The beginning of the 2008 tax season started with the bad news that many returns would be delayed because of legislation passed by Congress at the end of the tax year. The legislation in question concerned the patch for the Alternative Minimum Tax, which if left unchanged would have cost many middle income taxpayers a great deal more in taxes.
Ironically enough, the AMT system, that was put into law back in the late 60's, was for the purpose of stopping high income taxpayers from avoiding taxation of their income by taking excessive deductions and credits. As I am sure you have been reading in the news, this alternative tax system has not been indexed for inflation, and has therefore reached the point where its intentions have gone askew. There has been much printed material about this patch passed by the legislature without much being said on how this alternative system works.
As an instructor of tax courses for the past several years, it was always a challenge to explain how this parallel system of taxation interacts with the regular tax system. Other than a couple of transactions that a taxpayer can make which is a good indicator that the AMT will kick in when filing their return, there are no "rules" to clearly let a person know that they will owe AMT taxes on their return. The only way to find out if a taxpayer is affected by the AMT is to run all the numbers to see if the AMT applies. If a taxpayer itemizes or has taken depreciation on capital assets used in business or rental properties under the regular tax system, this recalculation for AMT can become a small nightmare.
Since the news media has been so vague in its presentation of this system and how it works, we have decided to attempt to give an explanation of the AMT system. Even a capsulated version can be somewhat lengthy, therefore hang on tight as we explore this often talked about but misunderstood system of taxation. NOTE: For those of you who would prefer to read this material offline, please open and print the MS Word document at the end of this web page.
To begin, we will first dissect the Form 1040 under the regular tax system. If you take a look at your Form 1040, lines 7-21 is the area where you enter in all of your taxable income. Line 22 is the summation of these lines and appropriately titled your total income (gross income).
Lines 23-35 are for adjustments (deductions) allowed under the current tax laws that can be subtracted from your total income to arrive at what is known as your Adjusted Gross Income (AGI) on line 37. Line 38 is once again your AGI without any changes.
Under the regular tax system, we now get to subtract from the AGI either a standard deduction based upon our filing status, (single, head of household, married filing joint) or if it is more beneficial, itemize deductions, if itemizing will exceed the standard deduction allowed.
Once we have subtracted this deduction from our AGI total, we are now allowed to subtract a personal exemption for each person claimed in the exemption section at the beginning of the Form 1040. An exemption is allowed for each person we can claim as a dependent as well as for ourselves and spouse if married.
(The standard deduction and personal exemption amounts allowed are usually indexed for inflation every new tax year.)
After the subtraction of the personal exemptions, we have now arrived at the taxable income on the income tax return. The computation of tax owed based upon this number can become complex depending upon certain types of income that may exist in our total income, but to keep things simplified we will just explore the tax computation from the tax tables.
Under the regular tax system, there are several tax brackets, 10%, 15%, 25%, 28%, 33%, and 35%. Each percentage has a bracket of income allocated to it, based upon a particular filing status. For instance, the 2009 tax rate schedule shows that the 10% bracket for a single individual is from $0 to $8,350, whereas the 10% bracket for a taxpayer who is head of household is $0 to $11,950.
A single person, who has taxable income of $15,025, has a tax liability of $1836 taken from the tax tables. The first $8,350 is taxed at 10%, the balance at 15%. The $1836 tax liability is 12.4% of the $15,025 taxable income, the mean of the two percentage brackets used to calculate the tax.
OK, now let's look at a simplified version of the AMT. The alternative minimum tax system does not recognize the standard deduction or personal exemptions of the regular tax system. It has its own deduction amounts based upon a filing status. The AMT also does not recognize the several tax brackets of the regular tax system. It has only two tax brackets, 26% and 28%.
AMT income is calculated on Form 6251. Line 1 of this form consists of either the AGI as calculated under the regular tax system or if itemizing deductions, the income total after the subtraction of the itemized deductions from the AGI. Lines 2-27 on this form is the modification of the income on line 1 to arrive at AMT income. Some of the entries on these lines can be a negative number that will lower AMT income or additions that will increase AMT income. Any entries on these line items are then totaled on line 28 to arrive at AMT taxable income.
Based upon the filing status on the regular return, you deduct the AMT deduction allowed from the AMT taxable income and multiply the result by the appropriate AMT tax bracket percentage to arrive at the AMT tax. If the AMT tax calculated is greater than the tax calculated from the regular tax system, the difference between the two is carried over to the regular tax Form 1040, line 35, and then added to the tax calculated from the tax table. The regular tax system 1040 now reflects the tax due in the AMT system.
Now that there is an explanation of how the AMT works, let's take a look at what happened. In 2006, the AMT deduction for single and head of household was $42,500, for married filing joint $62,500 and for married filing separate $31,275. In 2007, these deductions dropped to $33,750, $45,000 and $22,500 respectively. Without "the patch" many more taxpayers in the middle income bracket would have owed the additional AMT tax. The legislation passed by Congress at the end of 2007 increased the deductions to $44,350, $66,250 and $33,125 respectively, slightly higher than the 2006 numbers. This patch was put into affect for one year.
To actually see the affect this would have had without the patch let's look at an actual income tax return for 2007 before the patch was signed into legislation so that we can appreciate what was going to happen. John and Mary are married with two children. They had W2 income from their full time jobs of $75,000 plus some interest from savings of $357. Their total income (gross income) is $75,357. They had no adjustments to income so their AGI is also $75, 357. Since their income is over $63,700 they are considered to be in the 25% tax bracket. They do not itemize, so their standard deduction for being married is $10,700 for 2007 and with 4 exemptions @ $3,400 each, their exemption amount is $13,600. This leaves them with taxable income of $51,057. After the standard deduction and exemptions are applied to their AGI, they are now in the 15% tax bracket. Their tax from the tax table is $6,879, which is 13.47% of their taxable income, a mean of the 10% and 15% brackets. They never owed any AMT tax in the past. Since they do not itemize, we carry over their AGI to the AMT Form 6251, line 1. They have a very simple return and have no adjustments to make to this income for AMT purposes, so their AGI becomes AMT taxable income. They now subtract the pre patch deduction of $45,000 allowed a married couple. This leaves them with $30,357 of AMT taxable income that is multiplied by the lower AMT rate of 26% resulting with an AMT tax of $7,893. Since their AMT tax is greater than their regular tax by $1014, they must carry over this amount to their regular tax return. Now their tax due in the regular tax system is the same as the AMT calculation of $7893. (Please see the attached PDF file for the 1040 and 6251 calculations)NOTE: John & Mary did not have any adjustments to income or any itemized deductions. All they reduced their income by in the regular tax system was the allowed standard deduction and personal exemptions allowed all taxpayers. Considering the reason for the development of the AMT was to prevent high income taxpayers from taking excessive deductions/credits to pay their fair share of taxes, we can see where the AMT system is severely broken.
Believe it or not, this was a simplified example of the AMT system. There is much more to this system.
A taxpayer who itemizes has many corrections to make to arrive at the AMT taxable income on the Form 6251. Itemized deductions consist of medical expenses in excess of 7.5% of the AGI, taxes paid consisting of either state sales tax or state income tax, real estate taxes, personal property taxes and other allowed taxes, mortgage interest, points, investment interest and qualified mortgage insurance premiums, gifts to charity, casualty and theft losses, job expenses and various miscellaneous deductions.
If a person itemizes their deductions in lieu of the standard deduction in the regular tax system, they must add back some of the deductions taken when calculating AMT. The AMT tax system does allow for some of the itemized deductions taken in the regular tax system to be subtracted from the AGI before applying the AMT deduction.
For the person who itemizes, the Form 6251 AMT line 1 entry is the income from the regular tax after the itemized deductions have been subtracted as opposed to starting with the AGI in our previous example. The following items must be added back into the AMT income before applying the AMT deduction. AMT allows medical expenses in excess of 10% of the AGI, if there is a medical deduction on the Sch A, some income must be added back. Taxes taken as itemized deductions must be added back. Any mortgage interest allowed on the Sch A that was not from a loan to buy, build or substantially improve your main home or second home that is a qualified dwelling must be added back (Interest from equity debt is not allowed). Miscellaneous deductions from line 26, Sch A, must be added back. If itemized deductions were limited due to high income, this can also be corrected and entered as a negative number.
Another glitch to the AMT system involves depreciation. If any income included in total income from the regular tax system, was derived from self employment or rental activities and such gain or loss from these activities includes depreciation of capital assets, the assets must be recalculated using AMT depreciation. Such calculations will change the income gain or loss from these activities for AMT purposes. The difference of the regular income vs. the AMT income from these activities must be corrected for as a negative or positive number on the AMT Form 6251 depending if it is a gain or loss difference.
We mentioned at the beginning of this essay that there are certain transactions that are usually an indicator that AMT tax will apply to a return. One of these transactions is the exercising of Incentive Stock Options. If the exercise and sale occur within the same tax year then this is not an issue. However, if options are exercised and the resulting stock is held through the end of the tax year, then gain is recognized for AMT tax purposes. The gain for such a transaction is the difference of the fair market price of the stock on the date of exercise over the option price which is generally lower. Under the regular tax system no gain is recognized on such a transaction and the basis of the stock is usually the option price. Since gain must be recognized for AMT purposes, usually resulting in an additional AMT tax, the basis of such stock for AMT purposes will be higher than the basis for the regular tax system. At a point in the future, when such stock is sold, the gain on the sale is higher under the regular tax system since it had a lower basis than for AMT purposes. If AMT tax was paid at the time of exercise, a taxpayer can usually apply for an AMT tax credit by filing Form 8801 since the income at the time of exercise is considered to be a deferral item.
For people who buy tax software to prepare their own tax returns, itís unfortunate that these tax programs do not do all of the work for you in making the corrections to AMT income on the 6251. Knowledge of the tax laws are required to go in and manually make some of these changes in the AMT system.
We hope that with all that has been said, you now have a better understanding of the Alternative Minimum Tax system, how it works, and how it may affect you in the future if some major overhauls do not take place soon. The fact that this current patch was a band aid for 1 year is clearly not the answer to this growing problem.
Now we will leave you with some food for thought. Considering that the AMT was originally instituted to prevent high income taxpayers from taking advantage of excessive deductions so that they would pay their fair share, itís a wonder that those taxpayers who have some income in a 35% tax bracket under the regular system only have to calculate AMT tax at the maximum rate of 28%!