The Alternative Minimum Tax

The Rules – and the Impact

It began in 1969 with a mere 155 taxpayers. Now it is estimated that the Alternative Minimum Tax (AMT) will affect over 50 million taxpayers by the year 2015.

In 1966, those 155 taxpayers paid no tax on income exceeding $200,000 (estimated to be $1.2 million in today’s dollars). When Congress discovered the loophole in 1969, the Alternative Minimum Tax was born. While the initial intent of the AMT was to prevent those few high-income taxpayers from utilizing deductions that reduced their taxable income, the once obscure AMT now impacts more taxpayers than was ever originally contemplated.

The multitude of financial firms publishing articles on the topic have provided varying figures as to the number of taxpayers and income ranges that will be affected by the AMT over the next several years. Regardless of the exact numbers, it is certain that with each passing tax year, an ever-increasing number of taxpayers will be subject to the AMT, particularly:

• Residents of high income tax states including: New Jersey, New York, Massachusetts, and Maryland,
• Households with two or more dependents,
• Investors incurring large capital gains,
• Employees exercising large amounts of incentive stock options.

The growth of AMT taxpayers is due to certain “preference items” such as state and local income taxes, real estate property taxes, and personal exemptions that get added back to taxable income in order to calculate the AMT.

While the AMT rules permit an exemption of up to $58,000 for married individuals filing jointly, this exemption is phased out at a $150,000 income threshold.

Unfortunately, this threshold is not slated to adjust for inflation as the regular tax rules allow. The so-called “bracket creep” is the main reason the AMT has begun to have a greater impact. Investors incurring significant capital gains in a particular year – or – employees exercising large amounts of incentive stock options rapidly approach the phase-out threshold of $150,000 because these amounts are included in their regular income. As a result, they lose the ability to use their exemption, further increasing their AMT liability.

Unless the rules are changed, the opportunities to avoid the AMT are limited. Taxpayers subject to the AMT generally seek to accelerate ordinary income into the current year and defer those deductions that are not allowable for AMT purposes.

Consider the following strategies to reduce your AMT ability:

• If you live in a high income tax state, take advantage of pre-tax retirement plan contributions because they reduce taxable income, and, therefore, state income tax.
• If possible, delay realization of long-term capital gains to keep your income below the range of the AMT exemption phase-out.
• Sell shares that you have received in an incentive stock option exercise in the same year to offset AMT impact, or delay exercise altogether.
• Avoid taking substantial depreciation or gain/loss adjustments on business property.
• Avoid substantial one-time miscellaneous itemized deductions, such as large variable annuity losses.

Note: Before implementing any of these strategies, you should discuss them with your professional tax advisor to identify potentially negative consequences in other areas of your financial life.

If you would like additional information on the Alternative Minimum Tax or other wealth planning issues, please contact your Legg Mason Financial Advisor. Legg Mason has an experienced team of professional Wealth Advisors who will work closely with your Financial Advisor to tailor a wealth management strategy that can help you meet your financial goals.

Vanessa J. Duchman and Steve E. Shane