You did a bang-up job of tax planning in 1997. You exercised your incentive stock options (ISOs) instead of taxable nonqualified options. You sped up some expenses in your sideline business to create a net operating loss. You even prepaid state taxes on last year's big capital gains, so you could get that deduction onto your '97 return. So why does your accountant look so glum?
It seems that you overlooked something--the alternative minimum tax. While you were trimming the tab on your Form 1040, you were creating new liabilities for the AMT. The windfall from the ISOs will boost your minimum tax, and those business losses won't lower it. You've wasted a deduction as well, because your state tax payment can't reduce your AMT. And once the tax year is over, there's not much your accountant can do to get you out of the AMT. "The biggest problem with the AMT is spotting it in advance," says Andrew Biebl, a CPA in New Ulm, Minn.
The AMT is a parallel code designed to ensure that even the most creative tax-avoider antes up. The AMT taxes so-called preference items that are left off Form 1040, such as the gain from exercising ISOs and interest from some tax-exempt bonds. It imposes stricter accounting rules, slowing the rate at which you can deduct depreciation and research expenses. And it bars taxpayers from using personal exemptions, the standard deduction, and most itemized deductions. Instead, AMT taxpayers get a flat $45,000 exemption for couples ($33,750 for singles) that shrinks when income is above $150,000 ($112,500 for singles). Against this expanded tax base, the AMT levies two rates--26% and 28%. If that calculation yields a higher tax than the bottom line of the regular Form 1040, you pay the AMT total.
The AMT can bite even middle-income taxpayers. Heirs who take large capital gains or middle managers exercising stock options can find themselves lost in the thickets of Form 6251. A more insidious bite comes through personal credits--for the elderly, adoption, and dependent care, as well as the new child and education credits--which are capped by the AMT. Take a couple with $70,000 in wages and five kids: They'd qualify for $2,000 in savings from the new child credit, but the AMT will cap their credit at just $893, accountants Deloitte & Touche calculate. And "they're probably not even going to know they're in the AMT until they get a penalty notice," says Deloitte partner Clint Stretch.
That said, the AMT is mainly a problem for those at the top of the income range. For them, the curse isn't just the added cost--it's the way the minimum levy upsets standard tax planning, canceling deductions for such things as unreimbursed employee expenses and medical costs.
Fortunately, you can avoid the AMT trap by taking your tax planning to a new level. Tax software can keep tabs on AMT consequences of investment and business choices. If your projections show that you're headed toward an AMT bill, you can adjust course to avoid or minimize the levy.
WIPEOUT. Once you're in the AMT, you can even benefit from it. Say you expect to owe a big chunk of AMT for 1998 but think you'll avoid it in 1999. It might make sense to rush a yearend bonus so it will be taxed at '98's AMT rate of 28% rather than '99's regular tax rate of 39.6%, say tax-advice purveyors Practioners Publishing Co.
Not all AMT hits are equally painful. Itemized deductions wiped out in an AMT year are lost forever. But taxes on ISO gains, depreciation, and some other expenses can be recovered. Take ISOs: If you exercise a $50 option when the shares are at $80, you'll pay no regular tax on the profit. But if you're in an AMT year, you'll owe tax on a $30 gain. The benefit of paying: When you later sell the shares for $100, your cost basis is $80 and your taxable gain is only $20. Such items can be used to accrue a minimum-tax credit to offset future regular taxes. "Some preference items cause a prepayment of taxes rather than a permanent increase," says CPA Bernard Kent, Midwest director of personal finance for Coopers & Lybrand.
That's great--if you can handle the complexity and take the long view on your taxes. If you can't, even with a computer's help, you're better off with an adviser who can. In the realm of the AMT, tax planning isn't a job for the faint-hearted.