From the April 2009 issue of Wealth Manager Web • Subscribe!

Patching it Up

More On Tax Planning

from The Advisor's Professional Library
  • Precious Metal Taxation Precious metals can be used to better diversify a portfolio but can be volatile. The tax implications of investing in these types of assets vary depending upon the situation.
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Amidst all the partisan squabbling over the size of President Obama's economic stimulus package and the role of tax cuts therein, there was, at least, bi-partisan agreement on the need to address the Alternative Minimum Tax. The snag is that the cost of an AMT fix becomes more expensive every year. And AMT reform already appears to be DOA.

True, during the campaign, then-Senator Obama did not address the issue in detail, saying only that he would consider AMT reforms such as indexing the AMT exemptions--which have never been indexed.

In reality, President Obama would have to do far more to temper the AMT, which snags a steadily growing number of middle-income individuals, forcing them to calculate their taxes both under the regular system and the AMT. And they are nicked for whichever levy is larger.

Legislation
However, the American Recovery and Reinvestment Act of 2009, enacted this past February, authorized one of those temporary fixes for one year--the so-called AMT patches that raise the exemptions. The measure slightly increases the amounts for 2009 to $70,950 for married couples filing jointly and surviving spouses (up from $69,950 in 2008); $46,700 for single taxpayers and heads of household (up from $46,200 in 2008); and $35,475 for married couples filing separately (up from $34,975 in 2008).

On the plus side, the patch will keep many millions of taxpayers off the AMT rolls this year. The Tax Policy Center in Washington, a joint project of the Brookings Institution and the Urban Institute, estimates that whereas no patch would have caused 30.3 million taxpayers to be dunned for the AMT, the latest patch has decreased that number to 4.6 million.

But the legislation left unchanged the phase-out of exemptions when AMT income exceeds specified levels that vary by filing status--$150,000 for joint filers, $112,000 for singles and heads of households, and $75,000 for married couples filing separately. Moreover, nothing was done about the marriage penalties imposed by the AMT. "The exemption for couples is less than twice the level for singles, and the tax rate brackets are not adjusted for marital status," the Center notes.

Another unresolved problem is that the reduced rates for long-term capital gains and dividends also apply when calculating the AMT. An extension beyond 2010 of the lower rates for ordinary income, capital gains and dividends means the AMT is going to snare a steadily growing number of investors, diminishing any benefit from the reductions. The hit-list includes investors with substantial amounts of capital gains and dividends taxed at a top rate of 15%--especially those who file in high tax venues. Remember, the AMT does not allow itemized deductions for state and local income and property taxes.

Let's assume that proposed revisions cause the two top regular rates of 33% and 35% to revert to the pre-2001 rates of 36% and 39.6%. In that case, a variation of Murphy's Law kicks in for some higher-income taxpayers whose regular tax liabilities then become greater. Ironically, those increases free them from the clutches of the AMT.

The AMT "affects large groups of middle-class taxpayers with no tax-avoidance motives at all, unless one considers choosing to live in a high-tax state or choosing to have children to be a tax-avoidance motive," said Nina Olson, the IRS National Taxpayer Advocate, in her annual report to Congress.

How to resolve the AMT mess? This is a question your clients may ask, and you may want to address in conversations and newsletters. The answer is that there are no painless choices. One way would be to do away with it; another to permanently index it. Scrapping the shadow tax system once and for all is expensive and, therefore, unlikely. Full repeal could mean lost revenues north of $1 trillion over the next decade, worsening the deficit. Far simpler is a makeover: Boost the AMT exemption and index it, or end the denial of dependency exemptions, standard deductions and certain itemized deductions (see sidebar).

The ABCs of the AMT
The regular tax rates for individuals are six-tiered. They start at 10%, move up to 15%, 25%, 28%, 33% and peak at 35%. The AMT rates are two-tiered: 26% on the first $175,000 of taxable income ($87,500 for married persons filing separately) and 28% beyond that. The present difference between the top regular and AMT rates is only seven percentage points, compared to the 11.6-point difference before the 2001 Bush cuts to the regular rates. True, the highest AMT rate of 28% is lower than the two highest income tax rates of 33% and 35%. But the AMT rate is imposed on AMT-taxable income, which exceeds regularly determined taxable income.

The AMT has its own set of rules. They allow fewer write-offs and count more items as reportable income than the regular method used to determine tax liability. Consequently, taxes must be calculated both ways: First, under the regular rules, and then under the AMT rules. And surprise! The law requires payment of whichever bill turns out to be higher. This holds true even if adept use of legitimate deductions and other breaks greatly reduces--or even eliminates--the amount of regular tax. The AMT is structured to make sure that some taxes will probably have to be paid.

What advisors need to know
he best defense--the only defense--against the AMT is to plan for it. First, be aware that the AMT makes some traditional tax advice useless or even harmful--for instance, the long-established year-end mantra to accelerate payment of deductions into the current year and defer income to a later year whenever possible. The conventional wisdom remains appropriate for most people who figure their taxes under the regular rules--especially those who expect that their tax bracket will be lower in the later year. But taxpayers who suspect that they are subject to the AMT might want to do the opposite: Accelerate income into 2009 and defer deductions denied by the AMT until 2010.

For those who are able to file under the regular rules, one customary maneuver is to build up itemized deductions for this year. These possibilities include payment of property taxes and the fourth-quarter installment of estimated state and local income taxes before 2009 comes to a close, rather than wait until they become due in 2010--usually by Jan. 15. This saves taxes for regular filers who anticipate being in a lower bracket next year because the deductions are worth more this year.

However, because such write-offs are not permissible under the AMT, following that advice could mean that more winds up with the IRS. Assuming the AMT will not apply in 2010, it could prove advantageous to move those payments into 2010.

Dependency exemptions
The AMT also denies deductions for dependency exemptions. You read that right. The AMT treats children like tax shelters.

And the courts have agreed with the IRS that the disallowance of dependency exemptions ($3,650 per exemption for 2009, up from $3,500 2008 and $3,400 for 2007) under the AMT regulations does not infringe on the personal religious beliefs of individuals who raise large families. Nor, it ruled in the case of Klaassen vs Commissioner of Internal Revenue, is it an unconstitutional infringement of the First Amendment.

Julian Block, an attorney based in Larchmont, N.Y., conducts continuing education courses for financial planners. Information about his books can be found at www.julianblocktaxexpert.com.

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