Warning: This is going to get a little bit geeky. But stick it out, because there’s some useful tax advice that can save you real dollars.
Let’s say 2013 turns out to be a nice 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.
So where does my planning opportunity come in? While a taxpayer’s regular taxable income is subject to graduated rates with a high of 39.6 percent, the maximum rate under the AMT system is only 28 percent. And where I come from, 28 percent is less than 39.6 percent. And it’s this variance that gives rise to an often-overlooked opportunity for tax savings.
To illustrate, assume Joe earns $515,000 in wages in 2013. On the deduction side, Joe has $5,000 of charitable contributions, $28,000 of state income tax, $28,500 of mortgage interest deductions, and $10,000 of real estate taxes, resulting in taxable income of approximately $450,000 and a “regular tax liability” of approximately $125,000.
Unfortunately, Joe’s state income and real estate taxes are not deductible for AMT purposes; as a result, his 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 himself 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 intuitive reaction is no, because when taxpayers find they are subject to the AMT, they tend to freeze like the proverbial deer in headlights and assume any additional dollars of income will only bring more pain. That’s not the case however, and here’s why.
With taxable income (before considering the $40,000 bonus) of $450,000, the next dollars of income Joe earns will be taxed at the maximum 39.6 percent rate. 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 percent.
Should Joe choose to accelerate the $40,000 bonus into 2013, (and assuming no additional state withholding), 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 higher 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 percent. So despite having taxable income in excess of $450,000, Joe just paid tax on the $40,000 bonus at 28 percent — the AMT rate — rather than at the regular rate of 39.6 percent. 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 percent. Note, however, that while the 28 percent rate officially “starts” at AMT income of $179,500, through a quirk in the math the rate is actually 35 percent until the taxpayer’s AMT income reaches $477,100 (for married taxpayers), because it is at this point where the taxpayers are fully phased out of their AMT exemption.
It is this $477,100 of AMT income that represents the taxpayer’s “floor,” because from this point on, the next dollars of income will be taxed at a 28 percent tax rate.
• The ceiling: This opportunity has a ceiling as well, and it is the level of income 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 of 39.6 percent.
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, he had already exceeded his floor, and was in a position to take on additional income that would only be taxed at 28 percent.
But how far could Joe 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 not be taxed at the AMT rate of 28 percent, but rather at the top regular rate of 39.6 percent.
If you can determine your AMT floor and ceiling, you can turn the perceived negative of being in AMT into a positive by accelerating additional income subject to a favorable 28 percent rate. As you can see, however, these computations require attention to detail, as there are a lot of moving parts, so 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.
Tony J. Nitti, CPA, MST, can be reached at email@example.com .