When it comes to tax planning, nothing is simple. For example, first you need to consider your marginal tax rate—this is the regular rate you'll pay on your next dollar of "ordinary income" (salary, business income, interest and more).
Then there’s the alternative minimum tax ("AMT"), which was designed to ensure wealthy taxpayers with “excessive” deductions would pay some income tax. The top AMT rate is lower than the top regular income tax rate on ordinary income (salary, business income, interest and more). (See the Chart “2015 individual income tax rate schedules.") But the AMT rate typically applies to a higher taxable income base. So if you plan only for regular income taxes, it can result in unwelcome tax surprises.
You also need to consider the various tax deductions and credits that could save you taxes. On the other hand, income-based phaseouts and other limits can reduce or eliminate the benefits of these breaks, effectively increasing your marginal tax rate.
That’s why, no matter what your situation, it’s important to review your income, expenses and potential tax liability throughout the year, keeping in mind the many rates and limits that can affect income tax liability—and keeping an eye out for additional tax law changes. Only then can you time income and expenses to your advantage.
Before taking action to time income or expenses, you should determine whether you’re already likely to be subject to the AMT—or whether the actions you’re considering might trigger it. Many deductions used to calculate regular tax aren’t allowed under the AMT (see the Chart “Regular tax vs. AMT: What’s deductible?”) and thus can trigger AMT liability. Some income items also might trigger or increase AMT liability:
- Long-term capital gains and dividend income, even though they’re taxed at the same rate for both regular tax and AMT purposes,
- Accelerated depreciation adjustments and related gain or loss differences when assets are sold, and
- Tax-exempt interest on certain private-activity municipal bonds.
Finally, in certain situations incentive stock option ("ISO") exercises can trigger significant AMT liability.
Avoiding or reducing AMT
With proper planning, you may be able to avoid the AMT, reduce its impact or even take advantage of its lower maximum rate. (See the Chart “2015 individual income tax rate schedules.”)
Planning is a little easier now that the AMT brackets and exemptions are annually adjusted for inflation. Before 2013, Congress had to legislate any adjustments, which they often were slow to do. This left uncertainty about what the AMT situation would be the next year, inhibiting the ability to effectively implement timing strategies.
To determine the right timing strategies for your situation, work with your tax advisor to assess whether:
You could be subject to the AMT this year. Consider accelerating income and short-term capital gains into this year, which may allow you to benefit from the lower maximum AMT rate. Also consider deferring expenses you can’t deduct for AMT purposes until next year—you may be able to preserve those deductions.
Additionally, if you defer expenses you can deduct for AMT purposes to next year, the deductions may become more valuable because of the higher maximum regular tax rate. Finally, carefully consider the tax consequences of exercising ISOs.
You could be subject to the AMT next year. Consider taking the opposite approach. For instance, defer income to next year, because you’ll likely pay a relatively lower AMT rate. And prepay expenses that will be deductible this year but that won’t help you next year because they’re not deductible for AMT purposes. Also, before year end consider selling any private activity municipal bonds whose interest could be subject to the AMT.
The AMT credit
If you pay AMT in one year on deferral items, such as depreciation adjustments, passive activity adjustments or the tax preference on ISO exercises, you may be entitled to a credit in a subsequent year.
In effect, this takes into account timing differences that reverse in later years. But the credit might provide only partial relief or take years before it can be fully used. Fortunately, the credit’s refundable feature can reduce the time it takes to recoup AMT paid.
For further advice, contact a tax professional with LGT at (214) 871-7500 or www.lgt-cpa.com.
Seek the services of a legal or tax adviser before implementing any ideas contained in this blog. To reach a financial advisor at Lane Gorman Trubitt PLLC, call (214) 871.7500 or email firstname.lastname@example.org.