Alternative Minimum Tax: Common Questions
If the alternative minimum tax has come into your radar, this could be a sign that you are doing a bit well financially.
That is because this tax targets taxpayers in higher tax brackets.
In fact, when it was introduced in 1969, it targeted the very rich who were avoiding taxes. Over time, more and more households have become AMT-liable. That means it now affects even the middle class.
The problem with the alternative minimum tax is that it is extremely difficult to understand. Calculating regular income tax is already a huge problem for a number of people.
Now imagine another tax existing side-by-side with the regular income tax, and to make matters even more difficult, this second tax is calculated in a different way from regular tax.
AMT critics have complained about its complexity – consider that it is basically a parallel tax system and you have to calculate your tax bill twice using a different set of definitions and rules.
Add that to the fact that you don’t always know if you owe AMT until you calculate.
Now, once again add that to the fact that there are more people who do AMT calculations than there are people who end up AMT-liable.
This explains why the alternative minimum tax is arguably the least liked part of the federal tax code. For instance, one Forbes article referred to it as the normal tax system’s evil twin! Furthermore, loathing for the AMT has spilled over even into the political arena, where presidential candidates like Bernie Sanders and Marco Rubio have used it as part of their campaigns – by promising to eliminate it!
On the other hand, there are those who praise the AMT for disallowing a variety of preferences and deductions which clutter the tax code. Also favorable is the fact that the AMT’s marginal tax rate (28%) is lower than that of the regular tax system (39.6%). AMT supporters point out that it is better designed than the regular tax system.
Besides, it ensures the very rich do not avoid taxes. The AMT produces approximately $60 billion annually in federal taxes from taxpayers in the top 1% bracket.
If you are struggling to understand what the alternative minimum tax is, you have come to the right place. In this article, we have compiled a set of common questions people ask about AMT and broken down the answers in as simple a language as possible for clarity.
WHAT IS ALTERNATIVE MINIMUM TAX?
Considering that a lot of people do not even know about the AMT, it is only fair that we start with a definition. The alternative minimum tax (AMT) is a mandatory tax that operates as an alternative to the regular income tax.
You trigger AMT when your income is higher than the exemption and you use a number of common itemized deductions.
To put it simply, AMT is the minimum tax amount you are compelled to pay after the consideration of certain adjustments and preferences.
Let’s use an analogy to make it simpler. Imagine two calculations are being done on a calculator at the same time. The first calculation is based on “regular” tax rules, which means it is not subject to AMT. The second calculation is subject to a different set of rules, and by this we are talking about AMT.
What this means is that there are certain deductions which are allowed under regular income tax but are disallowed under AMT. In other words, some taxes that were deducted under regular income tax are added back when it comes to AMT. What you add back is what is referred to as adjustments and preferences.
After you perform the two calculations, you get two numbers: the regular tax number and the AMT number. The total tax amount you are expected to pay is whichever of the two amounts is higher. That amount is your minimum tax. The difference between the two numbers is what we call alternative minimum tax (AMT).
For instance, if your AMT-adjusted tax is $1500 and your regular tax is $1350, that means the alternative minimum tax is $150. While this example may be oversimplified, the intent is to get the point across without using confusing jargon.
WHY WAS AMT INTRODUCED?
AMT was introduced because a small number of extremely wealthy individuals were successfully avoiding tax payments, in spite of their high incomes. 155 households had used tax benefits and deductions to avoid paying a dime in taxes.
We are talking incomes of about $1,000,000 if quantified in today’s currency value. The rich were able to use numerous deductions to successfully cut down their tax to zero. In spite of their high incomes, they were paying absolutely no tax. This prompted Congress to get involved, and so in 1969, the AMT was introduced.
Congress created AMT as an add-on tax, with the intention of ensuring those high-income households were at least paying a minimum tax. The original formula was 10% of total tax preferences over $30,000 + your regular tax liability.
This predecessor “minimum tax” got enacted by the Tax Reform Act of 1969. It went into effect the following year, 1970.
Unfortunately, the AMT phase outs did not adjust for inflation since 1969, and the result is that as inflation rose, a lot of people, particularly the middle class, gradually got within the snare of AMT. This is in spite of the fact that the AMT was originally supposed to target the very rich. As a result, the number of AMT-liable households rose dramatically. In 1982, there were 200,000 AMT-liable households, but by 2017, the number had reached 5.2 million!
Over the years, the AMT has been subjected to several changes. The main one happened during the Reagan era as part of the Tax Equity and Fiscal Responsibility Act of 1982. The change from AMT as an add-on tax to its current form as a parallel tax system was as a result of this law.
Other notable, though less significant changes, to the law were made by congress in the years 1978, 1982, and 1986. The most recent changes were made by the Tax Cuts and Jobs Act (TCJA) in 2017.
While the Tax Cuts and Jobs Act of 2017 retained the AMT, it raised the exemption and phase-out levels for 2018 up to 2025. Also included is an automatic cost of living adjustment. In addition, Congress got rid of AMT for corporations.
The TCJA dramatically reduced the number of people expected to pay the AMT. It achieved this by substantially increasing AMT exemption, raising the income levels at which the exemptions phase out, and changing many of the tax breaks which triggered alternative minimum tax for middle class taxpayers.
HOW IS ALTERNATIVE MINIMUM TAX CALCULATED?
To calculate if you owe AMT, you can use tax software – it does the calculation automatically.
Filling out the IRS Form 6251 is also an option. The form takes into account your home mortgage interest, medical expenses, among other miscellaneous deductions, and then uses this to figure out if your deductions are past the limit the IRS has set.
The form will also require you to provide information on a variety of incomes, like investment interest, tax refunds, and interest you get from private activity bonds, plus numbers corresponding to the capital gains or losses involved in property disposition.
The IRS has set specific formulas for determining the portion of your income and deductions that you should put down in the Form 6251. In addition, it has another set of formulas for determining alternative minimum taxable income (AMT).
WHAT IS ALTERNATIVE MINIMUM TAXABLE INCOME?
The alternative minimum taxable income (AMTI) is the amount of your income that is subject to alternative minimum tax. You calculate it by taking your regular income and then adding back the disallowed credits and items.
The items and credits you add back include home equity loan interest deductions, foreign tax credits, local and state tax deductions, the bargain element of incentive stock options, and interest on private-activity municipal bonds.
A number or deductions, for instance charitable donations and the interest on your mortgage home loan, are still allowed under AMT.
After you calculate your AMTI, you then impose AMT on the total amount at a rate of 28% or 26%. The 28% tax rate is for incomes above the AMT threshold and 26% is for incomes below it.
For instance, in 2020, the threshold is $197,000 of AMT taxable income – this is for people who are filing as single and as married filing jointly. In the case of married couples filing separately, the threshold is $18,800 of AMTI. Note that exemption is higher than in the case of regular income tax.
WHAT ARE THE AMT ADJUSTMENTS?
When you are calculating alternative minimum taxable income, there are some items that you might be required to either add or subtract from your regular taxable income. This is because, as we said, certain tax items are treated differently when it comes to AMT.
These items that you add and subtract are what we call AMT adjustments. Some are common and some affect only a few individual taxpayers. The following are some common AMT adjustment items:
- Medical expenses
- Depreciation deduction
- Miscellaneous itemized deductions where the 2% Adjusted Gross Income floor is applicable
- The limitation on overall itemized deductions
- Some state, local, and foreign taxes
- Personal exemptions and standard deduction
- Incentive Stock Option (ISO) exercises
- Mining exploration and development costs
- Certain interests (these include home mortgage and investment interest)
- Circulation expenses
- Alternative tax net operating losses
- Research and experimental expenses
- Long-term contract expenses
- Amortization deductions for pollution control facilities
- Gain or loss on the disposition of property
You add or subtract your AMT adjustments on page 1 of Form 6251.
WHAT ARE THE AMT PREFERENCE ITEMS?
As we have mentioned, when you are calculating alternative minimum taxable income (AMTI), you also have to add back certain AMT preference items. This leads to an increase in the amount of your regular taxable income. These preference items include:
- Interest on private activity bonds
- Excess intangible drilling costs
- Exclusion of gain on qualified small business stock
- Accelerated depreciation on property placed in service prior to 1987
Please note that while adjustments may be either add-backs or subtractions, preference items are always add backs. That means, they items are added back to income (aiding in you calculating the alternative minimum taxable income). You add back the preference items on page 1 of Form 6251.
In the case of many (or most) taxpayers, their AMT preference items come from LLCs, partnerships, or S corporations on a schedule K-1.
WHAT IS AN AMT EXEMPTION?
Since the AMT was, in its inception, never intended to affect taxpayers in the lower and middle income categories, taxpayers are provided with exemptions to ensure the wrong people aren’t subjected to AMT.
The AMT exemption is an amount you are allowed to deduct from your AMTI before you work out your AMT liability. The exemption amount you are allowed depends on your filing status. There are three filing statuses
- Married Filing Jointly or Surviving Spouse
- Single or Head of Household
- Married Filing Separately
Below is a table showing the AMT exceptions for different filing statuses:
WHAT IS FORM 6251?
Form 6251 is the form used to calculate your AMT liability. The form has three parts.
- The first part, Alternative Minimum Taxable Income is where you calculate your alternative minimum taxable income (which you will then use in Part II).
- The second part, Alternative Minimum Tax is where you work out the amount of your AMT liability.
- The last part, Tax Computation is where, using Maximum Capital Gains Rate, you work out the amount of tax to enter on line 31 (relevant for your calculation of your AMT liability in Part II). This part is only applicable to people who have qualified dividend income or capital gains income – this is what helps you determine the tax amount you should enter on line 31.
WHAT IS FORM 8801?
Form 8801 is the form you use to calculate your refundable (affects only the applicable years) and nonrefundable (all years) Minimum Tax Credit (MTC), as well as Minimum Tax Credit that gets carried forward to the coming year.
The first part, Net Minimum Tax on Exclusion Items, is where you work out the amount of your AMT liability from the previous year that was caused by AMT permanent exclusion items.
In the second part, Maximum Tax Credit and Carryforward, you use information from other sections to determine which credits are refundable and work out if any MTC will be carried forward.
The third part, Tax Computations Using Maximum Capital Gains Rates affects you if you made any capital gains in the preceding year. This is where you work out the tax amount you should enter on line 11 in calculating the amount of your previous year’s AMT liability that was caused by exclusion items in Part I.
HOW DO I FIND OUT IF I AM SUBJECT TO THE AMT?
According to the IRS website, to find out if you need to pay AMT, you should consult the AMT line instructions in the Instructions for Form 1040 and 1040-SR (a PDF document). If you are subject to the AMT, the next thing you should do is complete and attach Form 6251, AMT – Individuals. You can instructions on how to do this here: Form 6251 Instructions.
WHO PAYS AMT?
You are only liable to pay AMT if your adjusted gross income is in excess of the exemption. If your income is at that level or above, that becomes your AMT taxable income.
That means you will have to work out your AMTI, which you can do either manually via Form 6251 or automatically using tax software package.
It is worth noting, by the way, that alternative minimum tax does not affect all taxpayers who are above the specified income thresholds.
Prior to the passing of the new tax bill, the alternative minimum tax mostly affected households with earnings of between $500,000 and $1 million per year. Still, even within that bracket, only 61.9% of those people paid the AMT. Here is a breakout for 2017:
The AMT is more likely to affect married taxpayers that have children, and there are a number of reasons behind this.
First, such households generally tend to have higher incomes, particularly when both spouses are working and earning.
Secondly, these households do not get any additional exemptions for every member of the household.
Thirdly, the AMT does not include any “marriage bonus”.
HOW DO I DETERMINE IF I AM ELIGIBLE FOR TAX CREDIT
You may be eligible for a tax credit if you fulfill the following two conditions:
- a) You aren’t liable for alternative minimum tax this year, and
- b) You have paid alternative minimum tax in previous years.
This will make you eligible for a special minimum tax credit against your regular tax – for this year, that is.
In the event that you are eligible for tax credit, you should complete and attach Form 8801, Credit for Prior Year Minimum Tax – Individuals, Estates, and Trusts (a PDF document). Doing so will enable you to get the minimum tax credit.
HOW CAN I AVOID/REDUCE AMT?
Since AMT was introduced to ensure high-income taxpayers don’t avoid paying their share of the tax burden, it is not that easy to avoid. The best you can do is avoid the types of income, deductions, and credits that are AMT-triggering.
Examples of these “red flag” items include: foreign tax credit, qualified electric vehicle credit, net operating loss deduction, credit for prior year alternative minimum tax, accelerated depreciation, and tax-exempt from private activity bonds. The average taxpayer is probably not familiar with many of these items.
After you qualify for the AMT in a tax year, you will have to pay it. However, you can adjust your spending so as to minimize your AMT for the next year. The following are some common methods of doing this:
- As an employee in a company, get your employer to reimburse you.
- Ensure you wait until your property taxes are due, and then pay them. In other words, do not prepay the next installment by year’s end.
- Ensure your state tax withholding is not at a higher amount than your expected payment. Note that under the AMT, state tax payments are not deductible.
- Be aware of the different ways that the timing of sale of incentive stock options (ISO) you have exercised affects your AMT liability.
HOW CAN I PREPARE/PLAN FOR THE AMT?
The following are some things you can do to plan ahead:
- Do an in-depth study of Form 6251 every time you file your tax returns, so as to ascertain how close you are to owing AMT. How close was your tentative minimum tax to your regular tax?
- Work with tax-planning software during the year. This will help you reduce your tax liability.
- Check the previous year’s return in case there are general business credits carried forward. If you find some, they may be as a result of the tentative minimum tax limit.
- Be aware that after exercising incentive stock options (ISO), the timing of your sale of the stock will affect your AMT liability in different ways.
The alternative minimum tax is one of the most complex taxes to understand, and you can rest assured that we have only barely scratched the surface! There is so much to this that lots of articles could be written about it and you still wouldn’t say you have mastered it.
That is why, for the sake of accuracy and your own convenience, we recommend that you use a tax software to do your AMT calculations.
The beauty of it is that the software will do the calculations automatically, so the likelihood of error will be far less compared to when you wing it without complete knowledge of how the AMT works. Another option is to get the help of someone who does this professionally.
If you are eligible for the alternative minimum tax, that basically means you are doing quite well financially, so congratulations are in order.
While you cannot avoid this tax, there are some precautions you can take to ensure your AMT liability isn’t so high. Once again, a good tax consultant/expert can guide you on that.