Contrarian Tax Planning: Increasing Income To Take Advantage Of The AMT

Tony Nitti a contributor for Forbes writes: Let’s say 2013 turns out to be a niiice year for you down at the ol’ cracker factory. A little bit too nice, in fact, and you find yourself subject to the dreaded alternative minimum tax (AMT). Might I recommend a bit of contrarian advice? Consider accelerating even more income into 2013, despite the fact that it, too, might be subject to the AMT.  Actually, strike that…consider accelerating more income into 2013 precisely because it, too, will be subject to the AMT.

I’ll explain, but first, a bit of background:

Individual taxpayers must compute their federal tax liability twice, once under the so-called “regular” system, and again under the parallel AMT system, which limits or disallows many of the deductions and preferences allowed for regular tax purposes. After computing your regular and AMT liabilities, the taxpayer must pay the higher of the two.

To prevent the AMT from impacting the middle class, Congress built into the law an exemption amount which prevents the first dollars of a taxpayer’s AMT taxable income from being taxed. In 2013, the exemption amounts are $80,800 for married taxpayers and $51,900 for single taxpayers.

These exemption amounts, however, are subject to phase-out once a taxpayer’s AMT income exceeds $153,900 in 2013. Starting at this income level, for each additional dollar of AMT income the taxpayer loses 25% of the exemption. Thus, for a married taxpayer, the $80,800 exemption will be fully phased out once AMT income exceeds $477,100.

So where does this planning opportunity come in? While a taxpayer’s regular taxable income is subject to graduated rates with a low of 10% and a high of 39.6%, AMT income is taxed at a flat 28% rate once it exceeds $179,500 in 2013. And where I come from, 28% is less than 39.6%. And it’s this variance that gives rise to an often-overlooked planning opportunity.

To illustrate, assume Joe earns $515,000 in wages in 2013. Keeping things simple, that’s all the income Joe generates. On the deduction side, Joe’s got $5,000 of charitable contributions, $28,000 of state income tax, $30,000 of mortgage interest deductions, and $10,000 of real estate taxes.

Note, while Joe’s itemized deductions total $73,000, he falls victim to the return of the PEASE limitation, which reduces Joe’s itemized deductions by 3% for each dollar his adjusted gross income exceeds $300,000 (since he’s married, only $250,000 if he were single). As a result, Joe can only deduct $66,550 of itemized deductions against his $515,000 of adjusted gross income for regular tax purposes, resulting in taxable income of $448,500 and a regular tax liability of $125,000.

Unfortunately, Joe’s state income and real estate taxes are not deductible for AMT purposes; as a result, his AMT income is $480,000, and the resulting AMT liability is $131,000. Because Joe has to pay the higher of his AMT liability ($131,000) or regular tax liability ($125,000), Joe finds yourself subject to the AMT.

Now, let’s say Joe has the option to accelerate $40,000 of income into 2013. Should he do it? The common reaction is no, because when taxpayers find they are subject to the AMT, they tend to freeze like a deer in headlights, and assume any additional dollars of income will only bring more paid. That’s not the case however, and here’s why.

With taxable income (before considering the $40,000 bonus) of $448,000, the next $2,000 of income Joe earns will be taxed at 35% for regular tax purposes until Joe hits taxable income of $450,000, at which point all additional income will be taxed at the maximum 39.6% rate. In addition, because Joe would continue to lose 3% of his itemized deductions for each dollar of income he earns, the marginal tax on the $40,000 bonus would reach a high of 40.78% (39.6% * 1.03). As a result, if Joe accelerates the $40,000 of income into 2013, his regular tax liability will increase from $125,000 to $141,500.

But remember: Joe is in the AMT. And as long as his AMT liability exceeds his regular tax liability, Joe will continue to be subject to the AMT and its maximum tax rate of 28%.

If Joe chooses to take the $40,000 bonus in 2013, (and assuming no additional state withholding or estimated payments), his AMT income will rise to $520,000 and his AMT liability to $142,000. Because Joe’s regular  tax liability was only $141,500, he must pay the AMT tax of $142,000.

But that’s a good thing, because Joe’s total tax liability rose from $131,000 without the bonus to only $142,000 with the bonus. That’s an increase of $11,000 on $40,000 of taxable income, or exactly 28%. So despite having taxable income in excess of $450,000, Joe just paid tax on the $40,000 bonus at 28% — the AMT rate – rather than at the regular rate of 39.6%. Not a bad deal, right?

Once a taxpayer is aware of the limits of this opportunity, it can be used to their advantage. But first, you have to understand the floor and ceiling of the taxpayer’s AMT range:

The Floor

The key to this planning opportunity is taking advantage of the maximum AMT rate of 28%. Note, however, that while the 28% rate kicks in at AMT income of $179,500, the rate is actually 35% until the taxpayer is fully phased out of their AMT exemption. This is because for each dollar of AMT income the taxpayer earns in excess of $179,500, the taxpayer loses 25% of their exemption, subjecting even more AMT income to tax. Thus, on each dollar of income in excess of $179,500, the AMT rate is 35% (28% + (25% * 28%) until the exemption is completely eliminated.

Once the exemption is fully phased-out, however, the next dollars of income are taxed at a pure 28% tax rate. It is this amount – specifically, AMT income of $477,100 for married taxpayers in 2013 – that signify a taxpayer’s “floor.” Importantly, each dollar of income the taxpayer earns in excess of this floor will be taxed at a flat 28%.

The Ceiling

Of course, this opportunity has a ceiling as well; specifically, that point at which the taxpayer’s regular tax liability first exceeds the AMT liability. Once the taxpayer reaches this point, any additional dollars of income will no longer be subject to the AMT, but rather to the regular tax rates at a maximum marginal rate of $39.6%, or 40.78% when factoring in the phase-out of itemized deductions.

Now, let’s go back to our sample taxpayer. Joe’s “floor” was AMT income of $477,100. Because in our example Joe had AMT income of $480,000 and was subject to the AMT, he  had already exceeded his floor, and was in a position to take on additional income that would only be taxed at 28%.

But how far could he go?

Assuming he purely added income and no deductions, Joe could take on $45,000 of additional income before his regular tax ($143,500) would exceed his AMT  ($143,400). This is Joe’s AMT ceiling, and to the extent he accelerates any additional income, it will be taxed not at the AMT rate of 28%, but rather at a marginal rate of 40.78%.

The following table illustrates five items:

• Joe’s AMT “floor” – the amount where his AMT exemption is fully phased out and every dollar of additional AMT income is taxed at 28%.
• Joe’s actual facts: wages of $515,000, itemized deductions after PEASE limitation of $66,550, and AMT add-backs of $38,000 ($28,000 state and local taxes, $10,000 of real estate tax).
• Joe’s tax liability if he accelerates his $40,000 bonus into 2013. Note that accelerating the income generates $11,200 of additional tax on $40,000 of additional income, or a 28% rate.
• Joe’s AMT “ceiling,” or the point at which his regular tax and AMT are equal. At this point, if Joe generates any additional income, it will be taxed at a maximum regular ate of 40.78%.
• To illustrate, If Joe takes an additional bonus of $45,000 on top of the $40,000 he previously accelerated into 2013, his taxable income rises to $536,000 and his regular tax liability to $159,902. Thus, his regular tax liability exceeds his regular liability at the AMT ceiling by $16,315, meaning his additional $50,000 of bonus was taxed at 40.78%.

	AMT FLOOR	ACTUAL FACTS	$40,000 BONUS	AMT CEILING	ADDITIONAL INCOME
AGI		$515,000	$555,000	$560,000	$600,000
TAXABLE INCOME		$448,450	$489,650	$494,800	$536,000
AMTI	$477,100	$480,000	$520,000	$525,000	$565,000
REGULAR TAX		$125,304	$141,547	$143,587	$159,902
AMT TAX	$130,000	$130,810	$142,010	$143,587	$154,610

If you can determine your AMT floor and ceiling, you can turn the perceived negative of being in AMT into a positive by generating additional income subject to a favorable 28% rate. And of course, it doesn’t have to be bonus income; rather, you could take a distribution from your retirement account or exercise stock options as well.

Of course, as you can see, these computations require attention to detail, as there are a lot of moving parts. For example, if you accelerate income in the form of wages and have state income tax withheld, the additional state income tax deductions will change your taxable income and regular tax liability. In summary, it’s best not to go it alone. Hire a tax advisor, have them compare the benefits of acceleration versus deferral into the next year, and come up with a plan.