How to Handle the Alternative Minimum Tax - TheStreet

How to Handle the Alternative Minimum Tax

Readers raise questions on dividends and capital gains in relation to the AMT.
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Ms. Goodman, my question is whether dividends must be included in the calculation of the alternative minimum income tax. For example, with no losses or other deductions applicable to the AMT, if you had $200,000 in dividend income and $100,000 in ordinary income, would you pay a 15% federal tax rate on the dividend income or would you have to lump it into a total income calculation leading to paying the AMT rate? Sincerely, William B.Dear Beverly, I've got a question about the new capital gains tax and its relation to the alternative minimum tax. If, with the new capital gains rate of 15% effective May 6, 2003, I decide to sell my business and reap a rich reward of $1 million as my share of the jointly owned business, how would I be taxed on the sale of that asset? Is the tax 15%, or about $150,000 on the $1,000,000 asset, or would the AMT kick in, forcing the effective tax rate up to about 33%, based on the value of the asset sale, my salary, dividends and other sources of income?Ed D.

Tuesday's

column elicited several questions -- the majority of which involved the alternative minimum tax.

The AMT -- for those of you lucky enough to not have encountered it -- is a separate tax calculation intended to prevent the super-rich from deducting away all their income tax liability. The trouble is, though, that unlike the regular tax calculation, which is constantly being tweaked and updated and adjusted, the AMT has not been materially changed since its inception in 1969. That means that it no longer applies to the super-rich; it could very well apply to

you

.

The AMT is paid to the extent that it exceeds a taxpayer's regular income tax liability. President Bush has reduced traditional income taxes, but has not addressed the AMT calculation -- so the lower taxes go under the standard calculation, the more likely the AMT calculation will result in a higher tax bill. Also, the regular tax brackets, personal exemption and standard deduction are always annually adjusted for inflation, but the AMT exemption and tax-rate brackets are not.

The good news is that the new 15% rates for long-term capital gains and some stock dividends enacted in 2003

will

apply for AMT purposes as well.

The bad news, though (and you knew this was coming), is that more people still will be ensnared by the AMT.

So while the $200,000 in dividends from the first example and the $1 million in capital gains from the second example still would be taxed at the 15% rate even if the taxpayer owes the AMT, it's very likely that such events are what put the taxpayer there in the first place.

The AMT calculation disallows many of the deductions (or "preference items" in AMT parlance) allowed on the 1040 -- including the deduction for state and local taxes. If your portfolio is packed with

General Motors

,

J.P. Morgan Chase

,

Dow Chemical

or other stocks paying a way-higher-than-average dividend, you'll likely incur higher state taxes. If you're also in a high-tax state, the deduction for state taxes alone can trigger the AMT. But once you're there, the dividends themselves will be taxed at the 15% rate.

The same scenario applies to a taxpayer with disproportionately high capital gains as well. In the scenario in which Ed sells his business, let's assume he's really selling his stock in the business. That would be a capital gain eligible for the 15% rate under either income tax calculation.

But if the $1 million gain he reaps from the sale of his share of the business is much greater than his salary and other income, it could lower his overall, or "effective," tax rate -- and that can push him into AMT territory. So while the gain still would be taxed at 15%, his other income may not fare as well.

(For the record, if you sell the business itself, not its stock, the proceeds may not be eligible for the capital gains rate. Profits received from the sale of inventory and accounts receivables, for instance, are taxed as ordinary income.)

There has been some minor effort made to temporarily stem the tide of taxpayers swept up in the AMT. The tax law implemented in 2001 provided a small increase in the AMT exemption, but for three years only. The 2003 act increases the AMT exemption even further until 2004, but did not cut the AMT tax rates commensurate with the reduced income tax rates.

The AMT exemption amount was increased from $49,000 to $58,000 for married couples in 2003, and from $35,750 to $40,250 for single filers. Without further legislation, though, the exemption will fall to pre-2001 levels in 2005 -- that would be $45,000 for joint filers and $33,750,500 for single filers.

Have a question for Bev on personal finance, tax or mutual fund matters? Write to her at beverly.goodman@thestreet.com.