Alternative Minimum Tax: Manufacturing’s Next Scourge?

By Timothy M. Foster

In the late 1960s, over 155 US citizens with incomes that exceeded  $200,000 – 20 of them millionaires – paid no federal income tax at all. They got off tax-free by taking advantage of existing loopholes in the system. This news was poorly received by the federal government and resulted in the creation of the Alternative Minimum Tax (AMT).
           
The goal of the AMT was to make sure the super wealthy were paying their fair share. At the time the AMT was implemented, it affected approximately 20,000 taxpayers. Unfortunately, this taxing mechanism has not been adjusted for inflation since its inception. As a result, the number of individuals and corporations being impacted by Alternative Minimum Tax is now in the millions and the numbers are growing. If the trend continues, the nation’s backbone – manufacturing companies, their owners, officers and shareholders – may one day find the AMT knocking at their doors. Since the AMT is a far less forgiving system than the standard method, it is important to anticipate it, understand how it works and to do whatever planning can be done to mitigate risk.

The History of AMT
When the federal government, and subsequently the press, first learned that many extremely wealthy individuals were legally evading tax payment, the public backlash helped to spur action. The House Ways and Means Committee set about to reform the tax code. The intention was not to increase overall federal tax revenue. Rather, it was to limit special tax advantages for those who could well afford to pay, so that the average citizen’s rate could be lowered.

The initial AMT was a flat rate of 10 %, and it applied to individuals only. Over the years, the flat rate for the individual alternative minimum tax has increase to the current rate of 26 to 28 % (depending on income). In 1986, Congress approved the creation of the Corporate Alternative Minimum Tax, which currently has a rate of 20 %.

Although the regular tax code has responded to the rising cost of living over the years with standard deduction amounts steadily increasing, the AMT has never been adjusted for inflation since its inception nearly 40 years ago. As a result, the number of people each year who reach the income figures that trigger the need to file for the AMT is on the rise.

AMT Affects Business Owners and Individuals
As far as today’s corporations are concerned, the AMT becomes an issue if a company’s average sales revenue over the previous three years exceeds $7.5 million. Significant numbers of manufacturing companies are achieving these types of profits.

For businesses set up as ‘C’ corporations, the business owners are responsible for the corporate level taxes as well as their own individual taxes. Accordingly, the AMT can affect them on two fronts.

The owners of businesses set up as ‘S’ corporations will not have to worry about the AMT on the corporate level. All the business taxes of an ‘S’ corporation (and approximately 75 % of all small businesses are set up this way) are the responsibility of the individual shareholders when they pay their personal income tax. Therefore, if a corporation’s revenue crosses the corporate AMT threshold, the shareholders may have a jump in their individual taxes, or at least an increase in the required tax forms that will need to be submitted.

For individuals, the point at which the AMT will generally start to have an affect on their personal taxes is when their annual income reaches $75,000. By today’s standards, people earning such an income might be classified as upper middle class, but certainly not the wealthy elite. A New York Times article stated that, “by the year 2010, nearly 30 million taxpayers will be hit,” by the Alternative Minimum Tax.

How the AMT Works for Individuals
The Internal Revenue Service has called the AMT one of the most complicated parts of the tax code in terms of compliance and administration. Even determining if an individual is subject to the AMT is not easy. Often verifying the need to file the AMT involves completing long worksheets or forms and/or reading many pages of instructions.

At some time, taxpayers or their CPAs realize they must file the lengthy additional paperwork required for the AMT. Although doing so can often lead to a substantial increase in payment due, in many instances, it turns out that no additional taxes are owed.

When someone crosses the threshold where the need to file the AMT kicks in, the following steps must be taken at tax time:

Traditionally the mechanisms used for tax planning are based on making sure individuals conduct their affairs, both business and personal, to maximize all available credits, deductions, exemptions and deferrals. In this way they can be careful about the amount of income they are exposing to tax.

The problem with the Alternative Minimum Tax is that it can neutralize those mechanisms.

Value of the Regular Tax System
Although the current regular tax structure is complex, it has enabled the government to favor certain activities like homeownership. That is why taxpayers get a generous home interest deduction. Likewise, with the high cost of raising a family, the deductions for dependents make a significant difference for those with children. Also, the regular tax code is adjusted for inflation each and every year (increasing the deduction amounts for items such as children and home interest.)

Unfortunately, once individuals reach a certain income level, many of the benefits of the regular tax system are taken away. The value of the preference items, like personal exemptions and deductions, which reduce their taxable income base in the regular system, are added back to their Alternative Minimum Taxable Income (AMTI). So, the more tax preference items individuals have, the more ‘add backs’ there will be. The more ‘add backs’, the greater the likelihood the AMT calculation will be higher than their regular tax calculation.

The AMT system is a source of aggravation for taxpayers and their CPAs, but to the IRS it is a source of increased revenue. By the year 2010, there will be about six million taxpayers who will have to pay AMT solely because they have children. Getting penalized for taking advantage of this particular ‘loophole’ is hard for any parent to swallow.

The original intent of employing a new taxing mechanism to guarantee the super wealthy pay their fair share and to take the burden off of the average taxpayer has also missed its mark. Now the AMT is lowering its sights and aiming more and more at the average taxpayer.

Though it is apparently difficult for the government to change this archaic system based on a set of numbers from 1970, Congress may see fit to do so soon. Until that time, the best defense is knowledge.

AMT: Ignorance Is Not Bliss
Many individual are unaware of the fact they have joined or are about to join the ever- growing number of taxpayers whom the IRS categorizes as wealthy. Therefore, people in this group will probably calculate their federal income tax the same way they have done in the past. If this happens, the IRS may flag the return and do an audit or at least let the individual know that an AMT tax calculation is required. If the person has taken advantage of the many tax preference items on their regular return, then it is likely the AMT calculation will cause them to owe additional tax. In that case, the IRS may charge interest and a penalty.

When CPAs do their clients’ individual taxes only, they may communicate with their clients only at tax time. Suddenly, when they are processing the personal returns using the regular tax software, the accountant may discover there is a need to do the calculations for the AMT. This would likely occur right before the taxes need to be filed. In this case, if the client is getting hit by the AMT for the first time, he or she may end up with a much bigger tax bill than anticipated.

Taxpayers Beware!

Taxpayers about to cross the $75,000 income threshold, either because of a raise in salary or, say, profits from a real estate sale that year, should be aware of aspects of their lives that will cause the AMT calculation to be larger than their regular tax calculation. Here are some of the triggering events:

These situations create tax preference items on the regular tax form. While the federal government has traditionally attempted to support people in such positions, they give them no special dispensation when calculating AMTI. In fact, increased income catches so many people off guard and throws them into uncharted waters that taxpayers are much better off finding out where they stand relative to the AMT before it becomes an issue.

Successful businesspeople in all industries, including manufacturing, usually plan their business and personal affairs to maximize credits, deductions and exemptions. That’s exactly what they are supposed to do. The tax system has been designed to help individuals and companies to succeed. In an attempt to capture an equitable amount of federal tax revenue from the extremely wealthy, though, the Alternative Minimum Tax was designed to remove many of these useful tools. Currently, it is affecting those far below the income levels of today’s super rich (who are now multi-millionaires), and there is little recourse until Congress decides to make an inflation adjustment. Until then, the ever growing numbers of tax payers about to fall into the AMT net need to open their eyes, talk to their accountants and not let their next tax return catch them by surprise. 

SIDE BAR
John Laubacher, a CPA in Camarillo, California tries to train his clients to keep him informed of their financial activities. “Rather than calling me and saying, ‘Guess what I did.’ I’m getting more and more calls over the years saying, ‘I’m thinking about doing this.’” He either tells them it sounds good or warns them, “If you do that, you might be subject to AMT.”

Here are some items Laubaucher suggests that business owners and taxpayers in general consider when their incomes are approaching or surpassing the AMT limit:

About the Author:
Timothy M. Foster, JD, MST, is a Tax Services Director for International Tax Advisors, Inc., a tax consulting firm and a related company of International Profit Associates, Inc. IPA and its combined family of consulting firms provide comprehensive business consulting, tax planning and business valuation services to companies in the United States and Canada. For further information, call 800 531-7000 or visit www.ipa-iba.com