From: Robert Sommers
Sent: Thursday, April 22, 2004 10:52 AM
To: Robert Sommers
Subject: Robert L. Sommers, Your Tax Prophet Update
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The Tax Prophet Newsletter   Issue # 10 April, 2004

In This Issue:
Introduction
What is the AMT?
How it Works
History of AMT
AMT's Impact
"Excess" Deductions
Conclusion

The Alternative Minimum Tax



Introduction It is a politician’s dream. Imagine a tax-code provision so devious that politicians can promise tax cuts to their voting constituency without significantly reducing revenues to the Treasury? Welcome to the Alternative Minimum Tax (AMT), the ultimate “gotcha.” Armed with the AMT, politicians cut taxes and expand deductions on the regular system, making sure that what they give taxpayers in the regular system is largely taken away by the AMT -- a trick that would make Houdini proud.


What is the AMT?

AMT is a parallel tax system that ensnares taxpayers with so-called “excess” deductions, such as state income and property taxes, too many dependents and itemized miscellaneous deductions. The AMT calculation is mind-boggling in its complexity, but in general, it is based on a taxpayer’s gross income (with few allowable deductions), rather than on net income (gross income less all the deductions allowed under the regular system). Taxpayers calculate their taxes under the regular tax system then under the AMT, and pay the higher amount.

How it Works

AMT offers a standard “exemption” amount. This amount varies depending on a person’s income and filing status. Practically all gross income left after taking this deduction is subject to AMT and taxable at 26% on the first $175,000, and 28% on any balance. In contrast, the regular system has graduated marginal rates from 10% to 35%, with most AMT victims falling in the 28-35% regular tax brackets. Even though the applicable marginal tax rate is usually lower under AMT, the amount of income subject to AMT rates is much higher which produces an overall higher tax.


History of the AMT

The minimum tax (forerunner to AMT) was enacted in 1969 because Congress believed that wealthy taxpayers should not radically reduce their tax burden by using various tax deductions and preferences allowed in the tax code. Wealthy taxpayers were considered to be those with adjusted gross incomes of $200,000 or more, based on 1964 dollars.

Today, AMT – originally enacted to ensure that the very wealthiest taxpayers, who at that time were escaping the payment of any tax – applies to middle-class workers. Why? Because, AMT’s exemptions have not been adjusted for inflation and AMT rates have increased from 10% to 28%. In contrast, tax rates under the regular system have fallen from a high of 70% to 35% over the same period.

Factoring in inflation, $200,000 in 1964 equates to $1,200,000 in year 2000 dollars. However, because AMT has not been adjusted, approximately 65% of taxpayers earning between $100,000 to $500,000 will be victimized by AMT. In fact, some commentators speculate that by 2008 the government would realize more revenue by abolishing the income tax and keeping AMT intact than it would receive by abolishing AMT.

Note: State income tax and property tax are not deductible under AMT, thereby ensnaring an ever larger segment of taxpayers having legitimate itemized deductions.

Unfortunately, the courts have not struck down AMT, even though its original purpose has been distorted beyond recognition. The courts claim it is Congress’s job to fix the problem and thus far, our legislators are enamored with AMT’s revenue generating capabilities since, through AMT, they can raise revenues without voting for tax increases.

AMT's Impact Depends on Where You Live

Quick, which states with large populations voted Democratic last presidential election? Now, guess which residents are disproportionately hit hardest by AMT? The answer is, of course, California and New York, because each has high state income and property taxes which are deductible under the regular tax system, but not under AMT.

According to the San Francisco Chronicle’s Kathleen Pender (Business Section, April 15, 2004) in 2001, California filed 11.3% of all tax returns, but paid 22.7% of the nation’s AMT. By contrast, the President’s home state, Texas, filed 7% of all AMT returns, but paid only 3.5% of the AMT. In other words, California paid twice as much and Texas paid half as much as the national average



Those "Excess" Deductions

Deductions disallowed under AMT include: (i) dependency exemptions; (ii) itemized miscellaneous deduction expenses, such as professional, investment and legal expenses, unreimbursed employee business expenses; (iii) state and local income and property taxes; (iv) interest on home-equity loans; and (v) the standard deduction. Added to AMT income are (i) the “spread” on incentive stock options; and (ii) interest on private-activity municipal bonds.

Note: contingency fees paid to an attorney are considered an itemized miscellaneous deduction which means those fees, which could amount to 50% of an entire award, are also not deductible under AMT.

Note: Those with ISOs should exercise extreme caution once they exercise their options; a drastic drop in the stock price will not reduce your AMT. In such a case, sell your stock by the end of the year in which you exercised the ISO to avoid AMT.



Conclusion

Unfortunately, there are limited tax planning opportunities to avoid AMT, other than to moving to Nevada, Washington, Texas, Florida or other states where there is no state income tax. Tax advisors recommend shifting income or deductions from one year to the next, depending on the impact of AMT. But this requires accurate tax calculations and predictions prior to the end of the year and flexibility regarding the timing of deductions which may be adversely impacted by AMT.

The definitive solution: Congress needs to substantially increase AMT exemptions and lower AMT tax rates. State taxes and itemized miscellaneous deductions should remain deductions under AMT, and the spread on an ISO should be calculated on the lower of the stock’s fair market value on the date of exercise or the end of the year. Or, Congress could just repeal AMT in total.




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All contents copyright © 1995-2004 Robert L. Sommers, attorney-at-law. All rights reserved. This newsletter provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.









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