The 2017 Tax Act was signed into law on December 22, 2017. As part of the tax reform “simplification” process, there was a strong movement to eliminate the alternative minimum tax (“AMT”) for corporations and individuals. The 2017 Tax Act does eliminate the corporate AMT but not the individual AMT. While the individual AMT was retained, it will now affect a much more narrow class of taxpayers as a result of increasing the income exemption levels as follows:
- The AMT exemption amount for joint filers is increased from US$84,500 to US$109,700 and for single filers from US$54,300 to US$70,300.
- More importantly, the AMT phase out level for joint filers was increased from US$160,900 to US$1,000,000 and for single filers to US$500,000 (the phase out level is that amount of alternative minimum taxable income (“AMTI”) above which the AMT exemption phases out by 25¢ for each dollar of AMTI).
- Both figures will be indexed for inflation but such changes are scheduled for sunset at December 31, 2025 at which point the 2017 AMT exemptions thresholds (indexed) will then be applicable.
The effect of the AMT exemption changes is dramatic as it is projected for 2018 that the number of taxpayers paying AMT will be reduced from 5,000,000+ to approximately 200,000. The revenue loss to Treasury as a result of the AMT changes and elimination of the corporate AMT is estimated by the Joint Committee on Taxation to be US$637 billion over the next 10 years.
The questions, therefore, are “who will remain affected by the new individual AMT” and “how does their tax profile affect the AMT calculation”?
The AMT is an alternative tax system established in 1969 as a separately calculated tax running parallel to the regular income tax. The general rationale was to ensure that all taxpayers who had the means to pay tax would in fact do so, even after taking into account tax deductions that might have otherwise eliminated their tax liability. The AMT calculation starts with taxable income as calculated for regular income tax purposes as its base and then adds back numerous “preference” items, adjustments and alternative timing items to arrive at AMTI. The exemption amount, unless phased out at higher AMTI levels, is then subtracted and this adjusted amount is then taxed at 28% (26% if AMTI for 2017 is less than US$187,500). If AMT tax is greater than regular income tax the AMT tax amount is payable. In short, the more tax deductions, credits, or exemptions a taxpayer has, the more likely they are to be in AMT.
Prior to 2018, the impact of the AMT was most significant in the case of middle to high income taxpayers (US$200,000 to US$500,000) living in states where there was a high income tax and high property tax. This impact occurred because state and local property taxes were deductible for regular income tax purposes but not for AMT tax purposes. The loss of this deduction essentially created a threshold where the 28% AMT tax on AMTI was greater than the regular income tax (taxable income in that range being taxed at rates from 35% to 39.6%) almost entirely on account of the state tax addback. With the now restructured SALT deduction limited to US$10,000 per taxpayer and the increased exemption amount/phase out threshold it is likely that this taxpayer class will not be susceptible to AMT taxation absent unusual circumstances.
The AMT also effects taxpayers with certain other adjustments or tax preference addbacks to regular taxable income in order to calculate AMTI. The most important of these addback adjustments/preferences to arrive at AMTI are:
- Additions for virtually all itemized deductions but for home mortgage interest and charitable contributions
- Changes to depreciation deductions as an addback related to accelerated depreciation over straight line depreciation
- Additions for oil and gas benefits relating to deductions for depletion and intangible drilling costs
- Additions for interest earned on “private activity” tax exempt bonds
- Additions for income “earned” at the time of exercise of incentive stock options (“ISO”)
- Additions for amortization rather than deduction of research and development costs
- Additions for 7% of gain amount on Section 1202 qualified small business stock sales excluded from taxable income
In addition to the above described tax preference and adjustment items that increase AMTI from the regular taxable income determination, long term capital gains and qualified dividends are subject to the same maximum 20% rate for AMT and regular income tax purposes. This rate equivalency consequently means that taxpayers with a significant amount of long term capital gains and/or qualified dividends included in their taxable income can be subject to the AMT with a minimal amount of add-on preferences or adjustments since the rate threshold discrepancy between regular income tax and AMT (37% regular rate versus 28% AMT rate) does not exist for long term capital gains or qualified dividend income.
In light of the foregoing summary of the “new” individual AMT, what types of taxpayers will likely be subject to the AMT?
- Individual taxpayers with taxable income above US$1,000,000 because the US$109,400 exemption amount for AMTI determination does not begin to phase out until AMTI exceeds US$1,000,000 (joint filers) with a full phase-out at US$1,437,600; the increased exemption and phase-out thresholds also do not apply to trusts
- Taxpayers with significant active investments in oil or gas because the preferences for oil and gas are added back to taxable income to arrive at AMTI
- Taxpayers with significant investments in municipal bonds that are characterized as private activity bonds
- Taxpayers with significant investment in depreciable properties and particularly depreciable personal properties
- Taxpayers realizing a significant profit at the time of ISO exercise since the “profit” is not includible in taxable income but is includible in AMTI
- Taxpayers recognizing a significant gain on the disposition of Section 1202 stock as 7% of that income otherwise excluded from taxable income is added back to AMTI
- Taxpayers with a high percentage of long term capital gains and qualified dividends in proportion to other income types since there is no rate differential with taxation at 20% for taxable long term capital gains and qualified dividends between the regular income tax and the AMT
The foregoing suggests that the AMT exemption/threshold changes in the 2017 Tax Act are intended to repurpose the AMT to what was intended with its initial passage in 1969. The AMT began in 1969 as an alternative tax that was intended to ensure that ultra-high net worth taxpayers would still have to pay a base tax regardless of their claimed deductions. The increase in the AMT exemptions and thresholds now means that approximately 96% of households previously subject to AMT will no longer be paying this tax until 2026 when the 2017 AMT rules return. Nevertheless, many ultra-high income taxpayers will remain subject to the individual AMT. To address this, such ultra-high income taxpayers may want to actively consider the timing of stock and asset sales that generate capital gains and also anticipate the timing of expenses and potential tax deductions. There are also timing considerations associated with options, such as incentive stock options (commonly referred to a ISOs).