What is the Alternative Minimum Tax (AMT)?

Yesterday I noted that Congress has passed a temporary fix for the Alternative Minimum Tax (AMT). This is actually something that’s been weighing pretty heavily on my mind lately so, when a commenter asked about what the AMT is, I thought I’d spend a little time pulling together some details…

For starters, exactly what is the AMT?

According to the IRS:

The tax laws give preferential treatment to certain kinds of income and allow special deductions and credits for certain kinds of expenses. The alternative minimum tax (AMT) attempts to ensure that anyone who benefits from these tax advantages pays at least a minimum amount of tax.

Hmmm… That’s not particularly helpful.

So let’s try this: The AMT is a parallel tax system with rates ranging from 26%-28%. If your liability is higher under the AMT than under “standard” income taxes, then you have to pay the AMT. Given that standard tax rates top out at 35%, this doesn’t sound too bad. Unfortunately, the AMT also disallows many routine deductions, resulting in a potentially large tax liability.

A bit of background

The AMT was first introduced in 1969 in an attempt to stop the richest households from getting off with little or no income tax liability. At the time, it was intended to target just 155 high-income households. Fast forward to today, however, and the AMT is getting fairly widespread attention. Why? Because it’s not indexed to inflation. Thus, an increasing number of “regular” taxpayers are falling prey to it. Last year the number had climbed into the neighborhood of 4 million filers, and this year it was slated to catch more than 20 million more filers if Congress hadn’t patched it.

AMT risk factors

The AMT disallows certain types of deductions them with a lump sum exemption. As an aside, this exemption is what Congress just voted to increase in order to protect millions of middle-class taxpayers from triggering the AMT. Back to the matter at hand… The more of these disallowed deductions that you would otherwise take, the more likely you are to have a higher tax liability under the AMT, and thus the more likely you are to be subject to it.

For example, the AMT throws out deductions for state and local tax, property tax, home-equity loan interest (if the loan isn’t used for home improvements), medical expenses (these are still allowed, but in a more limited fashion), and various other itemized deductions. All of these things are replaced by a lump sum exemption that’s phased out as your income increases — this is actually what Congress just increased to save taxpayers near the cutoff from slipping over the line.

Large numbers of personal exemptions also put you at risk since those aren’t allowed under the AMT (this, combined with a major uptick in income, is why I’m worried – remember, we have four kids). Other risk factors include large long-term capital gains, the exercising of incentive stock options (ISOs), and certain forms of tax-exempt interest (e.g., municipal bonds supporting so-called “private activities” such as building a stadium).

How do you know if you’re subject to the AMT?

Unfortunately, the only way to know for certain whether or not you have to pay the AMT is to calculate your tax liability both ways. If your AMT liability is larger than you standard income tax liability, then you have to pay the AMT. You can calculate your AMT liability using IRS Form 8801. From what I’ve read, it’s especially important to do this calculation if your gross income is over $100k. And if you don’t compute (and pay) the AMT when you should’ve, the IRS almost certainly will. And failing to pay the AMT when it’s due might trigger an IRS audit.

The good news

As they say, every cloud has a silver lining… In the case of the AMT, this silver lining comes in the form of the AMT Credit. As it turns out, some portion of your AMT liability (anywhere from none to all of it) may be eligible for a credit in future years. In short, if you get hit by the AMT this year but not next year, you may be able to use a portion of your AMT credit to reduce next year’s regular income taxes down to your AMT liability.

AMT resources

Here are a few useful articles on the AMT from various corners of the internet:

» AMT101 from Fairmark.com
» How to Understand the AMT from Yahoo! Personal Finance
» Topic 556: Alternative Minimum Tax from IRS.gov

11 Responses to “What is the Alternative Minimum Tax (AMT)?”

  1. Nickel

    Kris: That’s because you don’t truly understand the AMT until you’ve stared it in the face and done everything within your power to avoid it. 🙂

  2. Anonymous

    Nickel im a accounting major in college right now and ive never seen anyone actually break down the AMT as well as you did.

  3. Anonymous

    I just found the 2007 AMT Assistant on the irs.gov website. It helps you determine if you need to pay AMT. It was a BIG help to me, just make sure you have filled out your 1040 through line 44 and schedule A if needed.

  4. Anonymous

    The thing that annoys me most about AMT is that it hurts those of us who live in high-tax states. Why is state income and property tax deduction considered to be a loophole for the rich? Same with having lots of kids because it’s only rich people that have kids, right? I don’t have kids, but as I live in NY state and earn a little over 100K, AMT is always a risk, any time I am considering selling stock. Yes, I understand, many people may think I am rich, but I’ve worked hard for my money and I pay my fair share of taxes already. It’s not like those of us who work for a company have any loopholes.

    Another interesting thing about AMT is the treatment of options. Normally if you exercise options you don’t pay taxes until you sell stock and have actual gains, but under the AMT you owe taxes the moment you exercise options. Now imagine a situation in which you get some part of your salary in options – as it was with many dot-com employees during the internet boom, exercise options before they expire and then decide to wait with selling stock e.g. to have long-term rather than short-term gains or just because you like the stock. (Yes, I know it is stupid) In the meantime the bubble bursts, so there is no money, but you still owe taxes. Your startup may have gone out of business, so you are out of the job too. Apparently this happened to many people when the internet bubble burst. They ended up owing millions to the IRS without ever seeing the money. One could say they should’ve sold the stock the moment they exercised the options, but how many of us really know about this rule. I’ve never had any options, thankfully, but when I sold my condo (that I rented out) and did my taxes I read all the AMT rules, and found the stories on the internet.

    BTW – TurboTax figures it all out just fine, no need to get an expensive accountant unless the taxes are really complex.

  5. Anonymous

    This is exactly why I have a financial adviser. She takes care of us and figure this stuff out. The AMT personally is pretty annoying since my wife and myself would be paying it save for all the money we dump in our 401k and congress ‘fixing’ the problem for another year.

    Granted I know I should not be complaining, since it is really not a terrible problem to have. But still, its pretty obvious that the AMT really needs to be updated for this day and age. My wife and I work really really hard and invest a ton just to save our butts from AMT.

Leave a Reply