AMT 'Fixed' but Not Going Away

If any good came from last December's fiscal cliff drama on Capitol Hill, perhaps it is this: The alternative minimum tax at last has been patched permanently.

You may recall that, had the fix not taken place, more than 30 million taxpayers were in danger of having to pay the AMT, including many middle-income households who never had to pay it before. That's because the AMT, which is a parallel tax calculation designed to prevent wealthier Americans from using deductions and other loopholes to avoid paying taxes altogether, had never been indexed to inflation. Under the AMT formula, the standard exemption stood frozen at its 2000 level--$45,000 for married couples and $33,750 for individuals. Only repeated adjustments made by Congress in the years since--so called "patches" often made at the last minute that raised these exemption amounts to adjust for inflation--kept millions more taxpayers from falling subject to the AMT.

Fortunately, as a result of the American Taxpayer Relief Act of 2012, also known as the fiscal cliff deal, those exemption limits were raised for 2012--to $78,750 for married couples and $50,600 for singles. This higher exemption helps reduce the amount of tax owed under the AMT and thus the number of taxpayers forced to pay it. But just as importantly, the legislation also indexed these exemption levels to inflation so that in future years Congressional action will not be needed to keep millions of taxpayers from falling subject to the AMT. The act also made permanent the use of some nonrefundable personal credits such as the child tax credit, the dependent-care credit, and the lifetime learning credit in AMT calculations, which should help keep more people from having to pay it.

A Complex Calculation
The AMT basically serves as a parallel tax calculation that uses different exemption amounts and is more restrictive with regard to deductions and credits than the standard calculation method. Given the many tax breaks that have been added to the tax code over time, some taxpayers would not be required to pay anything or pay minimal amounts if not for the AMT.

The formula for determining the AMT is complicated but basically begins by calculating one's taxable income without many of the deductions allowed under the regular tax code. (You'll find the IRS' Form 6251 for the AMT here.) This new amount is the alternative minimum taxable income, or AMTI. An AMT exemption amount is then subtracted from the AMTI (this exemption is reduced by 25% for any amount of AMTI above $150,000 for joint filers and above $112,500 for individuals). The AMT tax liability is then calculated by taking the remaining amount and multiplying the first $175,000 (the limit is the same for both single and joint filers) by 26% and anything above that by 28%. 

If, at the end of this calculation, the AMT owed is greater than the amount owed under the regular income tax formula, the taxpayer must pay the higher AMT amount. Even taxpayers who don't have to pay the AMT may be affected by it because some personal tax credits are limited to the amount by which the taxpayer's regular income tax liability exceeds what he or she would owe under the AMT.

Determining Whether You Are Vulnerable
Despite the permanent fix to the AMT, millions of taxpayers will still have to pay it each year. In 2011, when a similar patch was in place, 4.3 million taxpayers paid the AMT, according to the Tax Policy Center.

So how can you tell if you'll be subject to the AMT? That's a common question, but the answer is complicated.

In general, taxpayers with household incomes above $200,000 tend to be most vulnerable to the AMT, though it's possible to be on the hook for AMT with lower income than that. You further ratchet up your potential for AMT liability if you take a lot of deductions, exemptions, and credits on your regular income tax return. That's because many of these tax-lowering mechanisms, while allowable on your regular tax return, are not usable when you calculate your AMT liability. Thus, your AMT liability is very likely to be higher than your regular tax liability and that, in turn, means you'll owe AMT.

For example, if you have a large family, you can claim exemptions for yourself, your spouse, and each of your kids on your regular tax return, but the AMT doesn't allow these personal and dependent exemptions. Deductions for some medical expenses; interest on home equity loans that you're not using to buy, build, or upgrade your home; real estate taxes; state and local income taxes; unreimbursed employee expenses; and investment-related expenses are also not allowable under the AMT system. If you're using a combination of these exemptions and deductions, you're a potential target for the AMT. You're also an AMT target if you don't itemize your deductions, as the AMT system doesn't allow a standard deduction. (Higher earners, who are most vulnerable to the AMT in the first place, usually itemize their deductions, however, so this isn't likely to be a problem for too many taxpayers.)

On the other side of the ledger, you also need to be mindful of certain sources of income, as they too, can affect your AMT liability. For example, income from municipal bonds issued to finance private activities is not subject to regular income tax, but it is subject to AMT.

Incentive stock options are one of the largest income triggers for AMT liability, however, and that's why you so often hear "stock options" and "AMT" in the same breath. If you have exercised ISOs and your company's stock price was a lot higher at the time of exercise than it was when your company granted you the options, there's a good chance you'll owe the AMT for the year in which you exercised.

Here's an example of how it works: Say your company granted you 1,000 incentive stock options in 2005 at the price of $5 apiece. By the time you exercised your options in 2012 and bought the stock, however, the shares had risen to $17. If you decide to hang on to your new shares because you like your company's prospects, you won't owe anything under the regular tax system; after all, you haven't sold shares and pocketed a gain. That's logical, but the AMT system sees it differently. For AMT purposes, the $12 spread between the option price and the exercise price--the so-called bargain element--is considered income, even if you haven't yet sold a single share of your company stock. And here's the really insidious part: If the stock were to slip to $3 after you've exercised your options, you're still on the hook for AMT taxes on that $12 per share in income--even though you have a loss in your own position. (On the plus side, your new basis in the stock is the higher number, $17. So if the stock goes back up to $17 and you sell at that level, you won't owe the Internal Revenue Service a penny.)

To help see whether you're likely to be subject to the AMT, the IRS' website includes an AMT Assistant that factors in information you provide.

While a permanent fix to the AMT is a significant development, another major component of the fiscal cliff deal may help keep some wealthier taxpayers from having to pay it. Recall that tax rates on singles making more than $400,000 and married couples making more than $450,000 were allowed to increase as part of the agreement, with the rate on income above these levels rising from 35% to 39.6%. As a result, taxpayers at these upper income levels will be required to pay more under the conventional income tax formula, which should keep some of them from falling subject to the AMT. Of course, that might just be cold comfort.

This article includes material previously published on Morningstar.com.