The IRS has specific guidelines regarding the rates of taxation for all taxpayers. Different types of income are taxed at different rates. You may be most familiar with the tax brackets and calculating tax rates via the tax tables. However, there are circumstances when the required tax rate is not met because a taxpayer has been eligible for various tax breaks. In these instances, the Alternative Minimum Tax, or AMT, may be owed.
Why Alternative Minimum Tax?
The Alternative Minimum Tax can be considered the lowest amount of tax that a taxpayer may be assessed. Typically, it is at a rate of either 26 percent or 28 percent. There is no way around paying taxes on income, so it is not possible to have income and not pay any tax. Therefore, the AMT was originally created to keep wealthy taxpayers from finding enough loopholes to avoid taxation. It reduces available deductions for certain taxpayers.
As inflation began rising, the middle class increasingly became subject to AMT. As a result, AMT was modified to include exemptions adjusted for inflation. The Tax Cuts and Jobs Act (TCJA) of 2017 further raised exemptions from AMT. Alternately, the TCJA also increased the kiddie tax rate to match that of the higher rates for estates and trusts.
AMT is calculated on IRS Form 6251 and it includes income that may not normally be subject to taxes, such as municipal bonds. These considerations are often attributed to wealthier individuals.
For tax year 2021, the exemption income level is $73,600 and phases out between $523,600 to $818,000 for unmarried filers. Married filers (filing jointly) have an exemption income of $114,600, phasing out at $1,047,200 to $1,505,600. The married filing separately exemption is $57,300, with phaseouts between $523,600 to $752,800.
What Triggers Alternative Minimum Tax?
It is difficult to get around the AMT because income that might be excluded or deducted from a 1040 may be included as income for the purpose of AMT. The AMT is typically associated with investment income from assets such as stocks or bonds. The IRS allows deductions related to investments that were spent in pursuit of taxable income, but when gross income is high compared to taxable income, it can result in AMT. When deductions reduce tax too much, the AMT is triggered.
Tax preference items very often trigger AMT because they provide benefits such as being tax-exempt. Incomes higher than the exemption limits can trigger AMT. Large amounts of income from long-term capital gains is another common trigger. This is because of the preferential tax treatment specific to long-term capital gains. Exercising incentive stock options and interest from private activity bonds also commonly trigger AMT.
Children may be assessed AMT if they have investment income that is subject to the kiddie tax and requires Form 8615. The SECURE Act of 2019 reduced the increases to the kiddie tax imposed by the TCJA which may provide some relief for taxpayers.
How Is Alternative Minimum Tax Calculated?
Income for the purposes of assessing AMT (known as AMTI) is not calculated the same way as income is calculated on IRS Form 1040. Form 6251 must be completed after calculating regular taxes from a standard tax return in order to determine AMT. Next, the results are compared between the 1040 and 6251. If the tax assessed on Form 6251 is the higher amount, then AMT will be owed.
Exempt income is deducted from the calculation as a measure to spare taxpayers with lower income levels from AMT. Exemption amounts decrease as income increases through phaseout thresholds. The AMT 28 percent threshold for tax year 2021 is $199,900 for most filers ($99,950 for Married Filing Separately). Children who are subject to the kiddie tax may also be assessed AMT.
If a taxpayer has previously paid AMT, they may be eligible for an AMT credit or Minimum Tax Credit (MTC). Form 8801 is used for AMT or MTC credits.
Incentive stock options are a deferral item that will equal stock fair market value after exercise expenses are taken out. Capital losses, including those carried over, will reduce overall income toward AMT. The standard deduction or itemization totals from Schedule A can be taken out of the AMT calculation on line 2A of the Form 6251. Exempt income goes on line 5. The foreign tax credit may be used to offset the AMT if Form 1116 is filed.
Overall, the AMT is specifically designed to allow very few deductions. If nothing substantial has changed since the previous filing year, it may be assumed that the rate of AMT will be roughly similar. The safest way to determine AMT is by using reputable tax software or working with a tax professional.
Read More: How to Recompute the Alternative Minimum Tax
Hashaw Elkins is a financial services and tax professional, as well as a project management consultant. She has led projects across multiple industries and sectors, ranging from the Fortune Global 500 to international nongovernmental organizations. Hashaw holds an MBA in Real Estate and an MSci in Project Management. She is further certified in organizational change management, diversity management, and cross-cultural mediation.