Staying Out Of The Tax Twilight Zone

The alternative minimum tax holds traps for the unwary

This has been a wild and crazy year for investors--and the pain isn't over yet. Whether you were lucky or unlucky in 2000, the Internal Revenue Service could have a surprise for you next April: the alternative minimum tax (AMT). Either big capital gains--the kind you might have if you cashed in your chips early in the year--or incentive stock options can shove you into this parallel tax universe, where deductions disappear and standard tax planning gets stood on its head. The result: a complicated tax return and a bigger check made out to "U.S. Treasury."

A quick review of your 2000 income and deductions can tell you whether you're likely to land in the AMT trap (table, page 216). And if you act before yearend, you have a chance to escape the AMT--or to make the best of a bad situation.

The AMT was designed in the 1970s to catch high-income investors who use hefty tax breaks to wipe out their IRS tab. Now, it's catching many less-than-wealthy families, because, unlike the regular income tax, its rate brackets and exemptions aren't adjusted for inflation. The new Congress might reform it, but the rollback would be small.

The AMT's Form 6251 requires you to add back to your taxable income a long list of "preference items"--from state and local income and property taxes to net operating losses. You then recompute your taxes based on 26% and 28% rates, vs. the 15% to 39.6% used for the regular tax tables, and pay the higher of the two tallies.

These calculations hold traps for the unwary. If capital gains make up a large share of your income, as they might if you cashed out appreciated stocks this year, they can shove you into the AMT. The reason: In place of personal exemptions and some itemized deductions, the AMT allows only a $45,000 exemption ($33,750 for single taxpayers) that starts phasing out when your income hits $150,000 ($112,500 for singles). Big gains can push your income to the point where those exemptions disappear, increasing your odds of paying AMT.

Exercising incentive stock options can also land you in AMT territory. Options let you buy your company's stock at a below-market price. ISOs are most rewarding if you hold the shares you buy for a year, so any profit is taxed at the capital-gains rate. If you're subject to the AMT, however, you've got to count as AMT income the difference between the price you pay and the stock's market value at the time you exercise the option, and pay up to 28% in taxes.

That could be especially painful for high-tech employees. "A lot of people exercised options when stock prices were high, but since then the stocks have tanked," says Martin Nissenbaum, head of personal finance and taxes for Ernst & Young. If, say, you paid $1 to exercise an option when your stock was at $11, you have a potential AMT of $2.80 per share. If the stock has since fallen 75%--as many tech stocks have--you could owe more in taxes than the shares are worth.

What to do? One way out is a "disqualifying disposition"--a stock sale that removes the option's special tax treatment. If you sell the shares within a year, you'll owe ordinary tax, but that could be less than the AMT. Taking the same example--shares bought at $1 that are now worth less than $3--you'd owe only 79 cents in tax, even at the top rate. What if you still want to own the stock? Unless you took a loss, you can buy back the same stock immediately. "Try to exercise options early in the year so you'll have the most flexibility if the stock falls," says Bernard Kent, a tax partner with PricewaterhouseCoopers.

Even this late, you can take steps to avoid the AMT. Collect income now that you normally wouldn't get until next year, and put off payments that might increase your deductions. Don't pay investment expenses, legal fees, or state or local taxes now: If you wind up owing AMT, you'll be denied the deductions for those costs.

If you're first encountering the AMT, determine if it's a onetime hit or a new, permanent feature of your taxes. Smart accountants can time your finances so you'll be in and out of the AMT in alternate years. That helps get you the most mileage from income, deductions, and stock options. It's tricky, but worth the effort if building your wealth--not Washington's--is your goal.

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