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Honey, I Shrunk the AMT

The alternative minimum tax: It isn't just for rich folks anymore. Originally established in 1969 to close loopholes that allowed 155 wealthy Americans to escape income taxes the previous year, the AMT is muscling its way in on the middle class, thanks to inflation that has pushed millions of ordinary Americans into the AMT zone, which was fixed when the law was written. The Joint Economic Committee

The alternative minimum tax: It isn't just for rich folks anymore. Originally established in 1969 to close loopholes that allowed 155 wealthy Americans to escape income taxes the previous year, the AMT is muscling its way in on the middle class, thanks to inflation that has pushed millions of ordinary Americans into the AMT zone, which was fixed when the law was written. The Joint Economic Committee of Congress estimates that the number of AMT tax returns could reach 17 million by 2010. Assuming the provisions of the 2001 tax cut remain in place, in seven years the AMT will affect 85 percent of all tax returns for filers with income between $100,000 and $200,000 dollars per year, according to Tony Berndt, a consultant with Virchow Krause, an accounting firm.

Clearly, then, if you understand AMT rules, you will have a growing competitive advantage over advisors who don't. You will attract more affluent (and lucrative) clients. You'll likely lose fewer clients to competitors. You'll find opportunities that other advisors miss. And you'll enrich your own life right along with your clients'.

Getting AMT-savvy isn't easy. And one magazine article isn't going to turn you into an AMT guru overnight. But here's how you can get a fast jump on the competition.

Red Flags

First, identify AMT-vulnerable clients. It's not just a matter of having high incomes, says San Jose, Calif., advisor Kent Noard with Sterling Wood Financial. Look for clients with a high ratio of capital gains to income, clients with several children, with large state and local or real estate tax bills or with high employee business expenses. Also, look for shareholders in Subchapter S-corporations or limited liability partnerships. And look for employee stock options and ESOP participants.

Seize the Day

Schedule an AMT review with your client and his tax advisor before the year ends. Go over the following:

  • Is this likely to be an AMT year? Go over the red flags listed above and take the time to do a provisional AMT calculation.

  • Have any stock options been exercised? If so, how's the stock doing? If it's tanked, and the calendar year of the exercise isn't up yet, your client can sell, or simply do an elective disqualification of his stock options, and pay taxes on his profits on the sale, rather than on the phantom profits based on his spread at the time of the exercise — profits that may no longer exist.

  • Does the client have state and local or real estate tax liability? These deductions don't apply when calculating AMT. So if AMT is likely this year, there's no point in prepaying any of these taxes or bunching deductions.

But advisors should look for chances to push deductions to a non-AMT year. “Non-reimbursable expenses in an AMT year are a waste,” counsels Glenn Frank, a CFP and CPA with Tanager Financial Services Group in Waltham, Mass. Rule of thumb: If your client is having an unusually good year, or experiences a windfall that causes him to pay AMT, then seek to push any deductible expenses to the following year.

  • Got lucky?

    In cases where a sudden windfall throws clients into AMT territory, Berndt suggests an immediate annuity, particularly for clients in lower brackets. True, annuity payments are taxed as regular income. But the AMT will guarantee that much of any lump sum will be taxed at 26 to 28 percent anyway. Meanwhile, your client can benefit from the tax-deferred growth on the remainder of the lump sum, as well as the reduced marginal income tax rates in later years of the 2001 tax cut.

  • How much is the client paying in advisory fees?

    One bold suggestion from Jeff Rattiner, author of The Financial Planner's Bible and Getting Started as a Financial Planner: If a client is subject to the AMT this year, but not next year, consider delaying payment of any investment fees until January. That way, the client doesn't lose this year's deduction for investment expenses, which are disallowed under AMT rules. (Warning: This technique has regulatory implications for some planners. Check with your legal advisor.)

Happy New Year

Recovered yet? Good. Now it's time to sit down with your client again and mitigate any AMT effects from last year. Identify the following:

  • Can the client take a net operating loss deduction?

    Up to 90 percent of a net operating loss may be used to offset AMT income.

  • Can you apply AMT credits from prior years?

    Careful: Many advisors are under the assumption that all AMT paid generates an AMT tax credit. That is incorrect, Noard points out. The only items that generate an AMT credit are timing items, such as incentive stock options (ISOs) and excess depreciation.

Preserve Your Options — Or Not

January's an excellent time to exercise any incentive stock options, says CFP David Bergmann of the David R. Bergmann Group in Marina del Rey, Calif. If AMT looks like a problem, your client has all year to avoid it by selling or disqualifying the options. If the stock looks strong at the end of the year, hold on one more month and it qualifies for long-term capital gains treatment. If the stock looks weak, you can sell it and raise your cost basis in the stock. (Your basis is then based on the fair market value of the stock upon the exercise, rather than on the lower grant price.)

  • Does your client have nonqualified stock options he can exercise?

    If the client has both ISOs and nonqualified stock options (NQSOs), you may be able to exercise some of the ISO's tax-free. Here's how this works: When you exercise NQSOs, it immediately creates a taxable event. Profits are taxed as ordinary income upon exercise. In so doing, you are effectively raising your regular income tax bill. Why would you do this? Because the higher you raise your regular income tax, the more ISOs you can exercise without AMT or income tax consequences. Your client just pays capital gains taxes when he sells the stock.

…And Then There Were Bonds

One mistake inexperienced advisors frequently make is thinking that all municipal bonds are federally tax-free, says Noard. Wrong. Income from certain types of municipal issues mostly issued for private purposes (private activity bonds) is taxable under AMT rules. Avoid them. For those who fluctuate in and out of AMT territory, Frank likes to use mutual funds, which help him get clients in and out of muni bond portfolios easily, based on his assessment of the clients' AMT situation.

To find out how much of a fund's income comes from private activity bonds, check with the fund companies themselves. Several fund companies, such as Nuveen Investments, Eaton Vance, and Strong have already filed for or have launched muni bond funds designed to be AMT tax-free.


Help your clients maintain perspective. “The AMT is usually a minor issue,” says Frank. “It shouldn't be the sole driver of investment decisions.” Sit down and talk quarterly with your clients and their tax advisors. Two things all our experts agreed on: Be proactive, and maintain open and honest communications with the client.

Stupid Tax Fact

While AMT rules disallow deductions for state and local income taxes, 90 percent of the foreign income tax paid is deductible for AMT purposes. That's right — foreign income taxes paid to the governments of Iraq, Iran and North Korea receive more favorable treatment under the tax code than do payments to Iowa, Illinois and North Dakota.

War Story No. 1

Glenn Frank had a new client who had just realized a large windfall made him subject to the AMT. Frank agreed to delay billing his client until January of the following, non-AMT year, thus preserving his client's deduction for investment advice, which otherwise would have been lost. The client saved several hundred dollars. “A great way to start a new relationship,” says Frank.

War Story No. 2

Brian Morin, a 30-year-old computer technician in Crown Point, Ind., worked for a cash-poor tech startup that frequently paid workers with stock options in lieu of cash. When the company was bought out in early 2000, Brian exercised his options — an event that unwittingly threw him into AMT territory. After the bust, though, the stock market plummeted. He finally sold his stock for an $80,000 profit over his actual cost.

The catch: Under AMT rules, all his options were taxable based on the spread at the time of the exercise, not at the time of sale, resulting in an AMT tax bill of some $300,000. Solution? Morin should have sold his ISO stock prior to the end of the calendar year in which he exercised. He would have had to pay short-term gains, but he could have avoided being taxed on profits that no longer existed.

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