The AMT: Watch out for this surprise tax

The AMT (alternative minimum tax) is a separate income tax created more than 30 years ago to stop wealthy individuals from escaping their fair share of taxes. The name comes from the way the tax works. It provides an alternative set of rules for computing income tax. In theory, these rules determine the minimum amount of tax that a person should be required to pay based on income. If one’s regular tax falls below this minimum, the difference will have to be made up by paying the alternative minimum tax.

Who is affected?

According to the Urban-Brookings Tax Policy Center, 12.7 million taxpayers will be subject to the AMT in 2005, and 33 million will be affected by 2010. At its inception, the tax affected only a handful of people, but its reach has grown over the years, particularly since the AMT exemptions and tax bracket amounts are not indexed for inflation. Increasingly, the implications of the AMT will affect middle-class America. Several factors will determine whether one is affected by the tax, including:

• Itemized deductions and large deductions claimed for taxes and/or miscellaneous deductions subject to the two percent adjusted gross income limit.
  
• Home mortgage or equity line of credit, with the money used to do something other than buy, build, or improve a home.
  
• Incentive stock options that are exercised without disposing of the stock in the current year.
  
• Large number of dependent exemptions that are claimed on the return.

What can you do?

• While most taxpayers cannot avoid the AMT trap, there are a few tax planning strategies that can help counter the tax.
  
• Watch out for traps. Income from private activity (municipal) bonds is subject to the AMT.
  
• Know when to hold incentive stock options (ISOs). ISOs, which enable individuals to buy company stock at a stated exercise price, have AMT implications. The bargain element of the ISO is considered a tax preference item for AMT purposes.
  
• Consider equipment leasing. For unincorporated business owners, AMT problems can stem from claiming accelerated depreciation deductions for business assets. Instead of buying new equipment, consider leasing it.
  
• Be cautious about prepayments of certain taxes. These tax payments, such as state income taxes and property taxes, are not deductible for the AMT calculation. It is best to check with a tax advisor before making end-of-year prepayments.