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AMT by ashrafp

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									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.

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 2007
tax rate schedule shows that the 10% bracket for a single individual is from $0 to $7825, whereas the 10%
bracket for a taxpayer who is head of household is $0 to $11,200.
A single person, who has taxable income of $15,027, has a tax liability of $1863 taken from the tax tables. The
first $7825 is taxed at 10%, the balance at 15%. The $1863 tax liability is 12.4% of the $15,027 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 reasons 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, it’s 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, it’s 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%!

								
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