Debt Free

At the time, it seemed like a great idea. Stop those that make a ton of money from skipping out on paying their fair share of taxes and transferring their burden to other American taxpayers. Congress' answer to these guys was the Alternative Minimum Tax. It was pretty logical, remove the loopholes and deductions the high income tax payers were using to pay virtually no, or no taxes. By 2010 however, the “great idea” will trap an estimated 17 million American taxpayers, and I bet most of those aren't rich by any stretch of the imagination. I posted about the AMT last year, and it's time to reexamine it once again. Maybe I should have done this a few months ago, but oh well, here goes.

When the fact that 200 rich folks weren't paying any taxes way back in the mid 1960's was brought to light, the public got all riled up, and congress passed the AMT overwhelmingly. The problem is that when they did so, few people had ever heard of things such as incentive stock options, and few regular folks made $70,000 - $100,000 a year. Well, this is 2007 and that sort of thing happens all the time to regular folks. You don't have to own a hugely successful business, or be a Fortune 500 corporate executive to rake in $90,000 a year, like you did in 1969.

Basically, the AMT allows the IRS to tax you at a flat 28% if you make over $175,000 in gross income, or if you make over $87,500 and are married and file separately. For the rest of Americans, a 26% tax rate applies. How it works is this. Every taxpayer is supposed to figure your taxes twice. The only deductions the IRS deems acceptable under the AMT are mortgage interest and charitable contributions. You the apply the flat rate to figure your tax. You then pay, you guessed it, the higher of the two tax bills.

What really sucks for the average American taxpayer is that the things that don't count in your favor, and typically ensnare taxpayers are, are you sitting down, the standard deduction, property taxes, exemptions for family or children, and any state and/or local taxes you might have paid. The IRS really doesn't care a bit that you paid a huge state or local tax bill, you can't deduct your state or local taxes when you figure what you owe under the AMT. Another thing that bites more and more American taxpayers every year is the fact that you can't deduct the interest on a home equity loan, a financial instrument used by more Americans all the time.

So, how do you avoid paying the AMT, and just pay your nice, familiar income taxes? Here are some things you need to watch out for that can trigger the AMT. The key is to accelerate income and defer deductions to the years where they'll the most advantageous.

Common AMT Triggers

1 - Incentive stock options – ISOs have probably caused more people to feel the pain and suffering of the AMT than anything else, especially in the early part of this decade when so many were exercised as part of the Internet boom. With ISOs an employee is granted the option to purchase stock at a set price, typically the lowest price in the year the options are granted, or in some cases, a contractual figure in the employment agreement. The difference between the fair market value on the day the options are exercised and the option price can be treated as income and liable to the AMT. If the exercise price is too much lower than the fair market value that can be a huge number. You'll can get really screwed if the stock drops in value after you exercise the options. Why? Because in the sick and twisted logic of the AMT, the exercise price is a realized gain, and you should pay taxes on it. So, if you are granted 40,000 options at $.50 and exercise them at $6.50, the IRS thinks you made $6.00 a share, or $240,000. If you then sell the stock, but by then the stock has fallen to $2.00, you'll only net $80,000, but be taxed on $240,000. If you're paying the AMT's 26% rate, that's a $62,400 tax bill, just for your stock options.

You'll really get yourself into trouble if you hold the stock past December 31^st of the year you exercise the options. If you sell before December 31^st, you are only liable for the income produced by the difference between the fair market value and the sale price of the stock. So, in the above example, you'd only owe tax on the actual profit of $1.50 share x 40,000 shares = $60,000. In addition, options sold before December 31^st don't trigger the AMT. Also, if you hold the stock longer than 1 year, you'll pay capital gains tax, currently a flat 20%, not income tax. You need to exercise your options gradually, rather than all in one fell swoop, to avoid the AMT.

With this one you'd better see a very qualified tax professional, or two, who has expertise in this specific area. One small mistake can cost you thousands or hundreds of thousands of dollars.

2 - State Taxes – If you're one of those people, such as a sales rep, that has cyclical income, it's common for you to have a high income year, followed by a low income year (See, I know what cyclical means!) depending upon your commission structure. If that's the case, you can time your state tax payments to coincide with your higher income years. That way there's a better chance your income will be below the AMT trigger point, where you can lose the effectiveness of the deductions. To make this strategy effective, you must pay your state and local tax bill by December 31^st on your high income year. Then you can deduct them in that higher income year, because that's when you paid them. That strategy is known as accelerating your payment.

Call your legislators and get them to stop the madness before it's too late. You can find out who your congressional representative is here:

http://www.house.gov/

Just enter your zip code in the search box at the top left to check who represents you in the house.