The Government’s Loophole
Understanding the basics of the Alternative Minimum Tax (AMT)
Election season in the U.S. is upon us. No doubt, the issue of taxes will be one of the hot topics. Some of the candidates will surface the centuries-old argument that the “rich” don’t pay their fair share and argue that we need to increase taxes on those who can afford them. Some will claim that there are many special, even “secret” rules and “loopholes” accessible only to high-income earners. It’s much easier to garner votes with classist rhetoric than to address issues with logic and reason.
One issue that will likely not attract much attention is the Alternative Minimum Tax (AMT). For many Americans, the AMT is largely a mystery (Did anyone get a lesson on this in high school, college, or grad school?). Yet in my opinion, the AMT is one of the biggest loopholes that the federal government has at its disposal to increase taxes for not only wealthy Americans, but also on the middle class. And yes, this loophole has a further reach than any “loophole” afforded to wealthy Americans or corporations.
The purpose of this article is to demystify how the AMT works and provide some strategies to managing it, if not avoiding it altogether.
History of the AMT
In 1969 Congress instituted the Alternative Minimum Tax to ensure that high-income earners paid at least a minimal amount of tax. The Secretary of the Treasury had pointed out that 155 people with adjusted gross incomes above $200,000 had paid no federal income tax on their 1967 tax returns. An easy solution would have been to simply eliminate a few of the deductions and credits in the tax code that were largely responsible for this tax avoidance. But efficiency and simple solutions are not typically part of our government’s vocabulary, so Congress decided instead to enact a complex parallel system of calculating taxes. Never again would those evil, wealthy taxpayers avoid taxes!
According to the Tax Policy Center, an estimated 3.9 million taxpayers were subject to the AMT in 2013. This figure is projected to grow to six million in 2023 under the current tax code. We are now at a point where this tax affects many middle class Americans.
How the AMT Works
One can think of the U.S. as having two distinct methodologies to calculate income taxes. With our clients, we like to refer to these as:
- The "Regular Method"
- The "AMT Method"
Whether they realize it or not, every year U.S. taxpayers calculate their federal taxes (and sometimes state taxes) under both methods. Essentially, whichever method yields the highest absolute tax is what the taxpayer pays.
A summary of the Regular Method is as follows:
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Income (e.g., wages, business profits, rental income, capital gains)
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The Regular Method uses a progressive tax system in which the tax rate increases as the taxable income increases.
For example, the marginal federal tax rates in 2015 for single filers is as follows:
Someone with a taxable income of $500,000 would pay $155,046 in federal taxes, which is an average rate of 31%. The tax rate on the next dollar of taxable income—known as the marginal tax rate—would be 39.6%.
The AMT Method is calculated differently, as summarized below:
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Taxable income (a)
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Let’s dissect this methodology:
(a) First start with the taxable income calculated under the regular method.
(b) Then add certain “preference items,” which are bad things that increase the taxable income figure. Some of the more common preference items are:
- State income tax deductions. If you live in a state like California, these can be quite significant. Under the Regular Method, state taxes can reduce taxable income. Under the AMT Method, state taxes are not deductible and so get added back to income.
- Real estate property taxes. The Bay Area is one of the most beautiful places to live, but the cost of a home has become borderline ridiculous. Property taxes are typically more than 1% of the property value. A three-million-dollar home will set you back more than $30,000 a year in taxes that you can’t deduct under the AMT method.
- Incentive stock options (ISOs). These are great for motivating and retaining tech and other employees, but they can cause AMT tax heartburn. The bargain element (paper gain) of an ISO—the difference between fair market value and strike price—is ignored under the Regular Method (until the stock is sold), but included under the AMT Method (before the stock is sold). In our experience, many folks are surprised that exercising the options of their illiquid stock triggers the AMT. A bad scenario is having to pay thousands or even hundreds of thousands of dollars in AMT that gets recovered later. A worse scenario is the rosy expectations of the company never materialize, and you get stuck with AMT credit for years or even decades to come.
(c) The AMT exemption is the government’s way of giving taxpayers a little love after increasing their taxable income through the preferences items add back. This exemption depends primarily on the taxpayer’s filing status. The table below shows 2015 figures:
But as always, government love is hardly unconditional. This exemption is quickly phased out at certain income levels. For 2015, the phase-out thresholds are as follows:
The phase-out calculations involve reducing one dollar for every four dollars of AMTI above the threshold amount for the taxpayer’s filing status. For example, let’s suppose a couple is filing jointly with an AMTI of $190,000:
- Full exemption amount: $83,400
- Reduction: 25% x ($190,000 – $158,900) = $7,775
- Net exemption amount: $83,400 – $7,775 = $75,625
(d) The AMT method taxable income is $190,000 – $75,625 = $114,375
(e) The AMT tax rate consists of two tax brackets: 26 percent for AMT taxable income below $175,000, and 28 percent for income above.
But these flat tax rates are a bit deceiving (yet another government “loophole”!). The effective marginal rate can be much higher than this because of the exemption phase-out discussed above. A simple example:
- Let’s say a taxpayer is at the threshold level of the phase out and her income goes up by $100
- The AMT exemption is therefore reduced by $25 (remember, $1 exemption reduction for every $4 of income)
- Therefore, AMT taxable income increases by $125
- Assuming a high-income earner, taxes would increase by 28% x ($125) = $35
Although the AMT marginal rate is advertised as a flat 28%, it could be as high as 35%! Got to love the government spin!
Managing the AMT
So how can you avoid the AMT? In some cases, it is impossible. But there are certain strategies that can at least reduce the probability of hitting the AMT. Some of the most common ones in our experience are:
- Manage adjusted gross income (AGI). The goal of every taxpayer should be to earn as much as possible. However, minimizing your AGI can be a way to pay by the Regular Method instead of the AMT Method. Maximizing your 401(k), SEP IRA, and other tax-deferred accounts is one sensible strategy. Investing in tax-efficient mutual funds and ETFs that don’t distribute too much in capital gains and dividends is yet another method we advocate. Timing of expenses and income for small businesses can also help avoid or at least defer the AMT. Conversely, you might instead choose to maximize your AGI, since at very high levels of income, the Regular Method will apply to you instead.
- Exercise the right number of ISOs. The key here is to only exercise enough incentive stock options (ISOs) so that taxes under the AMT Method and the Regular Method are about equal. In our opinion, exercising ISOs and paying additional AMT is not worth the risk-reward trade-off.
- Timing of property taxes. Oftentimes counties and municipalities will allow taxpayers to pre-pay property taxes in a given year. If you know that you’re likely to be paying the AMT this year, but not next year, it makes sense to wait. (The opposite is true if you’re likely to pay the AMT next year but not this year.)
- Timing of state income taxes. Similar to property taxes, it might make sense to pre-pay state taxes when your income is not going to be affected by the AMT. Moving to Texas or Florida can also be good options since the absence of the state tax deduction can help avoid the AMT.
Conclusion
The debate is not whether to tax or not, since taxes are a necessary evil for all societies. The burning questions relate to how much and whom to tax. In America, our politicians have adopted a dual system of calculating taxes that is confusing and often creates unintended consequences.
Because it is complex and not well understood, the AMT is unlikely to be repealed in the near future regardless of who wins the election. Like many other unfortunate taxes, it’s here to stay for the long-term and will likely increase its reach over time. There are many strategies to managing the AMT, including timing property and state tax payments and exercising ISOs. Even if the AMT is unavoidable, it’s still important to understand it in detail despite the fact that most of our politicians don’t.
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