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What is the Alternative Minimum Tax?

What is the Alternative Minimum Tax?

Although the alternative minimum tax (AMT) is an alternative method of calculating income tax, the "minimum" aspect is somewhat of a misnomer: the taxpayer must calculate his taxable income in both directions, once according to the usual IRC rules, then again using the alternative minimum method and paying the highest tax.

The alternative minimum tax aims to prevent the wealthiest taxpayers from minimizing their taxable income by using all available IRC deductions. They must pay tax if the alternative minimum tax calculation results are higher than they would otherwise be in that fiscal year.

There are two AMT tax rates for the 2021 tax year; the return you will file in 2022: is 26% and 28%. The "residual amount" that remains after calculating the AMT income and deducting any exemption amount you are entitled to is subject to this tax. Then it is multiplied by one of the two AMT rates. 

The minimum alternative tax exemption amount is re-determined in monetary terms, so it can be changed yearly and fixed before the reporting period.


How does the alternative minimum tax work?

Normal tax and AMT calculations start at the same point, with the total income entered on the 1040 tax return. Then, subtract various income adjustments to 1040, including deductions you don't need to itemize to claim. This translates to Adjusted Gross Income or AGI.

Then you have to add some of those income deductions and adjustments again, using a different form, to arrive at the alternative minimum taxable income.

Assume that after this process, your AMT earnings get to $75,000, which is more than the $73,600 you would be entitled to if you were a single filer in 2021. You would exceed the threshold by $1,400, so the AMT would be 26% of this amount, or $364 more than the usual tax bill.

The 26% AMT tax class ends, and the 28% AMT tax class begins, with an AMT income of $197,900 for the fiscal year 2021 for all taxpayers, except married filing separately. It starts at $98,950 for those who are single or married filing separately.

The AMT exemption works like a standard deduction. Instead of all of the deductions and other adjustments eliminated in calculating their AMT income, taxpayers can reduce their alternative minimum tax income by claiming the exemption amount for their tax filing status.

The exemption amount begins to gradually decrease by 25 cents per $1 between the AMT income and the value of the phase-out threshold. The elimination is complete, and the exemption value is reduced to zero when the AMT's revenues reach four times the value of the exemption plus the elimination threshold.


How to calculate the AMT

For regular tax calculations, you must subtract the standard deduction or the total of your itemized deductions from your total income to arrive at a taxable income. (TCJA suspended personal exemptions from 2018 to 2025.) This is the amount you normally use to track what percentage you owe the IRS.

However, taxable income for AMT purposes does not allow for certain income adjustments and itemized deductions, so your income may increase significantly if you fail to deduct all of these items. The resulting number is the AMT income amount which determines whether you have to pay AMT because your income is above the inflation-adjusted threshold.

The following cost are not deductible when calculating AMT, although you can deduct them when calculating ordinary tax: 

  • Accelerated depreciation

  • Mortgage interest on mortgage-backed debt

  • State and local taxes

Certain types of income that are not normally taxable are also taxable to calculate the AMT. For instance:

  • You must include the contrast between the fair market value of the stock options and their exercise price if the options are exercised and stay unsold at the end of the year.

  • You must also include tax without interest on corporate bonds, foreign tax credit, income and liabilities, and a net operating loss.


Do I have to pay the AMT?

The IRS provides a very simple worksheet in the Form 1040 instructions that you can use to determine if you need to complete the longer Form 6251 to calculate alternative minimum tax.

Most tax software automatically calculates the AMT. However, no software beats the input of a tax professional. If you are subject to AMT, we recommend that you review the actual tax form to understand what sources of income or deductions are causing your AMT obligation. Many taxpayers believe that deductions for state taxes, property taxes, real estate interest, and incentive income from stock options are the main causes.


Summary

  • The Alternative Minimum Tax (AMT) was created to prevent the wealthiest taxpayers from reducing their taxes to zero.

  • The AMT calculation uses a slightly different method to arrive at taxable income, largely eliminating certain deductions.

  • The AMT requires taxpayers who exceed certain income limits to calculate income tax in two ways and pay the highest tax due.

  • Subsequently, the AMT was indexed to inflation to avoid affecting certain middle-income taxpayers.


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