Physiatry Practice Management Resources

The alternative minimum tax system is a classic trap for the unwary. It is a system of taxation that is imposed under the Internal Revenue Code, and its general objective is to provide for equitable treatment among all taxpayers, regardless of wealth and income levels. The alternative minimum tax system imposes a tax that is in addition to the regular tax liability of a taxpayer, and is considered to be burdensome by virtue of the fact that many taxpayers are either unaware of it, or simply do not plan for it.

In many cases, taxpayers typically engage in tax planning and preparation that focuses strictly on the tax liability as computed under the regular tax system, without a view toward the unfortunate consequences under the alternative minimum tax system. The effect of this system is often felt by high net-worth individuals, such as physicians, through a mechanism that increases the annual federal income tax liability. The means by which the annual tax liability is increased is through a system of provisions that operate to reduce, defer or eliminate many preferential tax benefits and deductions to which individuals are otherwise legitimately entitled (often as a result of planning under the regular tax system).

Overview of the Calculation

Procedurally, the alternative minimum tax is computed by comparing the taxpayer’s "tentative minimum tax" with his or her regular tax. The alternative minimum tax is equal to the excess of the taxpayer’s tentative minimum tax for the taxable year over the regular tax for the taxable year. The term "tentative minimum tax" is a term of art, and is computed through the use of a mini-graduated rate tax scale under which two rates of tax (26 percent and 28 percent) are imposed. Specifically, the rates are applied to the taxpayer’s "taxable excess," which represents the taxpayer’s "alternative minimum taxable income" over his or her exemption amount. The exemption amount is defined by Section 55(d)(1). For example, for single individuals, the amount is $42,500 for 2006. For joint filers, the amount is $62,550 for 2006. These amounts are reduced at a rate of 25 percent of the excess of alternative minimum taxable income over certain thresholds ($112,500 for single filers and $150,000 for joint filers). The tentative minimum tax is equal to 26 percent of the taxpayer’s taxable excess up to $175,000, plus 28 percent of the taxable excess that exceeds $175,000. The $175,000 amount is reduced to $87,500 in the case of married individuals who file separate returns.

At the heart of the calculation is the concept of "alternative minimum taxable income," which is defined as the taxpayer’s regular taxable income, increased or decreased by certain "adjustments," and increased by "tax preference items." It is through this system of preferences and adjustments that certain tax deductions and other benefits are reduced, deferred or eliminated. As such, alternative minimum taxable income is broader in scope than regular taxable income.

Adjustments

Adjustments may operate to increase or decrease a taxpayer’s regular taxable income in arriving at alternative minimum taxable income. To the extent that adjustments relate to deductions for regular tax purposes, they may be curtailed or denied for alternative minimum tax purposes. As such, they are "added back" to regular taxable income in order to arrive at alternative minimum taxable income. Perhaps the most common (and possibly the most lethal) of the adjustments are those that pertain to a taxpayer’s itemized deductions. As revealed by the Tax Court in Katz, certain itemized deductions alone can trigger an unexpected application of the alternative minimum tax.

Among the itemized deductions that are the target of the alternative minimum tax system are so-called "miscellaneous" itemized deductions that are subject to the two percent of AGI limit. Certain miscellaneous deductions are deductible to the extent that they exceed two percent of adjusted gross income. These expenses, which are deductible in arriving at regular taxable income, are not permitted to be deducted in arriving at alternative minimum taxable income. Examples of such expenses include unreimbursed employee business expenses, professional dues, tax preparation fees, tax advisory fees, certain legal expenses, and certain investment-related fees and expenses.

In addition to miscellaneous deduction, state and local taxes are not deductible in arriving at alternative minimum taxable income. Such taxes include state and local income taxes, as well as real estate taxes.

Taxpayers who claim a deduction for qualified residence interest under the regular tax system may be required to make an adjustment for alternative minimum tax purposes. The Internal Revenue Code provides a subtle alteration to the deduction for interest under the alternative minimum tax system. Specifically, under the alternative minimum tax system, a deduction is permitted for "qualified housing interest."

Conversely, under the regular tax system, a deduction is permitted for "qualified residence interest." The latter is broader in scope than the former. For example, it is common knowledge that, under the regular tax system, a deduction is permitted for interest related to acquisition indebtedness, as well as home equity indebtedness. Acquisition indebtedness is defined as indebtedness which is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and is secured by that residence. On the other hand, home equity indebtedness means any indebtedness other than acquisition indebtedness, as long as it is secured by a qualified residence. A qualified residence is defined as the taxpayer’s principal residence and one other residence of the taxpayer.

Under the alternative minimum tax system, only qualified housing interest may be deducted. Qualified housing interest is defined as interest which is qualified residence interest and is paid or accrued during the taxable year on indebtedness which is incurred in acquiring, constructing, or substantially improving any property which is the principal residence of the taxpayer at the time the interest accrues, or is a qualified dwelling which is a qualified residence. Most noteworthy to this definition is its exclusion of interest related to loans that are not incurred to acquire, construct, or substantially improve property of the taxpayer. This effectively eliminates the deduction for interest on home equity indebtedness. Therefore, a taxpayer with home equity indebtedness may be required to make a positive adjustment to taxable income in arriving at alternative minimum taxable income.

Care must also be exercised in the case of refinancing activity. To the extent that the indebtedness resulting from the refinancing exceeds the outstanding debt immediately prior to the refinancing, the excess could give rise to a positive adjustment in arriving at alternative minimum taxable income.

In computing regular taxable income, taxpayers are permitted, within certain limits, to claim a deduction for personal exemptions and to claim a standard deduction in lieu of itemized deductions. These amounts are not permitted in computing alternative minimum taxable income, and thus must be added to taxable income in arriving at alternative minimum taxable income.

In addition to the foregoing, adjustments are potentially required for depreciation deductions. In general, if a taxpayer claims depreciation on certain personal property, such as business equipment, an adjustment may be required. For such property placed in service after 1998, depreciation for alternative minimum tax purposes is required to be computed using a less tax-advantaged method (i.e., the so-called "150-percent declining balance method") than that which is permitted under the regular tax system (i.e., the "200-percent declining balance method").

Actually, the 150-percent method produces smaller tax deductions only during the early years of the life of an asset. This generally reverses in the later years of the life of an asset. Section 56(a)(1)(A)(ii)(II) requires a switch from the 150-percent method to the straight-line method when the straight-line method produces larger deductions. Finally, no adjustment is required when the taxpayer elects to use the straight-line method or the 150-percent declining balance method for regular tax purposes.

To the extent that depreciation under the alternative minimum tax system exceeds the amount computed under the regular system, the difference is added to regular taxable income as a positive adjustment in arriving at alternative minimum taxable income. When the depreciation under the alternative minimum tax system exceeds the deduction under the regular tax system (e.g., in the later years of an asset’s life), then a negative adjustment occurs. Note also that, when an asset is sold, its regular tax basis (generally cost less accumulated depreciation) may differ from its alternative minimum tax basis, which will generate a gain under the regular tax system that is different from that which is recognized under the alternative minimum tax system. When this occurs, an separate adjustment is required.

Finally, taxpayers who own incentive stock options are entitled to benefits under the regular tax system. In general, a taxpayer does not recognize taxable income when he or she is granted an incentive stock option, nor does the taxpayer recognize taxable income upon the exercise of an incentive stock option. These rules apply as long as certain holding period requirements are satisfied. Thus, assuming satisfaction of the rules applicable to such options, taxation generally occurs only upon the disposition of the underlying stock. Any resulting gain on disposition is capital gain, since the stock is a capital asset. The rules related to incentive stock options are complex, and are beyond the scope of this article. They are, however, important to the realization of the desired tax consequences, and should be reviewed carefully prior to any transaction involving an option.

Under the alternative minimum tax system, the benefits related to incentive stock options are denied. As a general rule, the taxpayer is taxed at the time of exercise in an amount that is equal to the difference between the fair market value of the stock and the cost of the stock to the taxpayer. Consequently, this difference represents a positive adjustment to taxable income in arriving at alternative minimum taxable income. Note that, upon disposition of the underlying stock, the effect of the alternative minimum tax is theoretically reversed, since the basis of the stock for alternative minimum tax purposes will exceed that under the regular tax system. However, if the stock becomes worthless in a later year, the taxpayer may not be able to recognize this benefit, since the loss under the alternative minimum tax system will be a capital loss subject to the $3,000 limitation of Section 1211(b), and the taxpayer will not be permitted to carry back the loss to the year in which the income was recognized.

Preferences

Unlike adjustments, preferences generally increase taxable income in arriving at alternative minimum taxable income. Perhaps the most common of the preference items is tax-exempt interest income generated by private activity bonds. Many taxpayers may not be aware that the exempt interest income generated by their investments may give rise to alternative minimum taxable income, despite their exempt status under the regular tax system. Such interest is generally taxable under the alternative minimum tax system, and is often disclosed to taxpayers in year-end documentation generated by investment brokerage firms and similar organizations.

Other preferences include depletion and intangible drilling costs. The opportunity to deduct these items often arises as a result of an individual’s investment in a pass-through entity, such as a partnership. Note that, when an individual invests in a pass-through entity, the activity may be considered to be a passive activity, and separate and distinct calculations will be required for alternative minimum tax purposes.

In addition to the subtle element of additional taxation on those who least expect it, the alternative minimum tax regime is complex. Differences in taxation under the regular tax structure and the alternative minimum tax structure add to this element of complexity. As such, legitimate year-end (and year-round) tax planning may be compromised unless such planning considers the impact of the alternative minimum tax. Often overlooked, the tax is unfortunately a significant part of the taxation of individuals. Consequently, all taxpayers should review their tax postures with a view toward the impact and minimization of the alternative minimum tax.

Disclaimer

While the contents of this article are intended and believed to be accurate and authoritative, they should not be relied upon as tax, legal or accounting advice, or advice of any other nature. If any such advice or other professional assistance is required, the services of competent professional personnel should be sought.

IRS Circular 230 disclaimer: To ensure compliance with requirements imposed by the Internal Revenue Service, you are hereby informed that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any penalties that may be imposed, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. In addition, this article is intended to be a broad and general summary of the pertinent, but selected, rules.

By Joseph P. Nicola, Jr., CPA, JD
Source: Physician's News Digest
Joseph P. Nicola, Jr., CPA, JD, CVA is Director of Tax Services for the firm of Case Sabatini in Pittsburgh, Pennsylvania.