INVESTMENTS&WEALTH MONITOR 30 FEATURE | UNDERSTANDING AND PLANNING FOR THE AMT AMT—Basic Calculations e basic approach of the AMT system is rel- atively straightforward. On a stand-alone basis, it nearly functions as a basic flat tax: Add up your income, claim one large exemp- tion (to relieve lower-income taxpayers from any exposure to the AMT system), and flat- tax the rest. In practice, the AMT is only slightly more complex: Taxpayers claim a few other deductions besides the broad-based exemption, the exemption itself phases out at higher income levels, and the system has two tax brackets—26 percent and 28 percent— not just a single flat rate. Nonetheless, the AMT system is actually much simpler than the regular tax system, which has far more deductions to calculate, phaseouts to account for, and seven tax brackets to navigate. e determination of any AMT liability is far more complex in practice, though, due to the fact that the tax code does not actually determine AMT exposure by adding up income, subtracting a few deductions and exemptions, and applying the two tax brack- ets to whatever is leſt. Instead, the AMT is calculated by starting with the result under the regular tax system and then winding backward to determine what the tax liability would have been under the AMT system. AMT is calculated by first identifying the individual’s Taxable Income and then add- ing back any personal exemptions that were claimed under the regular tax system. Next, the taxpayer adds or subtracts any AMT adjustments (alternative methods to calcu- late gains, losses, and deductions under the AMT system), and adds back any AMT preference items (specific deductions or exclusions under the regular tax system that are outright disallowed under the AMT systems: the regular tax system and the alternative minimum tax system. Taxpayers ultimately owe a tax liability based on whichever of the two systems produces the higher tax liability. us, to the extent the AMT results in a higher tax burden than the regular system due to restrictions on various tax deductions, exclusions, and other preferences, then the AMT pushes up the total tax liability and sets the bar as the new alternative minimum amount of tax that must be paid. Over the ensuing decades the AMT system shiſted. It began as a method to ensure that those—generally high-income folks—who were taking aggressive advantage of various tax preferences would still be subject to some minimum tax liability and pay their “fair share,” but tax reform in subsequent decades significantly adjusted the effective scope of the AMT. Many of the tax prefer- ences that originally were allowed for regu- lar tax purposes and then disallowed under earlier versions of the AMT have since, from ongoing tax reforms since the late 1960s, been stricken entirely from the tax code. As a result, instead of having a regu- lar tax system with many deductions and exclusions, and an AMT system that put many of them back into income for tax purposes, we now have two systems that share the majority of their deductions, exemptions, and exclusions, and result in remarkably similar tax liabilities for a large number of clients. In turn, this means that small changes to either the regular or AMT systems at the margins can result in a large number of taxpayers crossing the line from one system to the other, which creates complexity and planning opportu- nities for many. T he alternative minimum tax has its roots in the late 1960s, as the gov- ernment sought to increase taxation, in large part as a means to help pay for the ongoing Vietnam War. Research at the time revealed that so-called “tax expen- ditures”—tax deductions or exclusions legally granted under the Internal Revenue Code that functioned as an expenditure by Washington to support/subsidize a particu- lar social/public policy activity—had grown to an incredibly high level and represented a significant drag on total tax revenue. e solution at the time was to allow tax expenditures for the majority of taxpayers but scale back or outright reverse them for a portion of higher-income taxpayers. e call for an implementation of the new system was hastened when a “scandalous” report hit the media in 1969 that 155 high-income individuals earning more than $200,000 in 1966 (more than $1 million of income in today’s dollars) paid $0 in tax lia- bilities that year due to the legal implemen- tation of various tax exclusions and deduc- tions. us, the alternative minimum tax (AMT) was designed in essence to ensure that even—and especially—high-income taxpayers paid their “fair share” of taxes, under one system or the other. In its early form, the AMT simply limited the amount of an individual’s income that could be excluded or treated as tax-exempt. For example, if you earned $200,000, and all $200,000 was excluded from income under various rules, the early AMT simply stated that you couldn’t exclude more than 50 percent of that income, so at least $100,000 of it must be taxed. In later years, it was expanded into its present form, which establishes an overlay of two tax Understanding and Planning for the Alternative Minimum Tax By Michael E. Kitces, MSFS, MTAX, CFP ® , CLU, ChFC, RHU, REBC, CASL ©2015 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved.
Understanding and Planning for the Alternative Minimum Tax
Jul 04, 2023
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