the Saturn Aura qualifies for the Hybrid Car Credit.

saura.jpg

Taxpayers buying this vehicle qualify for a $1,300 credit, unless they are alternative minimum tax-payers, who get diddly. Which makes some people grumpy.

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LEGAL FEES AND EMPLOYMENT LITIGATION

March 13, 2007

The tax law draws some distinctions between employees and the self-employed that seem completely whimsical. Sometimes these work out in favor of employees - for example, employees get to exclude fringe benefits that get taxed to the self employed. But some of the breaks cut in favor of the self-employed.

One area where the self-employed get treated better came into stark focus in the tax court yesterday. Philip Chaplin worked as a professional fiduciary with trust company Rice, Heard & Bigelow in Massachusetts. Mr. Chaplin got crossways with RHB and went to work for another company. Lawsuits followed, and Mr. Chaplin paid legal fees of $84,542.

Mr. Chaplin deducted the legal fees as if he were a sole proprietor, rather than an employee. If you are a sole proprietor, you can deduct all of your business expenses, including legal fees, "above the line." If you are an employee, in contrast, you have to take legal fees of employment lawsuits (other than civil rights suits) as "miscellaneous itemized deductions." Miscellaneous deductions are deductible for regular tax only to the extent they exceed 2% of your adjusted gross income; they are not deductible at all in computing alternative minimum tax.

The IRS disagreed with Mr. Chaplin; they said that the expenses were employment-related, rather than for a sole proprietorship. The taxpayer made a spirited argument that his role as a professional fiduciary meant he wasn't really an "employee" of RHB, but he wasn't able to even convince the tax court to waive penalties. The result? AMT of $21,082 and accuracy-related penalties of $4,837.

Unfortunately for Mr. Chaplin, his lawsuit didn't have any wrongful discrimination allegations. If you prevail on an employment discrimination lawsuit, you can deduct your legal expenses "above the line," without AMT or 2% haircut issues.

Cite: Chaplin, T.C. Memo 2007-58.

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AMT: THE INCONVENIENT TRUTH

March 09, 2007

Taxwriters in the new Congress came into office vowing to slay the AMT dragon. They held hearings this week, and the dragon is still alive. One reason: the hearings showed just who it is that the populist Democratic taxwriters have vowed to rescue. It's the top 10% of earners, clustered in high-tax (Democratic-leaning) states.

The Tax Policy Blog has prepared an eye-opening chart:

amtdist.JPG
Source: Tax Policy Blog

That doesn't mean the AMT doesn't affect a powerful political constituency. I would bet that the top 10% of the tax base is by far the biggest source of campaign cash. Still, it presents a marketing problem. The taxwriters have been trying to define "top 10 percent" as "middle class" as part of the debate, but it's not easy. "Save the Volvo Drivers - Repeal AMT" probably won't be a big-selling bumper sticker.

The Tax Policy Blog has the AMT solution about right:

The solution is not to pick our way through quick fixes or bomb one another with class warfare barbs that redefine the "middle class" to suit political ends. The AMT should be addressed. But only full repeal coupled with fundamental tax reform - reducing preferences and treating all income equally - offers a path that will not lead us back here again.

Unfortunately, fundamental tax reform is a policy orphan at the moment.

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CONGESSIONAL HEARINGS ON AMT TO EMIT CARBON DIOXIDE

March 07, 2007

Congress will be holding hearings about the AMT today. It will be lots of noise (AMT - Bad!) and no progress.

If you want to see what the real problems are in fixing AMT, go to the AMT page at the Tax Policy Center site. It won't be as easy as some folks seem to think.

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A MANDATE FOR BOLDNESS

March 05, 2007

Congressional Democrats have been saying they were ready to permanently solve the looming massive increase in the reach of the alternative minimum tax. Republican taxwriters have been kicking the problem down the road a year at a time with temporary increases in the AMT exemption.

Senate budget writers now are looking at a bold solution: ($link):

Senate Budget Committee Chair Kent Conrad, D-N.D., told Tax Analysts March 2 that the chamber's fiscal 2008 budget resolution will include -- at the minimum -- a two-year alternative minimum tax patch.

Whoa! Two years! Audacious!

The AMT is one of those commonly accepted lies has been ignored by both parties for their own reasons of convenience. Republicans have used the projected revenues from the AMT to help make their budgets look balanced; Democrats accept the temporary fixes because the AMT will hit blue-state Volvo drivers the hardest. That's tax policy for you. As former House Ways and Means Chairman Thomas famously put it,

"Don't think in this business that you're dealing with the best and the brightest," he said. "You're dealing with the available and the willing. One of the basic criteria is usually warm and vertical. That's optional in some instances."

The result: an AMT increase that nobody seriously believes will be allowed to take affect, but which is routinely used in federal budgeting and policymaking.

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IRS WEB SITE HAS 2006 AMT ASSISTANT

January 29, 2007

The IRS has posted a handy little web-based program to help do-it-yourselfers determine if they have alternative minimum tax for 2006.

For a quick and dirty idea whether you are likely to have AMT for 2006, you can take my quick-and-dirty quiz:

Do you live in Iowa, New York, California, New Jersey, Massachussets, Connecticut, or another high tax state?

If yes, do you have gross income in excess of $150,000 but less than $500,000 ($700,000 in NY, NJ or CA)? If yes, you probably have AMT.

Do you have a big capital gain in 2006? If yes, you probably have AMT.

Do you have more than 4 kids? You probably have AMT.

Wasn't that easy?

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AMT: IT'S THE DISHONESTY

January 15, 2007

Some of the big-time blogs were discussing the alternative minimum tax over the weekend. The alternative minimum tax is computed with fewer deductions and credits, but with a lower top rate; you compute both "regular" tax and "AMT," and you pay the higher amount. The biggest culprits in triggering AMT are state and local taxes and business tax credits.

Mickey Kaus said that the hassle of computing tax a second time is the real reason people hate it. Ann Althouse replies, "No, Mickey, it's the money." ($4,900 for Ms. Althouse, a law professor in Madison, Wisconsin)

Even the Instapundit weighs in, blaming Turbotax for tax complexity. Of course, regular Tax Update readers know that the root of tax complexity is the HP 12-C financial calculator.

As a confirmed AMT taxpayer, I would tend to agree with Ms. Althouse - it's the money. When I can use the office tax software to do my own return, the complexity doesn't make computation much harder (though it makes tax planning more difficult).

THE AMT BAIT AND SWITCH

But to me, it's really the dishonesty. The AMT has provided cover for sleazy tax policy ever since it was enacted. It works like this: a politician promises a tax benefit. The tax benefit is written so that it doesn't work for AMT.

When the technicians compute the revenue effect of the tax break, they take into account that it won't work for AMT. This makes the tax break much less costly than it would be otherwise.

The politician gets to brag about a brave new loophole, and the taxpayers think he's a great guy, or gal. Then they complain about how that darn AMT got them. It's the ultimate bait-and-switch of tax policy.

This trick has been part of every major tax break in the last 20 years, and many of the minor ones. Perhaps the biggest example is the 2001 Bush tax cuts, which reduced the top regular tax rate from 39.6% to 35%. AMT rates weren't reduced, so many taxpayers had their regular taxes cut, only to pay AMT. Other examples of this are the deduction for state and local sales taxes, the hybrid car tax credit, and the research credit.

Like any bad habit, this one is catching up with Congress; absent new legislation, up to 20% of tax filers will pay AMT for 2007. The politicians are making loud noises about repealing AMT, but they can't afford to. If the Bush tax cuts are to be kept in place, the AMT will provide $1.3 trillion of tax revenue in the next 10 years. So don't believe any politicians who promise to repeal AMT; they'll get it back from you somewhere else. They have to.

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AMT: WHERE YOUR COUNTY STANDS

January 10, 2007

Des Moines' western suburbs are outpacing the rest of the state in economic growth. They also have a less-prized honor: they are also the alternative minimum tax capital of Iowa.

The Tax Foundation has just issued a statistical summary of the AMT that ranks states, counties and congressional districts by how many of their taxpayers were subject to AMT for 2004. The AMT applies a 26 or 28% rate to a taxable income computed with fewer deductions - and no deduction for state and local taxes. There is a large personal exemption, but it phases out. Not surprisingly, high-tax states lead the way in the AMT rankings.

Nationally, New York's Westchester County has the highest incidence of AMT; 12.3% of the tony suburban county's taxpayers had AMT in 2004. Following closely are Hunterdon County in New Jersey and Manhattan.

In Iowa, 3.45% of Dallas Countians filing returns had AMT in 2004, making it first in Iowa and 103rd out of 3,142 counties nationwide. The incidence of AMT was 2.6% in the Peoples Democratic Republic of Johnson and 2.22% in Polk County. The three Iowa counties least hit by AMT were Pocohontas (.13%), Decatur (.16%) and Wayne (.24%).

Thirty-one counties nationwide had no AMT taxpayers in 2004, including two in Kansas and one each in Illinois, Missouri, South Dakota and Nebraska.

When AMT incidence is ranked by state, New Jersey edges out New York for the top rank. Iowa falls all the way to 35th in the percentage of tax returns hit by AMT. If you have taxable income from $150,000 to $500,000 in Iowa, or have lots of kids or capital gains, you are probably helping bring our rank up.

Outside the lower 48, both Aleutians East County in Alaska and Kalawao County in Hawaii had no AMT taxpayers. I suspect one of these counties has more moose, and the other has better weather.

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AMT REPEAL - SO SIMPLE!

January 05, 2007

After many years of hand-wringing, the incoming and outgoing chairmen of the Senate Finance Committee have cut the gordian know and proposed a bill to just repeal the Alternative Minimum Tax. An as-yet unnumbered Senate bill introduced yesterday by Max Baucus and Charles Grassley would simply make the AMT $0 for individuals starting this year.

Nothing to it. Well, nothing except the need to find an additional $750 billion to $1.3 trillion dollars to replace the AMT revenue that the government would lose over the next 10 years.

But it's simple! Just ask Senator Grassley:

I hope the new congressional leaders don't fall into traps on AMT repeal. One is counting on the revenue that the AMT raises for more government spending. It's ridiculous to rely on revenue that was never supposed to be collected in the first place.

That's priceless. Every tax bill passing through Senator Grassley's Finance Committee since 1986 has counted on AMT revenues. It's nice to know that they were just joshing us, that the revenue they projected to justify their tax and spending policies "was never supposed to be collected in the first place." We should remember that next time they issue revenue projections for one of their tax bills.

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LESS TO THE AMT-ISO BONE THAN MEETS THE EYE?

December 11, 2006

Kaye Thomas has an excellent discussion of the new tax break designed to help taxpayers who incurred big alternative minimum tax bills from the exercise of incentive stock options.

The article points out a feature that I had missed: under the bill, the 20% annual refundable minimum tax credit is computed on a declining amount. If you have a $1 million carryforward, your maximum credit is $200,000 the first year, $160,000 the second year (20% of the remaing $800,000), and so on.

My prior article on this break, now updated, is here.

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CONGRESS THROWS BONE TO AMT-ISO VICTIMS

December 09, 2006

We've discussed the disastrous alternative minimum tax consequences that can arise from incentive stock options several times (for example, here and here). The ISO-AMT rules clobbered many employees of telecom and tech companies by leaving them with a big tax liability for the purchase of employer stock that ended up worthless.

The ISO-AMT victims have been pushing for legislative relief ever since. This morning Congress threw them a bone that will allow many taxpayers to recover over the next few years the AMT attributable to their old ISO exercises. Perversely, some taxpayers may have to quit their jobs to cash in.

AMT CREDITS

One of the cruel jokes of the ISO-AMT is that it creates a "minimum tax credit." This credit reduces regular tax - not AMT - in future years, but only by the amount the regular tax exceeds your AMT that year. This amount generally varies between little and nothing for the ISO-AMT victims.

The new law allows individuals with minimum tax credit carryforwards to use a portion of them regardless of whether they would otherwise be subject to AMT, during the six year period starting in 2007. The extra minimum credit allowed under this provision is "refundable," which means that the IRS will issue a check for it even if you have no tax paid in for the year through estimated payments or withholding.

The formula for this credit is confusing and perverse. It works like this, best I can tell:

1. Determine your "long-term unused minimum tax credit" ("LTUMTC"). This is your minimum tax credit carryforward that originated from AMT at least four years earlier. For 2007, that means minimum tax credits from AMT incurred in 2003 or earlier. Note that this applies to AMT credits arising for any reason - though I suspect that most folks with large AMT credit carryforwards are ISO victims.

2. Determine your "AMT refundable credit amount. This the greater of $5,000 (or your LTUMTC, if less than $5,000), or
20% of your LTUMTC.

3. Reduce this amount by a goofy phase-out formula: 2 percentage points for each $2,500 your income exceeds a threshold amount. This eliminates your AMT refundable credit over a $122,500 range. The phaseout ranges for 2007:


Complete
Taxpayer's status Threshold phaseout
in 2007 amount after
----------------------------------------------------
Married or surviving spouse $234,600 $357,100
Heads of households 195,500 318,000
Unmarried (not surviving spouse) 156,400 278,900
Married filing separately 117,300 178,550

So, if a taxpayer's income is low enough, they can recover their entire AMT liability from their tech stock debacle in 2000-2001 between 2007 and 2012. If they have a good tech job, though, they're still out of luck.

It's not hard to imagine cases where taxpayers will be better off quitting their jobs so they can qualify for the credit. If you have a $400,000 per-year tech job and a $5 million AMT credit carryforward, you would earn more if you quit your job; quitting would entitle you to a $1 million check annually the first year from IRS for your unused minimum credit carryforward.

I love the tax law.

Other coverage of the extender bill provisions:

LAST GOP TAX BILL ADDS HSA IMPROVEMENTS

UPDATE: The refundable credit is computed on a declining balance. In my example above, the maximum credit would be $1 million the first year (20% of $5 million), $800,000 the second year (20% of $4 million), $640,000 the third year (20% of $3.2 million) and so on. Thanks to Kaye A. Thomas, who has an excellent article up about this break.

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GOING OVER THE AMT CLIFF

December 07, 2006

The Wall Street Journal, in a rare editoral page convergence with the Des Moines Register, ripped the alternative minimum tax yesterday. Their editorial ($link) included this chart of how AMT will increase sharply next year under current law:

amtbump.gif

Arnold Kling at Econlog sees the chart and ponders why so many taxpayers would suddenly face AMT.

The answer lies in the way Congress has been kicking the AMT problem down the road a year or two at a time since 2001. As Dr. Kling notes, the Bush tax cuts lowered the regular tax rates without lowering the AMT rates. As AMT applies when it is higher than regular tax, the arithmetic makes more folks AMT taxpayers.

Congress has fought the arithmetic with "temporary" increases in the AMT exemption. The 2006 exemption is set at $62,550 for joint filers and $42,500 for single taxpayers. Without further legislation, the exemption reverts in 2007 to its "permanent" level of $45,000 for joint filers and $33,750 for single filers. That will be enough to make millions of Americans pay AMT. Hence the jump in the chart above.

Why such obviously foolish tax policy? It's part of Congress' old game of making tax breaks "temporary" to disguise their true cost - the same game involved with the tax breaks in the "extenders" bill that is supposed to come out this week to preserve some other popular tax breaks, including the research credit. With AMT the numbers are so big for each year's temporary break that it is becoming hard for them to pull off.

The silver lining? They might be forced to look at actual tax reform; they might be forced into good policy because they have exhausted the alternatives.

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11 'KEY FACTS' ON AMT

December 05, 2006

The Tax Policy Center has a nice little piece up on "The Individual Alternative Minimum Tax (AMT): 11 Key Facts and Projections." Fact No. 4:

4. Two main factors behind the explosive growth in AMT: it is not indexed for inflation and the 2001-2006 tax cuts cut regular income tax without a permanent AMT fix. The AMT is not indexed for inflation and, therefore, it affects taxpayers with lower real incomes over time. The 2001-2006 tax cuts more than doubled the projected share of taxpayers who will face the AMT in 2010, from 16.0 percent to 33.6 percent. If the tax cuts had not been enacted and the AMT had been indexed for inflation along with the regular income tax in 1985, the number of AMT taxpayers would have remained between 300,000 and 400,000 through 2010.

This chart shows how the political pressure for an AMT fix might build:

1001046_table.gif


Why is it so hard to fix? Fact No. 9:

9. Repeal would be expensive and regressive. Repealing the AMT in 2007 would reduce revenues by $750 billion through 2016 if the 2001-2006 tax cuts expire as scheduled, and $1.3 trillion if they are extended. Almost 90 percent of the benefits of repeal would go to households with income above $100,000 in 2010.

Where do we look for reform? Raising other taxes or getting rid of the regular tax deduction for state and local taxes. Facts Nos. 10 and 11:

10. Simple reforms could spare most AMT taxpayers. Indexing the AMT for inflation and allowing personal credits against the AMT would reduce the number of AMT taxpayers in 2010 by over 85 percent.

11. Paying for reform is a key issue. Without revenue offsets, the reform above would reduce revenues by $520 billion over the next ten years (if the tax cuts sunset, $940 billion if they are extended). Rolling back the high-income rate cuts and the lower tax rates on dividends and capital gains enacted since 2001 would offset more than half of the revenue loss. If the tax cuts sunset, repealing the deduction for state and local taxes, as proposed by President Bush's tax reform panel, would more than offset the cost of reforming or repealing the AMT.

Of course, when the incidence of taxes is as skewed to the high end of the income scale as it is now, any provision that reduces any sort of tax is going to be "regressive." Good tax policy shouldn't die just because it fails to screw the top 20% of the income distribution a little bit more.

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PROJECTING YOUR 2006 AMT

December 03, 2006

A reader asks:

Your Dec. 1 column advises different tax strategies depending on whether you're subject to the AMT. The only problem is that as of Dec. 1 the IRS has not posted a 2006 AMT form (6251). How can taxpayers decide whether they're subject to the AMT without the 2006 form?

Good question. There should be few changes to the AMT form. The biggest change is the increased exemption amounts legislated last May for 2006, and the change in the breakpoints for the 15% bracket for regular tax. To help those who want to estimate their 2006 AMT, I have dummied up a 2006 form by updating the 2005 form with the new exemption and 15% bracket figures. You can find them in the extended entry below; to see them in full size, click on them.

Remember - these are not official forms, so don't use them to prepare your 2006 returns.

Click here to see the article the correspondent refers to.

UPDATE: Doh! Kerry Kerstetter kindly points out the IRS Draft AMT form is up at the IRS website, here. Instructions are here.

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YET ANOTHER TAXPAYER AMT-INCENTIVE STOCK OPTION DEFEAT

October 12, 2006

The Tax Court shot down yet another theory for avoiding alternative minimum tax on incentive stock options that go bust.

Incentive stock options, or ISOs, are employee stock options with a special tax feature. When you exercise ordinary employee stock options, the excess of their value over the price you pay to exercise the shares is taxed as ordinary wage income at rates up to 35%. In contrast, if you exercise ISOs and hold the stock for one year after exercise, there is no ordinary wage income. Instead, the excess of your sales price over your option price is capital gain, currently taxed at only 15%.

The catch? In computing AMT, the "bargain element" of ISOs is taxed at the time of exercise. That means you have to pay tax up front and hope that the stock is still worth something a year later. It's still a good deal if the stock price goes up, because you get a credit against your regular capital gain tax for the AMT paid when you sell the stock. If the stock tanks, though, it's a bad, bad deal.

Many telecom employees with ISO shares ended up paying large AMT bills on stock that became worthless not long after exercise. Iowa's Ron Speltz, who got clobbered on his McLeod ISOs, is a type specimen. Taxpayers have tried a number of ingenious arguments to avoid the ISO AMT on worthless telecom shares, but to no avail.

ARE AMT CAPITAL LOSSES DIFFERENT?

The Tax Court shot down the latest attempt yesterday. Jonathan Palahnuk exercised ISO in his emplooyer, Metromedia Fiber Network. He paid $99,949 to exercise shares worth $2,185,959. He had no regular taxable income on the exercise, but $2,086,009 in AMT income. As a result he ended up paying $586,066 of AMT in 2000.

Things didn't go so well for Metromedia in the next year, and he sold his shares in 2001 for $248,410. For regular tax purposes, he had a capital gain of $148,461 on the stock that had already cost him $586,066 in taxes. For AMT purposes, he had a $1,937,547 capital loss.

The catch? Capital losses are only deductible up to the amount of your capital gains, plus $3,000. The taxpayer tried to convince the Tax Court that the $3,000 loss limit shouldn't apply in computing AMT. The Tax Court didn't buy it. That means the taxpayer can take $3,000 of AMT capital losses against his AMT ordinary income for the next 646 or so years.

The Moral? I see two. For taxpayers, if you exercise ISOs, and you can't pay the AMT if the stock goes bust, sell enough shares right away to cover your taxes. You'll convert some potential capital gain into ordinary income, but at least you'll stay solvent.

For policymakers, it shows how unintended consequences can turn tax breaks, like ISOs, into tax nightmares.

Cite: Palahnuk, 127 T.C. No. 9.

Related Tax Update Coverage:


ANOTHER BAD DAY FOR AMT-ISO VICTIMS

DES MOINES REGISTER TAKES UP SPELTZ CAUSE

TAX COURT TO ISO-AMT VICTIMS: YOU'RE STILL SCREWED

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TOYOTA, LEXIS FUEL CREDITS PHASING OUT

September 21, 2006

The Toyota and Lexus hybrids are just saving too much energy, so the tax credit for them is beginning to go away.

rx400h.jpg

The IRS announced the phase-out rules yesterday. The phase out chart (courtesy of the TaxProf):

20060921cht.jpg

The credit remains fully available for Mercury, Ford and other brands. But remember: the hybrid credit doesn't work for Alternative Minumum Tax, so don't count on pocketing the credit unless you know you aren't an AMT taxpayer.

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ANOTHER BAD DAY FOR AMT-ISO VICTIMS

August 30, 2006

The Tax Court rejected pleas for relief from another taxpayer who was socked with alternative minimum tax from exercising incentive stock options. This taxpayer exercised incentive stock options for PMC-Sierra stock in 2000, paying $183,263 for stock valued at $2,910,251. This was non-taxable for regular tax, but resulted in $2,726,988 of AMT taxable income.

As in so many of these cases, the stock value collapsed and the taxpayer had nothing to show for the ISOs but an AMT bill of $786,000 or so.

The taxpayer tried to compromise her liability with the IRS; when they rejected her offer in compromise, she sued in Tax Court, saying the IRS "abused its discretion" in refusing to compromise the liability. Citing the Speltz case, where the court rejected a similar pleading from an Eastern Iowa McCleod employee, the court turned down the claim.

Cite: Wai, T.C, Memo. 2006-179.

THEY SHOULD HAVE SUED ME!

Tax Analysts reports another AMT-ISO case with some strange arguments. The taxpayer sued for a refund in the U.S. District Court for Central California on the grounds that she should have been sued under four different legal arguments for having exercised her stock options, and that therefore she shouldn't have had any income. The district court said that there was no evidence that any of those arguments would have succeeded, but I hope for her sake that the statute of limitations has expired for all of the things she thinks she should have been sued for.

Cite: Hernandez, DC CD-California, Case No. Case No. CV 04-9365.

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YET ANOTHER AMT-ISO VICTIM LOSES IN TAX COURT

August 29, 2006

The Tax Court shot down another taxpayer attempt to avoid alternative minimum tax from ISO exercise yesterday. Neild Montgomery was an executive for MCG Holdings, a Nevada telephone company. When he left the company his options vested and he exercised shares worth $10 million or so.

Unlike many AMT ISO victims, he sold some of his shares - $2.4 million worth, which went a long way towards covering the AMT due. That was wise, becasue whild ISO exercise doesn't trigger regular tax, the amount that the stock value exceeds the exercise price is considered taxable income in computing AMT. Like so many telecom stocks, MGC (later Mpower) stock collapesed and the company eventually went through Chapter 11. Mr. Montgomery had a $2.4 million tax bill for stock that ended up worthless.

When it came time to pay his AMT. Mr. Montgomery asserted a number of arguments against having to pay AMT. He said the company had made a mistake and disqualified his ISOs. The Tax Court disagreed. He said that he had a "risk of forfeiture" because of securities law rules that kept him from being taxable on his stock. His disposition of $2.4 million of stock hurt this argument. His other arguments were the same one shot down in the recent Merlo and Spitz cases.

The Moral? Again: if you exercise ISOs, figure out whether you can pay the AMT if the company goes under before the one-year capital gain period expires. If you can't, it may be better to sell some shares to make sure you can pay your taxes and forego the capital gain benefits.

Cite: Montgomery, 127 T.C. No. 3.

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YET ANOTHER LOSS FOR AMT-ISO VICTIMS

August 16, 2006

The Tax Court rejected yet another attempt to avoid the AMT consequences of incentive stock options gone bad yesterday.

While most employee stock options are taxable as ordinary income when exercised, incentive stock options are not, at least in computing regular tax; if you hold onto the stock for one year after exercising the option, you get capital gain on the sale, rather than ordinary income. The catch? It's all taxable for alternative minimum tax on exercise.

A Mark Spitz (not the Mark Spitz, as far as I can tell) exercised his ISOs and then saw the share value collapse before a year went by. He then had to pay AMT on the amount the value at exercise of the now-worthless shares exceeded thier exercise price. Like every ISO-AMT victim before him (including Iowan Ron Speltz), he lost.

Cite: Spitz, T.C. Memo 2006-168.

The Moral? If you exercise ISOs, exercise caution, too. If you can't afford to pay the AMT if the shares go bad, sell enough shares to make sure you stay solvent.

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ANOTHER AMT ISO DEFEAT

June 27, 2006

If one door is locked, you try another. That one's locked, too?

That's the problem for taxpayers who exercised incentive stock options and then rode their new shares down to the basement. These taxpayers often owe large amounts of alternative minimum tax as a result of acquiring now-worthless stock.

James Pavlosky exercised ISOs in 2000, paying $96,120 for shares worth $1,612,500. While this generated no income in computing regular tax, the $1,516,380 difference was taxable in computing AMT. He apparently hoped to take advantage of the main ISO break - capital gain tax rates on the disposition of the shares one year after exercise.

Unforturnately, the stock collapsed. Mr. Pavlosky was unable to pay the $430,000 AMT bill and he ended up in bankruptcy.

The Tax Court has been unhelpful to ISO-AMT victims, like Iowan Ronald Speltz, so Mr. Pavlosky knocked at the Bankruptcy Court door for help. Earlier this month the Sourthern District of Texas U.S. Bankruptcy Court declined to open the door that the Tax Court left shut.

It doesn't seem like the courts are going to help the ISO-AMT victims. At this point they can only look to Congress.

The Moral: if you exercise incentive stock options, make sure you have enough resources to pay the AMT if the stock goes bad. If you don't, sell enough ISO stock to cover your taxes. You forfeit the regular tax breaks, but you may avoid a trip to bankruptcy court.

Related Links:

NY TIMES RUNS STORY ABOUT MCLEOD AMT VICTIM

TAX COURT TO ISO-AMT VICTIMS: YOU'RE STILL SCREWED

Pavlosky v. United States (No 05-3350)

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ENERGY CREDITS: NOW SOME EVEN REDUCE AMT

May 31, 2006

One of the cruel jokes in the 2005 "energy bill" was that many of its core tax benefits didn't apply in computing alternative minimum tax. The effect was to negate the tax for millions of taxpayers in high-tax states, like Iowa.

The recently-signed "Tax Increase Prevention and Reconciliation Act" fixes this problem for many of the personal energy credits. Unfortunately, they don't apply to some of the most highly-publicized tax credits.

FIRST, THE GOOD NEWS:

These credits will now count for AMT:

Residential Energy Efficiency Credit. This credit is 10% of improvements to the "building envelope." This means roofing, doors, windows and insulation. It also is available in lump sums for certain appliances:

- $50 for each "advanced main air circulating fan";
- $150 for each "qualified" natural gas, propane, or oil furnace or water boiler, and
- $300 for "qualified energy-efficient property," including heat pumps, water heaters, and air conditioners."

These credits are limited to $500 in total, including a $200 limit on windows.

Solar credit

The 30% tax credit for residential photovoltaic, solar water heater and fuel cell property also now reduces AMT for 2006.

Be careful: thes credit only reduces AMT for 2006, even though the credits technically apply to property purchased through 2007.

NOW THE BAD NEWS

The alternative vehicle credit, which applies to hybrid cars, still doesn't reduce AMT. That means most Iowans who can afford the Lexus 400h SUV probably won't be able to use the credit.

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IT'S NOT FAIR!

April 27, 2006

The AMT, that is. But it's the law, fair or not. Russ Fox explains.

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TAX COURT TO ISO-AMT VICTIMS: YOU'RE STILL SCREWED

April 26, 2006

screw.jpgThe Tax Court shot down another attempt by an unhappy alternative minimum tax-payer to avoid the disastrous tax consequences incentive stock options.

This sad tax problem got national press when eastern Iowan Ronald Speltz was hit with a $206,000 tax bill for exercising McCleod ISOs that were nearly worthless by the time the tax bill came due.

When you exercise an incentive stock option, you get favorable tax treatment. You have no income for the "spread" -- the excess of the stock price over the amount paid to exercise the option -- and you have capital gain on the eventual sale of the shares. This contrasts with the more-common "non-qualified" options, which generate ordinary income immediately on exercise:

THE ISO DEVIL'S BARGAIN

There are two big catches in the favorable treatment of ISOs:

1. You have to hold on to the shares for a year after exercise to qualify, and

2. the favorable treatment doesn't apply when computing AMT; you report the spread is all ordinary wage income on Form 6251. This becomes a huge problem if the stock craters between the time you exercise the options and tax day.

Robert Merlo exercised options for 46,125 shares of Exodus Communications, Inc. on December 21, 2000. His exercise price was 20 cents per share, and the stock value at exercise was $23.3125. This gave him a "spread" of $1,066,064.

When the taxes came due the next April 15, the stock value had gone down to about $10.18. At this point, selling his shares would have still netted Mr. Merlo enough cash to pay his tax. He took another path.

FOUR SWINGS, FOUR MISSES

When he filed his 2000 return, he reported the bargain element as the difference between the exercise price and the value on April 15, 2001, rather than the exercise date. He held onto his shares and rode them down until Exodus made its, well, exodus by declaring bankruptcy on September 26, 2001.

The IRS noted that the tax law requires the bargain element to be measured on the date the option is exercised, not the subsequent tax return due date, and assessed him additonal AMT of about $170,000. Mr. Merlo didn't care for this. He apparently realized his initial return position wasn't going to work, so he raised a number of other issues:

1. He wasn't "vested" in his ISO shares under Code Section 83, and therefore had no income.

2. His AMT capital loss deduction on the worthlessness of the stock was not subject to the $3,000 annual limit on capital losses, so he had a net operating loss to carry back and get an offsetting tax refund.

3. The AMT treatment was just wrong, somehow.

The court disposed of the "vesting" argument last July, holding that the shares weren't subject to risk of forfeiture. Mr. Merlo had argued that he might lose his job because selling the shares was against the company's insider trading policy. The court said that even if that were true, it didn't matter, as long has he wouldn't have to forfeit share proceeds:

The evidence in the instant case shows that petitioner had no substantial risk of losing the rights to his shares of Exodus stock. There is no evidence that Exodus could have ever compelled petitioner to return his shares after he exercised his ISO; no sellback provision is present; nor is there any evidence that Exodus could have compelled petitioner to forfeit his shares of stock.

The court had no trouble ruling that the annual capital loss limitation applies for AMT purposes as well:

This Court has never addressed whether the capital loss limitations of sections 1211 and 1212 apply for purposes of calculating a taxpayer's AMTI. However, section 1.55-1(a), Income Tax Regs., states:

        Except as otherwise provided by statute, regulations, 
        or other published guidance issued by the Commissioner, 
        all Internal Revenue Code provisions that apply in 
        determining the regular taxable income of a taxpayer 
        also apply in determining the alternative minimum 
        taxable income of the taxpayer.

We find no statute, regulation, or other published guidance that purports to change the treatment of capital losses for AMT purposes.

Not a surprising result. AMT is mostly the regular tax system with a few specific changes. If the tax law doesn't specify that something is computed differently for AMT, regular rules apply.

The "just wrong" defense didn't get very far, either:

Petitioner also advances several "policy and legal considerations". Essentially, petitioner is arguing that, under principles of equity, he should be allowed to carry back his AMT capital loss to reduce his AMTI. Petitioner feels that applying the capital loss limitations of sections 1211 and 1212 to the calculation of his AMTI results in harsh and unfair tax consequences.

This Court has previously stated:

        The unfortunate consequences of the AMT in 
        various circumstances have been litigated since 
        shortly after the adoption of the AMT. In many 
        different contexts, literal application of the 
        AMT has led to a perceived hardship, but challenges 
        based on equity have been uniformly rejected. * * *
        * * * "it is not a feasible judicial undertaking 
        to achieve global equity in taxation * * *. And if 
        it were a feasible judicial undertaking, it still 
        would not be a proper one, equity in taxation being 
        a political rather than a jural concept." * * * the 
        solution must be with Congress.

Congress broke it; only Congress can fix it.

The moral? ISOs are a dangerous bargain. They carry a lure of future regular tax savings at the cost of current AMT. If the shares tank, you just get the AMT. If you can't afford the AMT if the shares become worthless, sell enough shares when you exercise the options to make sure you'll be solvent at tax time.

Cite: Merlo, 126 T.C. No. 10.

Related:

TAX COURT TO MCLEOD AMT VICTIMS: SORRY, BUT YOU'RE STILL SCREWED

ATTORNEY IN MCLEOD ISO AMT CASE RESPONDS

NY TIMES RUNS STORY ABOUT MCLEOD AMT VICTIM

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ALTERNATIVE MINIMUM TAX: YOU'RE NOT JUST IMAGINING IT

April 10, 2006

It's official. There's a lot more AMT going around lately.

The IRS last week released its latest "Statistics of Income Bulletin." Among other items, the Bulletin documents how the number of taxpayers subject to alternative minimum tax (AMT) jumped from 2002 to 2003. You can see it in the chart below, adapted from one in the Bulletin:

amt0203.JPG
Source: Individual Income Tax Rates and Shares, Mudry and Parisi. SOIB, Winter 2006.

The chart measures how many taxpayers were in AMT in 2003 and 2002, arranged by adjusted gross income (AGI). The number of AMT returns went up 24% from 2002 to 2003. The incidence of AMT increased in the $100,000 - $200,000 range by 11%, but it more than doubled in the $200,000 to $500,000 range.

WHY?

The increase in AMT is largely attributable to the rate cuts enacted in 2001 and the reduced rates on dividends and capital gains. It's a matter of the arithmetic. The AMT is computed with fewer deductions, at purportedly lower rates. When the individual rates were cut the AMT rates stayed the same. Inevitably many individuals found their individual regular taxes lowered below the AMT threhhold.

The arithmetic of the AMT and regular tax rate structure hits the $200,000 - $500,000 bracket the hardest. For most of that range, the tax on a given amount of income under the AMT system is barely under the regular rate. State and local taxes are deductible for regular tax, but not for AMT, so almost everyone in that range who lives in a state with an income tax finds that they owe AMT.

The capital gain and dividend rate cuts also push a lot of folks into AMT, at all income ranges. While the stated rates for capital gains are the same under both system, AMT has fewer deductions. If you have the same rate for two taxes, but one has fewer deductions, the one with fewer deductions tends to be higher.

WHAT TO DO?

The best way to avoid AMT is to project your income and try to time your state and local tax payments to match your income. If you are close to the AMT, you may find that you should get out of muni bonds, which often increase state taxes and push you into AMT. But for many taxpayers, the only way to get out of AMT is to kick thier kids out of the house (personal exemptions don't apply to AMT) and move to a low-tax state like Florida or beautiful South Dakota.


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THE COST OF FRENZIED TAX CHANGES

December 23, 2005

The Tax Policy Blog has two worthwhile posts up on "The Cost of Unstable Federal Tax Law."

The second post talks about how potential buyers of the Toyota Prius are waiting until January to buy the car because only purchases after December 31 qualify for the new hybrid car credit.

Of course, if these folks are subject to AMT in 2006, they are in for a nasty surprise: the credit doesn't count for AMT. If they are in AMT every year they may be better off closing the deal before year end to qualify for the current law clean fuel deduction.

Links:

The Cost of Unstable Tax Law
The Cost of Unstable Tax Law, Part II

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AMT, RECONCILIATION BILLS ROLL INTO 2006?

December 14, 2005

Senate Majority Leader Bill Frist says nothing will happen before year-end with the AMT punt fix and the Tax Reconciliation bill. So far the Senate Democrats haven't panicked like their house counterparts to pass a separate AMT fix. If the AMT fix has to be included in the Tax Reconciliation, Republicans may be unable to extend the reduced capital gain and dividend rates beyond 2008.

The status of Bill Thomas as a diabolical genius hangs in the balance.

The Tax Prof has a full roundup of big-media coverage.

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YEAR-END PLANNING: WHAT'S YOUR AMT STATUS?

December 08, 2005

In our first piece on 2005 year-end tax planning I said you need to start with a 2005 tax projection. The first critical piece of knowledge this will produce is whether you are likely to pay alternative minimum tax in 2005. Tax planning for AMT is different.

If it looks like you have AMT this year, it changes your year-end tax planning. A lot of tax planning tricks don't work for AMT. For example, it usually doesn't make sense to prepay your state and local income and property taxes before year-end if you have 2005 AMT, as these items are not AMT-deductible.

If you are in AMT or close to it, you should continue your tax projections into 2006. By judiciously allocating your deductions between 2005 and 2006 - say, by prepaying some of your state and local taxes - you may be able to minimimize your taxes over a two-year period.

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BILL THOMAS: DIABOLICAL GENIUS?

December 08, 2005

deviousbill.jpgWhen Ways and Means Committee Chairman Bill Thomas left alternative minimum tax (AMT) relief out of his version of this year's Tax Reconciliation bill, he said he was doing it to spur debate on tax reform. Of course, I mocked this idea:

That's a bit like spurring debate on fire-sprinkler laws by committing arson.

Now Mr. Thomas may have the last laugh. He appears to have been playing a deeper game than he let on. It happens than AMT falls disproportionately on the "blue" states -- states where Democrats are ascendant. This is because blue states tend to have high state income taxes; these aren't deductible for AMT and therefore make AMT routine for two-earner upper-income couples in high-tax states. As a result, Democratic legislators overwhelmingly favor the AMT relief bill; failure to extend AMT relief set to expire this year would result in a big blue-state election year tax increase in 2006.

Mr. Thomas left the AMT relief out of the reconciliation bill so he could include an extension of lower capital gain and dividend rates under its revenue cap. For arcane reasons the reconciliation bill can pass with only 51 votes in the Senate.

Mr. Thomas's deeper game? If the 414-4 vote in favor of stand-alone AMT relief in the House yesterday is an indication, the Democrats will pass AMT relief anyway, so he didn't need to waste the budget cap in the reconciliation bill on it. If the Senate Democrats also pass stand alone AMT relief, and the Tax Reconciliation is enacted with extended capital gain and dividend rate relief, I will have a new respect for Mr. Thomas's machiavellian ways.

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MERCURY MARINER, FORD ESCAPE HYBRIDS CERTIFIED FOR CLEAN FUEL DEDUCTION, CREDIT

November 09, 2005

The IRS has certified two new vehicles as qualifying for the $2,000 clean fuel deduction for 2005. The Mercury Mariner and Ford Escape now qualify for the clean fuel vehicle deduction. The deduction expires at the end of this year, to be replaced by a tax credit in 2006.

DEDUCTION OR CREDIT?

If you take possession of the vehicle before year-end, you get the deduction. If you wait until next year, you get the credit. Which should you do?

The answer depends on what your alternative minimum tax (AMT) situation is. You can take the deduction in computing AMT and get a tax benefit right away. The credit is not allowed for AMT, and you won't be able to use it until the day in the misty future when you no longer are paying AMT. But if you can use the credit, it's better than the deduction.

How do you know whether you will be in AMT? You have to run the numbers. As a shortcut, if you are a two-earner professional couple in a high tax state, like Iowa, you are a likely AMT candidate as far as the eye can see - especially if you have kids.

mmariner.jpg

Link: Complete list of qualifying vehicles

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BETTER THAN KING FOR A DAY

November 08, 2005

In a comment to this entry, reader Jeff Jacobs riddles me this:

- I regard your postings highly. But we all know that "being President for a day" doesn't guarantee enacting the tax laws you prefer.
- So let me ask you a more pragmatic, non-professorial question: What if someone made you Commissioner of Internal Revenue for one day? And what if your salary was based on 1% of the revenue you collected? Which of the current laws included in the Internal Revenue Code would you choose to enforce?

I will treat this as two questions: what I would do for good tax policy if I were IRS Commissioner for a day, and what I would do to make myself horrifically wealthy if I got a cut out of increased collections.

POLICY: I would set up a special IRS unit devoted entirely to detecting and shutting down illegal tax shelters and scams. It would be a multidisciplinary group with technical and litigating attorneys, as well as criminal and civil agents. At the first whiff of a new tax scam, this group would be empowered to analyze the transaction, fly to the location as a SWAT team and with maximum publicity get the approprate warrants and court orders to raid and close criminal tax scam enterprises. No more letting scams fester for months or years before taking action, I say. Nothing is more demoralizing for law-abiding taxpayers than undisturbed scammers.

GREED: I would program the IRS computers to run a match routine on the mortgage interest forms of every taxpayer paying AMT to look for deductions of home equity interest. While interest on home acquisition indebtedness is AMT-deductible, home equity loan interest isn't; I would bet my 1% skim that this AMT adjustment is missed more than it is made. I'd be hated, but I would simply go through witness protection and leave the country (unfortunately, probably the same way Jimmy Hoffa did).

Now if I were dictator of Iowa, then I'd have some real fun...

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TIME TO HARVEST THE FALL TAX DEDUCTIONS

November 03, 2005

The leaves are gone, the harvest is ending, the gray skies of November close in. For some, its a time to think of hot chocolate, apple cider, and the approaching warmth of the Thanksgiving holiday. We prefer to ponder taxes.

By mid-November, most taxpayers can have a pretty good idea what their income will be, and we still have six weeks or so to do something about it. Where to start?

Are you feeling really charitable?

In response to Hurricane Katrina, Congress is allowing taxpayers to deduct cash charitable contributions up to 100% of their taxable income for 2005 only. In most years, this limit is 50%.

You ask: why would I want to do such a silly thing? Well, few people are interested in giving away so much cash, but this 100% limit might be useful is if you want to donate a large IRA to charity -- perhaps as part of your estate planning. You could cash out the IRA and donate the entire balance to charity, with the charitable donation eliminating almost all of the tax on the IRA withdrawal. (Youd have about a 1% net tax in most situations, for technical reasons too revolting to review here).

O.K., are you just feeling somewhat charitable?

2005 has been a banner year for disasters. The Tsunami, Hurricanes Katrina and Rita, and the South Asian Earthquake have touched hearts everywhere. If you are looking to make a charitable contribution before year-end, look to your investment portfolio. If you donate publicly-traded securities before year-end, you may deduct the fair market value of the stock without ever paying tax on the appreciation. Just remember: you have to have held the stock for over one year. You should also get started with such donations right away. While most national charities handle contributions of securities promptly and efficiently, local charities may need extra time to process the contributions. If you wait too long, your deduction might not get completed before year-end.

Consider Alternative Minimum Tax.

More and more of us are becoming acquainted with the alternative minimum tax, or AMT. This tax was originally touted as a way to keep the wealthy from avoiding all taxes. If paying AMT means you are wealthy, Iowa is a rich state indeed.

The AMT is a sort of shadow tax, computed alongside the regular income tax. It is computed with a large exemption that disappears as income increases. It has a lower top rate (28%) than regular tax (35%), but fewer deductions. The biggest deductions missing from the AMT are the deduction for state and local income and property taxes and the personal exemptions for yourself and your dependents. This makes residents of high-tax states, like Iowa, and parents with large families, most vulnerable to AMT.

AMT matters because many tax planning tools dont work when AMT applies. If you have family income between $100,000 and $500,000, large capital gains, or more than two or three children, you are a likely AMT candidate. The only way to tell for sure is to run the numbers -- that is, estimate what your income for the year will be and compute your projected regular tax and AMT. Your tax advisor can help you out here. This process works best if you can also project your 2006 tax picture.

Once you know whether you will have AMT in 2005, you can consider some additional tax planning moves:

Prepay state and local taxes. If you expect to owe income taxes to Iowa next April, you might want to pay them now so you can deduct them this year. You might also want to get your March 2006 property tax payments in by year-end. But this wont work if you have AMT in 2005.

Bunch up your miscellaneous deductions.
You can deduct tax return preparation fees, union dues, certain unreimbursed employee business expenses, and fees to investment advisors and financial planners, but only if these miscellaneous deductions exceed 2% of your adjusted gross income. By bunching these expenses into one year say, by prepaying them you can sometimes cross the 2% barrier and get a tax benefit. Your tax preparer will be happy to discuss a 2% of AGI billing plan to help you get there (just kidding!). But beware these deductions arent allowed for AMT.

Hybrid Cars. Maybe youve had your eye on a Prius or that Lexus hybrid SUV. If you are in AMT, and will continue to be in AMT indefinitely, this is the year to buy. For 2005, you can deduct up to $2,000 of the cost of a hybrid car above the line, without itemizing. This deduction works for AMT, too. Next year, the deduction becomes a credit, and the credit doesnt work if you are paying AMT.

(Note: a version of this piece is slated to appear in the December issue of "50-plus Lifestyles." )

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TOP SENATE TAX STAFFERS BLAST AMT

August 10, 2005

The top two Republican staffers on the Senate Finance Committee attack the alternative minimum tax while defending Senator Grassley's AMT record in a Tax Notes article made available by the TaxProf today.

DEFENDING GRASSLEY

The staffers are responding to criticism that the AMT has been used cynically to enable Congress to enact tax cuts that are really illusory because they don't work for AMT. Their response to the criticism, largely consisting of saying Senate Finance Committee Chairman Grassley has long opposed the AMT, is unconvincing. They cite a 1999 bill to repeal the AMT vetoed by President Clinton; that bill "was never serious legislation," as tax prof Sheldon Pollack recounts, and should not be considered a serious attack on AMT.

Tax revenue projections are critical parts of all tax legislation. Whether used cynically or not, they are deeply woven into the legislative process. The AMT greatly reduces the cost of many different tax breaks; the just-enacted credits for residential energy savings are a classic example. The AMT probably made the president Bush's 2001 tax cuts possible by reducing their size.

Senator Grassley has been on the Finance Committee since the current version of the AMT came to life in 1986. While he can't be held solely responsible for the state of the tax law, he has been the chief Senate taxwriter for most of the last three presidential terms. No legislator has had more ability to affect the tax law over that time then Senator Grassley, so attempts to deflect responsibility from him can't entirely succeed.

THE AMT PROBLEM

The staffers are on more solid ground when they describe the practical effect of AMT:

But there are other very compelling reasons to repeal
the AMT. Not only has the AMT failed in its original
objective, but the AMT has lost its policy purpose.
Currently, the AMT derives its revenue base from large
families and those who pay high state income taxes.
According to data provided by Everson to Sens. Grassley
and Baucus in 2004, the top 15 states affected by the AMT (in order of impact) are: New York, New Jersey, California, Connecticut, Maryland, Massachusetts, Rhode Island, Oregon, Ohio, Maine, Wisconsin, Illinois, Minnesota, New Hampshire, and Vermont. From a horizontal equity perspective, Kevin Hassett made the following remark in his May testimony: "While it was originally motivated as a tax to ensure social justice, it likely does the opposite. It taxes individuals across states in a hodgepodge way, hitting similar individuals quite differently."

This is exactly right. A two-earner professional couple with children is pretty much doomed to AMT in Iowa, for example, but will be AMT-free in Nevada.

They defend their stopgap attempts to prevent AMT from affecting even more taxpayers -- Congress has increased the individual AMT exemption several times -- and they correctly note that failure to index AMT exemptions have made the AMT problem worse.

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ENERGY EFFICIENT APPLIANCE CREDITS - GREEN PIE IN THE SKY?

August 09, 2005

The President yesterday signed H.R. 6, the long-awaited energy bill. The bill, loaded down with corporate tax incentives and subsidies for ethanol, also has some consumer-specific provisions. These are touted in a recent press release from Senator Grassley:

* Up to a $500 tax credit for money they spend on
energy improvements in their homes. Homeowners
could qualify for as much as a $300 credit for installing
a highly efficient central air conditioner, heat pump or
water heater. Installing energy-saving windows could
net as much as a $200 credit. Those who want to take
advantage of these breaks must do so between Jan. 1,
2006 and Dec. 31, 2007. (An income tax credit directly
reduces the amount of income tax paid by offsetting
other income tax liabilities.)

* A 30 percent tax credit for the purchase of solar,
photovoltaic (or solar electric) and fuel cell properties
for use in residences.

* More access and lower prices for energy efficient
washers, dryers and refrigerators. New tax breaks for
the manufacturers of these appliances are expected to
increase the items' availability and drive down their
costs for consumers.

* Expanded tax credits for those who buy alternative
fuel vehicles, including an expansion of the range of
hybrid and clean vehicles that qualify for the alternative
motor vehicle tax credit. By purchasing such a car after
Jan. 1, 2006, consumers can get a tax credit anywhere
from $500 to $3,400, depending on the fuel efficiency
of the car.

Unfortunately, these credits are a mirage for many Iowans. These credits only reduce regular income tax - but they don't reduce alternative minimum tax. A provision to make the credits apply for AMT died in the house-senate conference on the bill.

As we've discussed, AMT applies to more taxpayers each year, especially in high-tax states like Iowa. AMT is computed at lower top rates, but with fewer deductions; when AMT higher than regular tax, you pay the AMT. Because AMT has no deduction for state and local taxes, many Iowans (and Californians, New Yorkers, Minnesotans, Wisonsinners, etc) pay AMT.

There is some cold consolation - if AMT limits your energy credits, they carry forward to future years. But that doesn't help much if you are in AMT then, too.

The moral? If you are considering an energy-efficient appliance, don't bank on the tax credits unless you know you won't be in AMT. That would probably mean you live in Texas, Tennessee, Florida, New Hampshire, South Dakota, Nevada or Washington, which lack a state income tax.

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REPEAL AMT WITHOUT TAX REFORM?

May 24, 2005

The ranking members of the Senate Finance Committee, including Senator Grassley, have introduced a bill to repeal the alternative minimum tax independent of tax reform. The bill provides no offset for the $600 billion to $1 trillion revenue reduction slated for the bill over the next ten years.

This is a high-powered bipartisan lineup (tri-partisan, if you count Senator Jeffords as an independent). Still, it's hard to imagine this passing outside of tax reform; it could kill any tax reform effort by forcing it to include a big tax increase. Maybe that's the point.

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ANOTHER STORY ON THE SPELTZ AMT WOES

April 05, 2005

Mary Deibel of Scripps-Howard News Service has another profile on the Speltz AMT-ISO debacle. State 29, who noticed the S-H article, remains unmoved.

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AMT, ISO RESOURCES AT BENEFITSBLOG

April 04, 2005

The BenefitsBlog has assembled a set of links dealing with ISOs and other AMT issues. These are the problems that have led to the financial debacle experienced by the Speltz family of Ely, Iowa.

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NY TIMES RUNS STORY ABOUT MCLEOD AMT VICTIM

April 01, 2005

From yesterday's Times:

Windfall Never Came; Big Tax Bill Did
Ronald J. Speltz and his wife face a huge bill for taxes on income they could have had but never received. They have little in the way of assets to pay the bill, and now a tax court judge has turned down what may have been their last hope to avert financial ruin. Their troubles underscore how taxpayers can be tripped up by stock options if they do not know how to handle them properly. The options the Speltzes thought had made them wealthy instead brought on their current troubles.

The article gives some background on the Speltz family, who live in Ely, Iowa, and the politics behind the failure to remedy the Alternative Minimum Tax effect of ISOs when the ISO stock collapses.

Prior Tax Update coverage of the Speltz case:

TAX COURT TO MCLEOD AMT VICTIMS: SORRY, BUT YOU'RE STILL SCREWED

ATTORNEY IN MCLEOD ISO AMT CASE RESPONDS

Thanks to Tim Carlson for the pointer.

UPDATE: State 29 is experiencing a sympathy dearth.

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ATTORNEY IN MCLEOD ISO AMT CASE RESPONDS

March 31, 2005

We received the following email in response to our post, TAX COURT TO MCLEOD AMT VICTIMS: SORRY, BUT YOU'RE STILL SCREWED. The author was the taxpayer attorney in the Speltz case discussed in the post.

Dear Mr. Kristan,

I felt the article on the Speltz Tax Court decision was very well written and properly hit home on the need for Congress to provide remedial relief on this critical area of unfairness and injustice.

One thing I did want to point out, however, is that the conclusion that as a matter of law, the Judge was right is actually in my belief not correct. Certainly there is no question that the liability imposed by the ISO AMT code is correctly calculated, but that is not the end of the inquiry. Congress passed Section 7122 in 1998, and that law and its corresponding Regulations provide for relief in situations where public policy and equity considerations engage. Certainly I would argue (and did, in fact) that if that provision does not apply in a case where a taxpayer is being asked to pay taxes at a 220% tax rate (11x that of a similarly situated taxpayer), then Im not sure it has any meaning at all and Congress does not pass laws that have no meaning. Proper consideration and statutory interpretation of all the tax laws that apply in this case (the ISO AMT Statute, the ISO Statute and the ETA Statute) and a review of the relevant legislative history, lead to the conclusion that the Speltzes are indeed entitled to relief under the public policy/equity prong of Section 7122, and also under the hardship prong.

Of course, relief from the Court would only have solved half the problem for the Speltzes, who are already overextended in their efforts to pay over $100,000 in excess tax. Relief from Congress is needed, and thankfully is gaining great support in both the House and Senate. After a number of years, we are hopeful that Congress is now focusing on the need for relief for persons subjected to these egregiously disproportional ISO AMT tax liabilities.

Attached please find (i) one of the Briefing papers for the Speltzes that supports the positions Ive summarized above, (ii) a summary and PowerPoint Presentation on the proposed legislation, and (iii) an encouraging mention of this legislation in a recent Tax Notes article, with positive comments from Reps. McCrery and English. We are encouraged that relief is on the way for the Speltzes and the many others harmed by this unintended effect of the ISO AMT law.

Please do not hesitate to contact me if you have any questions.

Best Regards.

Tim Carlson
President
Coalition for Tax Fairness
301.515.6584

Links to the attachments mentioned are below. We don't link to the Tax Notes article because it is a copyrighted piece behind a subscriber firewall.

Tax Court Petition

Summary of proposed AMT relief legislation

Powerpoint discussion of ISO AMT rules

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TAX COURT TO MCLEOD AMT VICTIMS: SORRY, BUT YOU'RE STILL SCREWED

March 24, 2005

screw.jpgThe bursting of the telecom bubble left victims strewn across the landscape. None got a worse deal than telecom employees who had exercised "incentive stock options" (ISOs).

ISOs were set up to be a better deal than ordinary "non-qualified" stock options. When taxpayers exercise non-qualified options, the difference between the price they pay to exercise the options and the value of the stock is treated as salary, and they pay taxes on it.

Example: A taxpayer owns non-qualified options on 100 shares of stock with an option price of $1. She pays $1 per share to exercise the stock when the shares are worth $10 each. The $9 per share "bargain element", or $900, is added to her W-2 income.

ISOs are different. The taxpayer pays no tax when an ISO is exercised; if the shares are held for a year after exercise, the "bargain element" is taxed on sale as a capital gain.

Did we say "no" tax? That's not quite right. You pay no "regular" tax, but you do have to pick up the "bargain element" as salary in computing alternative minimum tax. And that's where the nightmare begins.

MCLEOD ISOS - A BAD BARGAIN

Ronald J. Speltz, of Ely, Iowa, was earning about $75,000 annually as a senior manager for McLeodUSA. He exercised McLeod ISOs in 2000 with a bargain element of $711,118, resulting in $206,191 of AMT. Mr. and Mrs. Speltz also owed Iowa AMT of $46,792

As many Iowans know, McLeod's stock collapsed. Mr. Speltz found himself with a $206,000 tax bill on now nearly-worthless McLeod ISO shares.

Mr. Speltz paid part of the tax with his 2000 return and borrowed $134,000 from a bank to pay some more; he then entered into an installment deal to pay the rest. He then tried to compromise the remaining $125,000 or so that he owed with $4,457, which was the cash value of a life insurance policy.

The IRS, as is their custom, turned down the offer, saying Mr. and Mrs. Speltz had the ability to pay the full balance, over time.

NO 'ABUSE OF DISCRETION'

Mr. Speltz went to Tax Court. He argued that the IRS "abused its discretion" by refusing his offer. An attorney who has been fighting for other telecom ISO AMT victims joined the case.

Tax Court Judge Cohen yesterday said her hands were tied. Tax Court judges can't overturn a tax assessment just because the tax law is unfair:

Petitioners hardship argument is essentially that the
tax liability is disproportionate to the value that they
received from the ISOs and that they have already been
forced to change their lifestyle unreasonably. Although
we sympathize with their situation, this type of hardship
is not unique.

WHERE IS CONGRESS?

As a matter of law, the judge is right. What is baffling is the failure of Congress to deal with this issue. They are the only ones with the authority to fix this mess. Many taxpayers face the same financial disaster as Mr. Speltz. The telecom meltdown is obviously not just an Eastern Iowa problem; ISO AMT victims are strewn up and down Silicon Valley, and everywhere else the bubble burst.

Congress has passed four major tax acts and a number of minor ones since the telecom bust. The American Jobs Creation Act passed last year had goodies for just about any lobbyist worth his Gucci loafers, but no relief for ISO AMT victims. Senate Finance Committee Chairman Grassley, call your office.

Cite: Speltz v. Commissioner, 124 T.C. No. 9

UPDATE: The Speltz attorney responds.

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MY HOME EQUITY LOAN IS DEDUCTIBLE. ISN'T IT?

March 18, 2005

Home equity loans are very popular. They have lower interest rates than credit card debt. Their tax deductibility often clinches the deal. Unfortunately, for many taxpayers that deduction is a mirage.

A Revenue Ruling issued yesterday highlights the often-overlooked dark side of home equity loans: they are deductible for regular tax, but not for alternative minimum tax.

In Revenue Ruling 2005-11, a taxpayer borrowed $100,000 to purchase a home. Over time, and after one refinancing, he had paid the balance down to $80,000. He then refinanced the home again for $110,000, not using any of the refinance proceeds to improve the home.

In computing his deduction for regular tax purposes, the taxpayer can deduct his interest on the entire $110,000 balance. In computing the interest for AMT, however, he can only deduct interest on $80,000. At a 7% interest rate, that translates into a lost deduction of $2,100.

As we've discussed, AMT is becoming the default tax system for more and more taxpayers. This is especially true in states like Iowa with high state income taxes, which are not deductible for AMT. Almost any two-earner professional couple with children is a likely AMT candidate in Iowa.

The moral? Don't bank on a home equity loan deduction unless you know you are not paying AMT.

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FACT SHEETS TALK OF AMT, PROGRESSIVITY

March 03, 2005

The Treasury Department issued three "Fact Sheets" on taxes yesterday. Covering them in decreasing order of political content:

How Have the Presidents Tax Cuts Encouraged Investment?

This sheet focuses on the "marginal effective tax rate on new investment," or "METR." The paper says boasts that the now-expired bonus depreciation provisions "lowered by one-half or more the METR on qualifying investment." Perhaps this is a lead-in to the tax reform debate, where we are likely to see arguments for much faster write-offs of capital equipment.

Who Pays the Most Individual Income Taxes?

This fact sheet wades into the progressivity debate. It shows that the share of income taxes paid by the top 1% and 5% of taxpayers has decined since 2000, but is higher than in 1995. The top 1% of taxpayers (by AGI) pays 33.7% of taxes, while the bottom 50% pays 3.5% of the income tax.

David Cay Johnston would hasten to point out that this only accounts for income taxes, and that the top 1% only pays 25% of all federal taxes. He would also assert that progressivity breaks down at the very top of the top 1%.

Both the Treasury and Mr. Johnston are right. What isn't clear is whether progressivity itself should always drive tax policy. This can be an uncomfortable debate for both sides. Even if it were demonstrated that lower effective rates for the top 1/10th of 1% of taxpayers made everyone wealthier, any forthright defense of this would lead to attacks on "trickle-down economics." On the other hand, if the connection between lower rates at the very top of the scale and an improved economy were demonstrated, those advocating more progressivity would implicitly be willing to make everyone a little poorer to make sure those at the top are paying their "fair share." At some point, progressivity gets in the way of other tax policy goals.

amtchart.jpg
Historical progressivity chart from Treasury Dept. fact sheet

The Toll of Two Taxes: The Regular Income Tax and the AMT

This last paper is the least political. It simply states the grim math of the alternative minimum tax:

Left unchanged, the AMT will affect increasing numbers of taxpayers. As can be seen in the graph [below], assuming the 2001 and 2003 tax cuts are made permanent, the number of taxpayers with increased taxes due to the AMT will increase from 3.8 million in 2005 to 20.5 million in 2006 and to 51.3 million in 2015.
amtchart.jpg

Chart showing that it will be cheaper to get rid of regular
income tax than AMT by 2013

This math is why it is likely that the ultimate "fix" for AMT from the tax reform process is likely to leave us with an income tax that looks something like the AMT - a system with fewer deductions (including a repeal of the deduction for state and local taxes) - and a lower top rate.

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AMT TAX PLANNING IS DIFFERENT

December 08, 2004

Many taxpayers got an unpleasant surprise last April when they discovered that they were subject to the Alternative Minimum Tax. The AMT is a shadow tax computed at a lower top rate, with a large standard exemption but fewer deductions. It applies when it exceeds regular income tax.

The 2003 tax changes that lowered the regular tax rates did not change the AMT rates. This change often reduced regular tax enough to make it lower than the AMT. Surprise!

The item that causes AMT for most Iowans, and residents of other high-tax states, is the deduction for state and local income and property taxes. Now that sales tax are deductible in lieu of income taxes for regular tax (but not AMT!), residents of other states will be joining the AMT party.

CAPITAL GAIN AND AMT

While the same long-term capital gain top rate of 15% applies for both AMT and regular tax, taxpayers with large capital gains often find themselves facing AMT. Why? Think about it: a 15% tax with fewer deductions is likely to exceed a 15% tax with more deductions. If you are paying the top 8.98% rate on Iowa capital gains, you can get to AMT in a hurry.

WHO IS LIKELY TO SEE AMT?

For Iowa taxpayers AMT is widespread, and often impossible to avoid, for gross incomes between $150,000 and about $500,000. If your income includes large capital gains, this income range widens. If you are blessed with children, the AMT applies at lower income levels because there is no AMT dependent exemption.

HOW AMT PLANNING IS DIFFERENT

The common tax planning strategy of prepaying state and local income and property taxes by December 31 generally fails when AMT applies. Sometimes you can maximize the value of these deductions by paying just enough before December 31 to move you to the verge of AMT.

Other strategies still work for AMT. Charitable deductions are fully deductible for AMT, for example. Home mortgage interest on "acquisition" indebtedness - the loan to buy or remodel a residence - is also deductible, but home equity loan interest is not deductible for AMT.

To do serious AMT planning you need to compute projected taxable income for both 2004 and 2005. Timing discretionary income and deductions among years is often the way to minimize taxes when AMT lurks.

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THE ECONOMIST SEES AMT AS ROUTE TO TAX REFORM

December 06, 2004

The TaxProf Blog notes an article in The Economist that suggests using the Alternative Minimum Tax as a backdoor to tax reform:

   From the perspective of tax reform, however, the AMT is less an 
   expensive problem than an opportunity. Why not use the AMT 
   as the vehicle for tax reform? By 2009, it will be less costly to 
   ditch the income tax and keep the AMT than to repeal the AMT 
   and carry on with the income tax. The AMT is far from perfect
  its personal exemption is not indexed; quirks in its structure  
   can mean high marginal rates for some taxpayers; and it 
   allows some needless deductionsbut it is less riddled with 
   loopholes than the current income tax. Thus it is a good 
   starting-place for base-broadening, exemption-ending reform.

Does The Economist read the Tax Update?

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AMT: IT'S FOR EVERYBODY!

December 18, 2003

Commentators are piling on the alternative minimum tax (AMT).

Today's Wall Street Journal Tax Report (subscription required) reports that Taxpayer Advocate Nina Olson will call the AMT "the most serious problem encountered by taxpayers" in an upcoming report. "It's a train wreck," Ms. Olson says.

The article also forwards helpful advice from Len Burman, co-director of the Tax Policy Center, on avoiding AMT:

"Get rid of your children, and move to a low-tax state."

The USA Today weighs in with Tax cuts may push some families into AMT trap (thanks to BenefitsBlog for the pointer):

The AMT was created in 1969 to prevent the super-rich from using sophisticated loopholes to avoid paying taxes. But because it wasn't indexed to inflation, the number of taxpayers who fall into the AMT net has increased. In 2003, an estimated 2.4 million taxpayers will pay the tax. Unless Congress changes the law, up to a third of all taxpayers will grapple with the AMT by the year 2010

We have discussed the AMT here and, more recently, here.

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NEW LAW TIP: BEWARE AMT

September 16, 2003

We know that every cloud has a silver lining. Of course, every shiny silver lining has a dark cloud, too. The recent tax law is no exception.

Many taxpayers now dazzled by the bright shiny lining of the reduced individual tax rates of the 2003 tax law will face the dark cloud of alternative minimum tax next April. As we've noted before, AMT looms for more and more taxpayers.

The AMT is a shadow tax system that lurks alongside the regular income tax. It has only two rates - 26% and 28%; a generous exemption; and fewer deductions. If AMT exceeds the regular tax, the AMT applies. For most taxpayers, the biggest regular tax deduction missing from the AMT systems is the deduction for state and local taxes.

LOWER RATES, BUT FEWER DEDUCTIONS

In 2002, when the top individual rate was 38.6%, there was a 10.6% difference between the top regular rate and the top AMT rate. Now, there is only a 7% difference, making it easier to slip into AMT. The tax law increased the AMT exemptions for 2003 and 2004 to help alleviate this, but the exemption - like so many features of the tax law - is phased out at certain income levels. For example, the $59,000 AMT exemption for married taxpayers begins to phase out as income exceeds $150,000.

Iowans with taxable incomes from around $150,000 to $500,000 will find it very difficult to avoid AMT this year; it some cases, it will be impossible. It will be especially difficult for taxpayers with large amounts of dividends and capital gain income. These items are taxed at the same 15% federal top rate for AMT as for regular tax, but Iowa taxes them at the same rate as ordinary income. A 15% tax without a deduction for state and local taxes can exceed a 15% tax with such deductions in a hurry.

WHAT TO DO?

Taxpayers need to be especially careful with their year-end planning this year. Typical strategies, such as paying property taxes and state income taxes before year-end, can backfire when AMT applies. Taxpayers should project their income and carefully evaluate any year-end strategies with AMT in mind.

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