One of the less celebrated provisions in this year's tax-relief package was the increase in the alternative minimum tax (AMT) exemption. During the 2003 and 2004 tax years, the AMT exemption was raised for all taxpayers, regardless of their filing status.
But, barring further Congressional action, advisors must be aware of a big catch: In 2005, the exemptions will revert to even lower levels than 2002s, effectively wiping out the previous years' gains. While the specifics of the AMT and how it is calculated are extremely complicated, financial advisors — particularly those with high-net-worth clientele — ignore it at their peril.
The AMT is an incremental tax enacted more than 30 years ago to stop people with extremely high incomes from dodging their fair share of taxes. According to the Urban-Brookings Tax Policy Center, 2.4 million people will be subject to the AMT in 2003. But in 2005, when the qualification thresholds shift, that number rises to 12.7 million taxpayers — 33 million in 2010.
What's more, it's estimated that in 2010, 95 percent of taxpayers with incomes between $100,000 and $500,000 will be hit with the AMT — paying an average of an extra $10,000 each year in taxes.
An AMT Workout
Determining AMT liability is time-consuming and cumbersome, but advisors should still do it throughout the year.
To determine AMT liability, first calculate tax exposure under the “regular” rules. Then, using IRS Form 6251, calculate liability using the AMT rules. If the regular tax liability is larger than the AMT tax, the AMT does not apply. However, if the regular tax liability is less than the AMT amount, the AMT applies.
For example, the Smith family's regular tax bill is $35,000. With an AMT liability of $25,000, they would be exempt from anything beyond the $35,000. But if their AMT exposure was $45,000, they would owe another $10,000 on top of their basic taxes.
Sounds simple enough. But it gets more complex. AMT's rules are set up to prevent many deductions that are permitted through the regular tax system. Though charitable giving and mortgage interest can be deducted, many deductions must be added back to taxable income before computing AMT exposure. Among the add-backs: itemized deductions for state and local taxes (including property taxes) and various market-related deductions, such as the spread between the market price and the exercise price when exercising incentive stock options (ISOs).
So, for instance, a client who lives in a city that raised taxes substantially to address budget deficits will have that larger tax bill count against him in the AMT calculations — a double whammy, if you will.
What actions should an advisor take to reduce clients' AMT exposure? The answer is: Often the exact opposite of what he or she would recommend as a remedy for “regular” income tax planning. In regular tax planning, advisors typically encourage clients to accelerate deductions from next year to this year (e.g., prepay state and local income tax and defer income from this year to next year. With the AMT, however, the advisor would do the opposite. Why would anyone want to accelerate income or defer deductions? Under AMT rules, it may be more advantageous to do so.
Consider a client who is subject to the AMT; no amount of planning and dodging can avoid this fact. In this instance, the client may want to consider accelerating income to the current year and pay the 26 percent/28 percent rate. By avoiding the highest regular income tax rate of 35 percent next year, the client reduces his overall tax liability over a two-year period.
So, as you can see, the AMT is not a one-year issue. Advisors must analyze affluent clients' projected income and tax situation over several years to make the most of your planning opportunities. In the past, advisors may have thought the AMT was only an issue for tax advisors. However, knowledge of its intricacies can be a valuable weapon in the battle for affluent clients.
Susan L. Hirshman is vice president at JPMorgan Fleming Asset Management. jpmorganfleming.com