Could You Get Tangled In The Alternative Tax Net?

These days, voters in Iowa are hearing a lot about the flat tax from the Republican Presidential hopefuls. But the concept of a flat tax is really nothing new to taxpayers who have found themselves subject to the alternative minimum tax (AMT). Indeed, thanks to the sizzling stock market in 1995, a whole new group of people--including those who exercised incentive stock options (ISOs) or paid big investment management fees--may encounter this federal flat tax of sorts.

The AMT came into being in the 1970s to prevent the highest income earners, who were then in the 70% bracket, from deducting and sheltering their way out of paying their fair share of tax. These days, the AMT is much more egalitarian. That's because the difference in rates between the regular tax, where you get to take deductions, and the AMT, where you qualify for almost none, is not that great. Now, the top regular tax rate is 39.6%, while the AMT maximum is 28%, the highest it has ever been.

"PREFERENCES." True, the AMT is not an honest-to-goodness flat tax. For one thing, there are two rates. For another, there is an exemption. But as with a flat tax, you get almost no deductions. That's why it's not uncommon to figure your regular tax, breathe a sigh of relief, then calculate your AMT and discover that you owe a lot more. Unfortunately, you must pay the higher of the two.

To come up with your AMT liability, you start with your regular taxable income and add back deductions or "preferences" that are allowed under the regular tax rules but are disallowed or in need of adjustment for the alternative minimum tax. For instance, if you exercised ISOs to buy 1,000 XYZ shares for $10 each at a time when the stock was selling at $100, then you've got a $90,000 preference item. For regular tax purposes, you don't owe anything until you sell the shares. But for AMT purposes, you must add back this amount to your income.

You'll find a whole list of other add-backs on the AMT Form 6251: medical expenses, charitable contributions, state and local taxes, investment management fees --just about everything but interest on your home mortgage. After you figure your AMT income, you subtract an "exemption amount" that diminishes as your income rises--the AMT's way of hitting you harder if you're wealthier. Next, multiply the result by 26% or 28%, which also depends on your income, with some adjustments. If your AMT is higher than your regular tax, you pay the AMT.

One reason tax advisers hate the AMT is that the strategies you would normally use to minimize your regular tax are precisely the booby traps that prompt the AMT. Let's say your accountant told you to prepay your state and local income taxes in 1995 to get a deduction on your federal return. You've reduced your regular tax, but you may also have bunched too many deductions into one year. When you add all those deductions back to your regular income, you are more likely to trigger the AMT. So the traditional rule of thumb that says you should accelerate deductions and defer income gets thrown out the window.

Another example of where you think you're doing the right thing--but aren't--concerns investment management fees. Your broker has sold you on the idea that you shouldn't pay commissions on trades because that would encourage churning. Instead, you should pay an investment advisory fee of 2% of your assets under management. So now, you're spending $20,000 per year for a money manager to handle your $1 million portfolio. The problem is, investment fees are considered a miscellaneous itemized deduction that constitutes an AMT preference. In contrast, brokerage commissions are part of the calculation for capital gains--by increasing the cost basis when you buy and reducing the price when you sell--and do not affect AMT calculations.

ILL WILL? Currently, one tax benefit does escape the AMT: the preferential rate on capital gains. Although the maximum tax rate on ordinary income is 39.6%, the top rate on capital gains is only 28%. The difference is not considered an AMT preference item. However, that could change if Congress ever solves its budget crisis. As part of the Senate package, capital-gains taxes could be cut from 28% to a maximum of 19.8%, but the bill would make half the capital-gains tax benefit a preference item. "This would generate a lot more revenue for the government," says Janice Johnson, a tax partner with Coopers & Lybrand in New York.

It would probably generate ill will among some taxpayers, too. The alternative minimum tax is so unpopular among those who must pay it that politicians advocating a flat tax must only hope voters won't equate the two. Otherwise, they'll never get elected.

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