In 1969 the Secretary of the Treasury testified before Congress that 155 individuals with Adjusted Gross Income of more than $200,000 (over $1 million in today’s dollars) paid “0” tax on their 1967 tax returns. Congress received more letters that year on the Secretary’s testimony than its did on the Vietnam War. Of course Congress being Congress, rather than acting logically and eliminating the loopholes in the tax code that allowed the high income individuals to avoid paying tax, it created a complicated alternative tax system, originally known as the Minimum Tax, which has since evolved into the Alternative Minimum Tax (AMT).

The passive activity and other rules included in the Tax Reform Act of 1986 effectively closed many of the loopholes used by the wealthy to avoid taxes that had led to the creation of the AMT. Unfortunately the Act did not do away with the AMT. Instead, it increased the reach of this alternative tax system as a “back-door” method of offsetting some of the front-door tax reductions.

None of my clients ever paid AMT until the early 1990s. Now several clients are regular victims of AMT, and I must check each year to see if the AMT applies for many other clients.

A favorite instructor for the National Society of Tax Professionals, who has since gone on to his final audit, used to tell the tale of one of his older clients. One tax season, after signing his finished returns, the gentleman told the instructor, “Dennis, I will continue to come to you to have my taxes prepared each year, because you always make sure I pay the ‘minimum tax.’ I like that! My old preparer never did that for me. In fact, one year he actually had me pay the ‘maximum tax!'”

FYI – when I began preparing 1040s in 1972, there was also a “maximum” tax – which made sure that earned income was not taxed at more than 50%.

Like many taxpayers today, Dennis’s client was confused about the concept of the “minimum tax.”

The AMT is a separate tax system which does not allow you to deduct personal exemptions, the standard deduction, state and local income, sales, real estate and personal property taxes, home equity interest or “miscellaneous” items such as employee business expenses, investment expenses and tax preparation costs. In addition, certain “tax preference items” must be added back to income in calculating the tax. The net Alternative Minimum Taxable Income, after deducting an exemption amount based on filing status and level of income, is taxed at a flat rate of either 26% or 28%. A taxpayer calculates his tax liability under both the “regular” income tax rules and the AMT rules and must pay the higher amount.

“Alternative Minimum Tax” is a misnomer. It is neither an alternative option nor is is a minimum tax. The AMT is MMT – “Mandatory Maximum Tax”.

The AMT targets not the very wealthy, but middle and upper middle class taxpayers in highly taxed states. Those in the top brackets – the top 1% of taxpayers - are rarely subject to AMT, because the “regular” tax rates of 35% and 39.6% greatly exceed the top AMT rate of 28%.

What would make someone a victim of the Alternative Minimum Tax?

In my experience the biggest trigger for AMT is large deductions for state and local income, and property taxes.

While taxable income, state and local taxes and the “cost of living” varies geographically, the federal income tax is geography-neutral. Income of $200,000 is taxed the same for a resident of New Jersey or New York as it is for a resident of Kansas. Although the Democrats seem to think that a person earning $200,000, or a couple earning $250,000, is “wealthy” this is not necessarily the case for those living and working in highly taxed states like New Jersey, New York, and California. A couple earning $250,000 in Kansas may be living like royalty, but a couple in New Jersey or New York with the same income is barely “comfortable” and may just be getting by.

My former home state of New Jersey, where 99% of my 1040 clients live and work, has the highest property taxes in the country and one of the highest state income taxes. Taxpayers who live in New York City are hit even harder than those from the Garden State when you add in the New York City resident income tax. The largest deduction on Schedule A for most of my working clients is the deduction claimed on Line 9 – “Taxes You Paid.” State and local income taxes, or sales taxes and property taxes are fully deductible on Schedule A under the “regular” income tax system, but they are not deductible under AMT.

The personal exemption for taxpayers and their dependents is also not deductible under AMT. So add the loss of exemption deductions for dependent children to the loss of deductions for state and local taxes and AMT exposure increases.

Another trigger is excessive capital gains. While qualified dividends and long-term capital gains, including year-end capital gain distributions from mutual funds, are taxed separately at special reduced rates for both the “regular” income tax and AMT. These items increase Adjusted Gross Income, and, therefore, also increase Alternative Minimum Taxable Income (AMTI).

The AMT exemption is reduced if AMTI exceeds a certain threshold based on filing status. For tax year 2015, if the AMTI of a married couple, including all qualified dividends and long-term capital gains, is more than $158,900, the couple's $83,400 AMT exemption is reduced by 25% of the excess. If the couple had a special $25,000 one-time capital gain in 2015, which resulted in an AMTI of $182,900, their AMT exemption would be only $77,400. This is an additional $6,000 if income that would be taxed at 26% under AMT. The capital gain would certainly increase their AMT if they were already a victim, or could cause them to become a victim.

So, in reality, qualified dividends and long-term capital gains can be effectively taxed at rates much higher than the “advertised” 0%, 15% or 20%.

While not common in my experience, an especially egregious AMT trigger involves individuals who receive substantial court awards, judgments or settlements for actions other than those that involve unlawful discrimination.

Taxpayers who receive taxable legal awards, judgments, and settlements must report the full amount on Line 21 of Page 1 of their Form 1040. This is not the amount actually received, but the full amount of the award before any legal fees and other expenses are deducted. The legal fees, contingent or otherwise, and other expense which are deducted from the award is deducted as a Miscellaneous Deduction on Schedule A, subject to the 2% of Adjusted Gross Income exclusion. “Job Expenses and Certain Miscellaneous Deductions” reported on Line 27 of Schedule A are not deductible in calculating AMT.

Let's say you receive a judgment for $240,000. Your lawyer gets 1/3 of this. So you are only “in pocket” $160,000. You must report $240,000 as gross income, which increases your AGI and your AMTI, and can deduct the $80,000 on Line 23 of Schedule A. But you probably will not get a full tax benefit for the entire $80,000, because total miscellaneous deductions reported on lines 21 – 23 must be reduced by 2% of your AGI.

Under AMT the $240,000 is fully taxed – there is no deduction allowed for the $80,000 of legal fees - and this additional income will very likely reduce your AMT exemption.

You can claim an “above-the-line” deduction as an “adjustment to income” (which reduces AGI and therefore AMTI) for legal fees and related costs paid or withheld if the judgment is the result of a claim of unlawful discrimination.

An even more obscure, again in my experience, trigger for the AMT is the exercise of an Incentive Stock Option (ISO). The difference between the amount paid for the stock acquired via the ISO and the fair market value of the stock at the time of the exercise is added to AMTI, unless the stock is sold in the same year it is purchased.

You shouldn’t just dismiss the Alternative Minimum Tax because you are not “wealthy.” You, too, could be a victim!

Here are the applicable AMT numbers for 2015 and 2016 -

The AMT exemption amount for 2015 is –

  • $53,600 - Single and Head of Household
  • $83,400 - Married Filing Joint and Qualifying Widow(er)
  • $41,700 - Married Filing Separate

The 2015 AMT exemption is reduced as Alternative Minimum Taxable Income exceeds –

  • $119,200 – Single and Head of Household
  • $158,900 – Married Filing Joint and Qualifying Widow(er)
  • $ 79,450 – Married Filing Separately

For 2015 the 28% AMT tax rate kicks in at AMT net taxable income (after deducting the exemption allowed) of $185,400 ($92,700 for Married Filing Separate).

The AMT exemption amount for 2016 is –

  • $53,900 - Single and Head of Household
  • $83,800 - Married Filing Joint and Qualifying Widow(er)
  • $41,900 - Married Filing Separate

The 2016 AMT exemption is reduced as Alternative Minimum Taxable Income exceeds –

  • $119,700 – Single and Head of Household
  • $159,700 – Married Filing Joint and Qualifying Widow(er)
  • $ 79,850 – Married Filing Separately

For 2016 the 28% AMT tax rate kicks in at AMT net taxable income (after deducting the exemption allowed) of $186,300 ($93,150 for Married Filing Separate).