A Complex Tax   Shocking Many People   This Filing Season

New Law Aids Stock Option Victims of the AMT

The alternative minimum tax (AMT) has been wreaking havoc on many people who exercised incentive stock options (ISOs) to buy stock of high-flying tech companies around the turn of the century. In some cases, those individuals faced a whopping AMT liability on stock that is now virtually worthless.     A law passed at the end of last year - the Tax Relief and Health Care Act of 2006 - provides some relief.     Details: Under existing rules, the amount of AMT liability attributable to an ISO can be credited against your regular tax liability in a future year. So, if regular tax exceeds your AMT liability in a subsequent year, you can apply the credit against the difference between the two.     New law change: Starting in the 2007 tax year, the new law allows you to use a portion of the credit carried forward, regardless of whether or not you're liable for the AMT. This tax break is available for a six-year period. The credit is "refundable," meaning the IRS will give you a refund even if you haven't paid any tax through withholding or estimated tax payments.     Essentially, the lower your income is, the more tax benefit you can get. Consult with your tax professional about the best way to proceed.

At least this much is sure: The AMT will continue to hit tens of thousands of unsuspecting taxpayers on their 2006 tax returns, which are due on April 17 this year. And, as one court case illustrates, you generally can't wriggle out of the AMT at tax return time.

First, let's briefly explain how it works. The AMT calculation runs side-by-side with your regular income tax calculation. The starting point for the AMT is your annual taxable income. Next, you add in special "tax preference items" and make other technical adjustments. Then you subtract a special exemption amount based on your tax return filing status.

Finally, you must apply the AMT rate to the remainder and compare it to your regular tax liability. In effect, you're required to pay the higher of the two. The AMT rate is 26 percent for the first $175,000 of AMT income; 28 percent above the $175,000 mark.

The exemption amounts for 2006 returns have been bumped up from the levels in the prior year. But Congress has not yet granted taxpayers any reprieve for 2007. One current proposal basically raises the income levels taxpayers would need in order to get hit with the tax.

Can You "Undo" the AMT at Tax Time?

The AMT often applies to taxpayers with large deductions for state income taxes. These deductions must be added back as part of the AMT calculation. 

In one court case, a taxpayer who itemized her deductions elected to forego any deductions for state and local income taxes. The IRS audited her return and reduced the amount of the refund she claimed by taking into account the state and local income taxes.

The taxpayer argued that she wasn't required to add back the deductions for AMT purposes. But a federal court disagreed. "The amount she owes due to the Alternative Minimum Tax ... in no way depends on whether she chose to take a deduction for state and local income taxes for purposes of computing her regular tax liability," the court stated.

In other words, if the taxpayer is entitled to the deductions, they must be included in the computation. Result: The taxpayer had to pay the AMT anyway (Qureshi, U.S. Court of Appeals for the Fed. Circuit, 06-5002, 9/6/06)

The moral of the story: If you're stuck paying the AMT, there's generally no way out. The best approach is to take steps during the current year to reduce or avoid AMT liability.

Who is Liable?

Computation of the AMT is extremely complex. Various factors make it difficult to pinpoint exactly who will be affected. But there are some common danger signs:

Q. Why Doesn't Congress Just Repeal the AMT? A. The answer, not surprisingly, is money. According to the Congressional Research Service, which provides information to legislators, repeal of the AMT would reduce federal tax revenues by over $1 trillion between 2006 and 2015. Congress was told in one report: "Projections indicate that it will soon be less expensive to repeal the regular income tax than to repeal the AMT."

Large families resulting in quite a few personal exemptions for dependents.

Incentive stock options exercised during the year.

Large deductions for state and local income and property taxes and home equity loan interest.

Miscellaneous itemized expenses (such as investment expenses and unreimbursed employee business expenses) deducted for regular tax purposes.

Large long-term capital gains.

Medical expenses that you've deducted for regular tax purposes.

Interest from "private activity bonds," which are tax-free for regular tax purposes but taxable under the AMT rules. 

Significant regular tax depreciation write-offs for personal property assets such as machinery, equipment, computers, furniture, and fixtures. These items must be depreciated using slower methods for AMT than for regular tax.

There's one bit of good news: If you are liable for alternative minimum tax this year, you may be eligible to take a special minimum tax credit against your regular tax in the future.

Six Ways to Plan Ahead to Avoid or Reduce AMT in the Future

It isn't easy to "plan around" the AMT. In fact, Congress carefully drafted the rules to curtail such moves. Even so, there is hope.

For example, any planning move that reduces your adjusted gross income (AGI) might help. Why? A lower AGI means a better chance of claiming a bigger AMT exemption. Lowering your AGI also slashes your state and local income taxes, which are disallowed in computing the AMT. 

Here are some ways to cut your AGI:

1. Make a deductible IRA contribution if you qualify.

2. Contribute the maximum amount to your tax-deferred retirement plan (Keogh, SEP, 401(k), etc.).

3. Contribute more to a cafeteria benefit plan at work (contributions lower your taxable salary and thus your AGI).

4. Prepay deductible business expenses near year-end if you run a business as a sole proprietorship, LLC, partnership, or S corporation. The deductions are "passed through" to you, resulting in lower AGI. Similarly, postponing the receipt of taxable income until next year also reduces your AGI.

5. Take some year-end losses on investments if applicable. You can use the capital losses to offset capital gains, which reduces AGI. Any leftover capital losses, up to $3,000, are deductible against taxable income from all sources (such as Schedule C or E income, salary, interest or dividends). So your AGI is reduced even further.

6. Consider deferring security sales that produce taxable gains until next year. In addition, carefully time the exercise of any incentive stock options. Triggering these options when there's a big spread between current market value and the exercise price is one of the most common causes for unexpected AMT bills.

Consult with your tax adviser if you suspect you may be subject to AMT. Smart planning can help you avoid or reduce the tax bite in future years.