Why You Need to Be Aware of the Alternative Minimum Tax (AMT)

The AMT – that is, the alternative minimum tax – is fast becoming the federal income tax most people pay.  While the tax originally was intended to be a tax for the “rich,” more and more of the middle class (as well as, of course, many wealthy taxpayers) now find themselves AMT taxpayers.  And if you are a business owner in New York State/City, the recently enacted increases in NYS and NYC tax rates, together with the AMT, may well result in a higher overall tax bill despite the highly published rate reductions in the regular federal income tax.

In broadest overview, the AMT is a fully separate, parallel tax system; a kind of shadow tax system lurking next to, and independently of, the so-called regular tax.  Calculating the amount of income tax payable to the federal government takes two fully separate procedures.  First, the regular tax must be calculated, taking into account all available deductions and exclusions.  Then, the AMT must be calculated.  In calculating income subject to the AMT, various deductions are eliminated and certain types of excluded income are added back in.  The actual tax owed is the higher of the regular tax or AMT.[1]  (Note that “alternative” in alternative minimum tax does NOT mean that there is a choice in whether or not you pay the AMT.)

The highest federal regular tax rate is 35% (lowered from 38.6% by the 2003 tax act).  The maximum AMT rate imposed on most types of income is only 28%. [2]  However, the amount of income subject to the AMT – alternative minimum taxable income or AMTI (the AMT, like so much of tax, is a jargon-laden quagmire) – can be significantly greater than the amount of income subject to the regular tax. [3] 

AMT will have tremendous impact on individuals in the New York area who own businesses as sole proprietors, LLC members, partners and S corporation shareholders, thus making the tax life of entrepreneurs more and more complicated and expensive.  For these individuals, all business income and associated deductions generally are reported on their personal Form 1040s.  Interestingly, a person who owns a business through a C corporation, and who takes only a modest salary from the corporation, may be able to escape the brunt of the AMT storm by keeping his or her income and deductions at a low level.

So why are so many taxpayers, particularly business owners, in the metropolitan New York area, now AMT taxpayers?  As stated above, many deductions that are permitted for the regular tax are not permitted when computing AMT.  The most significant for those living in “high tax states” like New York (and New Jersey) is the disallowance of any deduction for state and local taxes.  Recent tax rate changes have exacerbated the AMT problem.  In particular, the decrease in the top federal tax rates to 35% without any corresponding adjustment to the AMT rates makes it more likely that AMT at a lower rate on a broader base will result in a higher tax than the regular tax.  This year's increases in New York State and City personal income tax rates (the maximum NYS rate increased from 6.85% to 7.7% and the maximum NYC rate increased from 3.64% to 4.45%) worsen the AMT problem (because the increased itemized deduction lowers the amount that would be payable under the regular tax).

In addition, no miscellaneous deductions are allowed (including unreimbursed employee business expenses and investment expenses).  As if these disallowances were not enough, no personal exemptions are allowed, interest on home equity loans is disallowed and medical expenses are allowed for AMT purposes only to the extent that such expenses exceed 10% of adjusted gross income (compared with 7.5% for regular tax purposes).  The only itemized deduction of any importance that survives unscathed in the AMT context is the deduction for charitable contributions.  Finally, most personal credits (including various educational credits, the dependent care credit and the child tax credit) do not reduce AMT.  The fact that most credits may not be used to offset AMT is another reason why more and more low and middle-income taxpayers are subject to AMT.  The AMT adjustments to itemized deductions, combined with the increases in New York State and  City tax rates will throw almost all New York area residents with incomes much over $100,000 into the AMT.