Quarterly Investment Guide

Investors beware: Alternative minimum tax can still hit some taxpayers despite reform

Key Points
  • Last year President Trump and the GOP changed the alternative minimum tax rules through passage of the Tax Cuts and Jobs Act.
  • The maximum AMT rate dropped from 39.6 percent to 28 percent.
  • The tax law increased the exemption on income not subject to the AMT.
  • Exercising qualified or incentive employee stock options and owning private-activity bonds can trigger the tax.
President Donald Trump speaks about tax reform at the Indiana Farm Bureau building on the Indiana State Fairgrounds September 27, 2017 in Indianapolis, Indiana.
Brendan Smialowski | AFP | Getty Images

The Trump administration and Republicans in Congress drove a stake into the heart of the alternative minimum tax late last year, but this vampire is not completely dead. So do you have to worry about it or not?

The good news is that if you weren’t subject to the AMT before the reforms, you most certainly don’t have to worry about it now, unless you’ve suddenly become much wealthier.

But tax advisors say that households who were at risk of having to pay this extra-high income tax in the past are still wise to see if it will apply to them today — and to take evasive action if it might. At risk are people with mid-six-figure incomes, lots of kids, itemized deductions and long-term capital gains, and holdings like incentive stock options and private-placement bonds, tax experts say.

In 2015, the most recent year for which full-year data is available, 10.3 million individual taxpayers filed the AMT return, including more than 60 percent of households earning between $200,000 and $500,000, according to The Tax Foundation. That year, 4.9 percent of all taxpayers faced the AMT, paying a total of $33.2 billion, according to The Tax Policy Center.

“Which taxpayers are likely to be affected the most? Taxpayers with large families, employees who claimed a large amount of employee business expenses, very successful small business owners,” says Mark Steber, chief tax officer at Jackson Hewitt, the tax-preparation firm, noting that far fewer taxpayers will face AMT now.

The first AMT was created in 1969 to make sure wealthier people could not use loopholes to escape income tax entirely, but it has been modified numerous times. Under the AMT, people with higher incomes were not allowed to reduce taxable income with items like the personal exemption, deductions for state and local taxes and certain miscellaneous itemized deductions. Even deductions for mortgage interest and medical expenses were lower than on the standard return, and the AMT was especially hard on successful small-business owners who took deductions, like accelerated depreciation on property and equipment.

James Boulette | Getty Images

Taxpayers in potential AMT territory fill out an AMT return in addition to the ordinary return, then pay the larger of the two tax bills.

But the Bush tax cuts of 2001 had the perverse effect of making more taxpayers subject to AMT by reducing taxes on the regular return. And the AMT was not indexed to inflation, so over time it applied to more and more taxpayers as incomes grew, dipping deep into the middle class that was not the original target. Originally aimed at fewer than 200 high-income households, the AMT return was completed by more than 10 million households in 2015, the latest year for which final figures are available, including nearly 60 percent of households earning between $200,000 and $500,000, according to a Tax Foundation analysis of IRS data. About 4.4 million households had to pay extra tax as a result.

Reducing a dreaded tax bite

This has long been a contentious issue, and last year President Donald Trump and Republicans in Congress changed the rules through passage of the Tax Cuts and Jobs Act to reduce the number of taxpayers affected and the cost they will bear. The maximum AMT rate, for instance, dropped from 39.6 percent to 28 percent.

Among the numerous changes, the law increases the “exemption,” or income not subject to AMT, to $109,400 from $84,500 for married couples filing joint returns, and to $70,300 from $54,300 for single filers.

The second big change slows the pace of “phase-out,” which reduces the exemption as income gets larger. For couples filing jointly, the exemption is cut by 25 percent of the income that exceeds $1 million, up from $160,900 in 2017. For other filers the phase-out threshold is now $500,000, up from $120,700 for unmarried filers.

“The combination of these two changes makes it less likely for AMT to impact taxpayers, especially those at the lower income levels,” said Mike D’Avolio, senior tax analyst at Intuit, the business and financial software company that produces the TurboTax tax software. The Congressional Joint Committee on Taxation estimates that about 600,000 taxpayers will pay AMT this year.

In addition, he said, the new tax law reduces some deductions on the regular return. The personal exemption is eliminated, for example, and the deduction for state and local taxes is capped at $10,000. That means many taxpayers will not add those items back to income when they do their AMT return, further restricting the AMT income and reducing or eliminating AMT.

To reduce one’s regular and AMT tax bill, folks can apply some general principles, such as deferring income by investing in a retirement plan and accelerating deductions by prepaying expenses.
Mike D’Avolio
senior tax analyst at Intuit

He gives an example of a married couple with two children that files a joint return with $200,000 in income and deductions of $22,500 for state and local taxes, $17,000 in mortgage interest and $8,000 in itemized deductions. In 2017 this household would have owed $1,494 in AMT on top of regular income tax, but they would have no AMT this year.

Who is still at risk

Still, the AMT will continue to bedevil taxpayers with higher incomes, so experts recommend several steps.

See if you are a target. If you paid AMT for 2017, or nearly had to, and your situation is not dramatically different from last year, it’s only prudent to think about how your income will fit the new rules and to set money aside if an AMT bill seems likely.

“The best way to start to determine if you're going to be subject to an alternative minimum tax is to look at your prior year’s tax return,” said Paul T. Joseph, CPA at Joseph & Joseph Tax and Payroll in Williamston, Michigan. “If you were subject to an alternative minimum tax in 2017, you need to determine essentially what caused [it].”

Tax-preparation software generally does both returns automatically, so it can pay to do a trial run as soon as the 2018 software is available late this year, using estimates for figures you’ll receive in tax documents after January 1. The IRS offers an AMT calculator.

Consider your filing status. Some married couples file separate returns rather than joint ones, but now it could pay to reexamine that practice. Under the new AMT rules, separate returns can be costlier than a joint return if one spouse makes substantially more than the other, said Jim Dedyne, partner at CPA firm Maner Costerisan in Lansing, Michigan.

“If a couple has drastically different income levels and then they choose to file separately, they could be affected by the AMT,” he said. A joint return combines the large and small incomes, so filing jointly could help avoid an AMT that might apply to the higher-paid spouse filing a separate return.

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Check stock options. This problem hits people who exercise incentive stock options when the strike price paid for the stock is lower than the stock’s actual value at the time, said David Levi, senior managing director at CBIZ, a national accounting and professional services provider.

On the regular return, this difference is not taxed until the shares themselves are sold to realize the gain, but the AMT can tax the paper gain the year the options are exercised even if the shares are not sold.

“While that gain is not taxed for regular tax purposes, that spread is an item that needs to be added to calculate AMT,” he said.

Use tried-and-true strategies. Many longstanding strategies for avoiding or minimizing AMT by reducing taxable income will still work and can be especially valuable to business owners who can postpone income and take deductions and book expenses sooner.

“To reduce one’s regular and AMT tax bill, folks can apply some general principles, such as deferring income by investing in a retirement plan and accelerating deductions by prepaying expenses,” D’Avolio said. Investors can avoid AMT triggers, like owning private-activity bonds, as those interest earnings are taxable for AMT but not on the regular return.

Figuring your AMT risk ahead of time is difficult, since total income can change at year-end due to things like bonuses and investment sales. Of course, experts note that wealthy taxpayers and small-business owners are often wise to get expert tax advice year-round.