AMT TACTICS

The regular tax rates are six-tiered. They start at 10%, move up to 15%, 25%, 28%, 33% and 35%. The AMT rates are two-tiered: 26% on the first $175,000 of taxable income ($87,500 for persons filing separately) and 28% beyond that. Thus there is a difference between the top regular and AMT rates of only seven percentage points, compared with a difference of 11.6 points before the cuts in regular rates introduced by the 2001 legislation.

True, the highest AMT rate of 28% is lower than the two highest income tax rates of 33% and 35%. But the AMT rate is imposed on AMT taxable income, which exceeds taxable income determined under the regular rules.

The AMT allows fewer write-offs and counts more items as reportable income than the regular method used to determine your tax liability. Consequently, you must calculate your tax both ways--once under the regular rules and then using AMT rules--and pay whichever bill is higher.

The only defense against the AMT is to plan for it. First, know that the AMT can make some traditional tax advice useless or even harmful. For instance, the long-established year-end advice is to accelerate paying deductions into the current year and postpone income to a later year whenever possible. But people who suspect they might have to pay the AMT might want to do the contrary: Accelerate income into 2007 and defer deductions denied by the AMT until 2008.

Be mindful that the AMT is not unleashed only by deductions and income exclusions. It's governed by the amount of regular tax clients pay on their total income. That's why sizable capital gains and dividends taxed at a top rate of 15% under both the regular and AMT rules can propel clients into the AMT zone. Link those kinds of income to hefty deductions for state and local taxes, causing a dip way down in the amount of tax paid relative to income, and clients will find themselves in AMT trouble.

The folks more likely to become ensnared in the AMT are middle- and upper-middle-income investors in high-tax states like California, with its top rate of 9.3%, and New York, with its top rate of 7.7% (an additional 4.45% for city residents). Consider residents of San Francisco or New York City who receive sizable capital gains distributions from actively managed mutual funds, which they might not become aware of until year-end distributions are made. Many of them will belatedly learn that those sales boost their state and city income taxes, triggering the AMT.

As the law stands, AMT exemption are: $62,550 for married persons filing jointly; $42,500 for single persons/heads of households; and $31,275 for married persons filing separately. Moreover, these exemptions phase out when AMT income exceeds levels that vary by filing status--$150,000 for joint filers, $112,000 for singles and $75,000 for married filing separately.

Without an agreement by President Bush and Congress on an extension beyond 2006, the exemptions will revert to what they were before the enactment of the 2001 tax act. Should reduced exemptions kick in, the AMT will suddenly target a huge number of individuals--particularly those in high-tax states like California, Connecticut, Maryland, Massachusetts, New York, New Jersey and Oregon. It will force them to pay higher taxes than promised in 2000 by Bush, whose spinmeisters consistently say that his first campaign's pledge was to cut everyone's regular rates, not to counteract the AMT.

EXEMPTIONS

Suppose that your 1040 Form is a straightforward one without any preference items attributable to tax-shelter losses. Does that enable you to sidestep the complex AMT? Not if you have a large number of children. Yes, you read that right. The AMT treats children as tax shelters.

The disallowance of dependency exemptions ($3,400 per exemption for 2007, up from $3,300 for 2006) under the AMT rules does not infringe on the religious beliefs of individuals who raise large families. Sure, the AMT might have the effect of making the observance of some religious beliefs more expensive. Still, that does not render it an unconstitutional infringement of free exercise of religion under the First Amendment, according to the Tax Court.

Similarly, the AMT disallows the standard deduction and certain itemized deductibles. Among the targeted itemized deductions are:

• State and local taxes, whether on income or on year-round residences, second homes or other kinds of real or personal property;
• Interest charges on home-equity loans for first or second homes, unless the loan proceeds are used to buy, build or improve the dwellings;
• Miscellaneous expenses, which include unreimbursed employee business expenses and write-offs for investors, such as magazine subscriptions and fees for investment management and return preparation; and
• A new threshold for medical expenses of 10% of adjusted gross income (AGI), up from 7.5%.

Not all itemized deductions are disallowed. Charitable deductions are acceptable, as are gambling losses. But write-offs for losing bets are allowable only up to the amount of winnings.

Lest there be any misunderstanding, the AMT applies only to taxable income figured under the AMT rules, not to taxable income figured the regular way. To start, have your client fill out Form 1040 to calculate his or her regular taxable income and take all allowable write-offs. Next calculate whether the AMT produces a bigger tax than the regular rules. Do that on Form 6251, available at www.irs.gov/pub/irs-pdf/f6251.pdf.

Not everyone has to complete Form 6251. That is why the filing instructions include a 16-line worksheet to see if you should. To sidestep the worksheet and greatly simplify the process, use an IRS online tool, AMT Assistant, available at http://apps.irs.gov/app/amt/. This electronic version requires you to answer several questions and input a few figures from your 1040 Form. (Anonymously, says the IRS; no cause to fret about agency snooping.) The program tells you only that you definitely need not complete Form 6251, not the amount of your AMT liability.

Completing Form 6251 is unavoidable for individuals who claim certain deductions, such as accelerated depreciation or investment interest expense, or who exercised ISOs without selling the stock in the same year. If you must do the paperwork, Form 6251 requires them to increase regular taxable income by tax preference items. Also, it adds back the dependency exemptions, standard deduction amounts and itemized deductions that are knocked out by the AMT, and which are normally available to everyone. Then the increased amount is offset by an AMT exemption; what is left is taxed at the AMT rates. The IRS's take: the higher of the regular or AMT tax.

FUTURE LEGISLATION

There are no painless choices on how to resolve the AMT mess. Scrapping the shadow tax system is unlikely; it is enormously expensive. Full repeal could mean lost revenues north of $1 trillion over the next decade, worsening the federal budget deficit. The simplest way to defuse the problem is to do a makeover--boost the exemption and index it or end AMT denial of dependency exemptions, standard deduction amounts and itemized deductions.

Most people are unaware of the AMT until their paid preparer reveals they owe more than anticipated, frequently thousands of dollars, or the IRS bills them for additional taxes, plus nondeductible interest charges and late-payment penalties. Eaton Vance Corp., a Boston-based investment management firm, conducted a survey of investors on the AMT. Only 47% professed to know what it is. Worse still, only 8% said their broker or planner had briefed them on the AMT.

My take is that priority attention for curtailing the AMT, or ending it, will have to wait until we pick the next president or until enough pressure builds to do something, perhaps as another top-to-bottom restructuring of the tax code.

Julian Block is a syndicated columnist and attorney based in Larchmont, N.Y. His books include Year Round Tax Savings. Visit www.julianblocktaxexpert.com for more information.

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