United States: A Refundable Credit To Offset The "Secret Tax" May Be Available To You

One of the biggest and hottest tax topics continues to be the ever-growing exposure to the AMT. By law, everyone who files an income tax return is required to determine whether or not they have to pay AMT. Often, taxpayers who decide to prepare their own income tax returns fail to calculate this "secret tax." In short, the AMT is a separately computed federal income tax that eliminates many deductions and credits otherwise available to us, thus increasing our federal tax liability. Individuals are required to compute their tax under two systems, the regular tax system as well as the AMT system, and pay the higher of the two. In computing this secret tax, certain deductions are not allowed.

The AMT now snags more and more people every year and was expected to affect about four million taxpayers this past tax season. Barring significant action by Congress, the number of taxpayers owing the AMT is expected to increase to 24 million in 2007 and to more than 30 million taxpayers in 2010. Recent studies have indicated that one in five taxpayers will have an AMT liability by the year 2010 if the system is not changed.

Congress has been talking about eliminating this tax for many years. But to do so, other taxes would have to be raised to offset the lost AMT revenue, which is in the billions of dollars.

The AMT, which was created about 40 years ago, was designed to affect high-income taxpayers claiming certain expenses or deductions that were disproportionate to income. Currently, it is affecting many other taxpayers due to the compression of the tax rates (from a high of 70% to the current maximum tax rate of 35%), rising incomes and the failure of the government to increase the exemption amount by the rate of inflation. Consequently, more and more taxpayers will be subject to the AMT (and many may not even know it).

Taxpayers most likely affected include:

• Taxpayers with annual incomes between $100,000 and $500,000.

• Taxpayers with children.

• Taxpayers who:

Short of moving to a no- or low-tax state, there is not much you can do to avoid AMT. You can, however, take steps to minimize it, essentially by controlling the triggers to AMT such as those noted above.

And, as a result of the 2006 Tax Relief and Health Care Act, a new refundable AMT credit may now be available to you to further minimize the AMT hit.

Starting in 2007, individuals who have unused minimum tax credits (also called "AMT credits") from more than three years ago may be entitled to a reduction in income tax this year and possibly a greater refund.

Some background information may be helpful. The AMT is imposed on alternative minimum taxable income (AMTI), which is taxable income increased by certain preference items and adjusted by denying the regular-tax income deferral allowed for certain items ("deferral adjustments"), some of which are noted above. For example, the rule requiring you to pay AMT on the value of the stock you receive (minus what you paid for it) in the year you exercise an incentive stock option (ISO), even though it is not subject to regular tax, is a deferral adjustment. Other deferral adjustment items, typically the result of having a different basis under the regular tax system than under the AMT system, include depreciation after 1986, gain or loss on the sale of property, loss limitations due to at-risk rules and passive activities.

AMT attributable to deferral adjustments generates an AMT credit that can be used to reduce regular tax in a later year. The AMT credit for a year generally is limited and, as a result, cannot be used to reduce AMT liability in the year to which it is carried. In other words, if you are already paying AMT in a particular year, no AMT credit is allowed. Also, the AMT credit is nonrefundable, i.e., any amount in excess of the limitation cannot be refunded, although the excess can be carried forward (but not back) indefinitely.

The legislative history indicates that Congress provided this refundable AMT credit, effective for tax years beginning after December 20, 2006 (an AMT credit was available in non-refundable form since 1987), in response to the hardships that resulted from the unfavorable treatment of ISOs under the AMT. Under the new rule, individuals who become subject to the AMT, or whose AMT liability increases as a result of exercising ISOs, may be entitled to a refundable credit attributable to that AMT liability. However, the new rule does not alleviate the immediate AMT burden that results from the ISO exercise, as discussed below.

Here is the new rule in a nutshell followed by illustrations: If you have a "long-term unused AMT credit" (i.e., an AMT credit from more than three years ago that has not been used) for the tax year, your AMT credit for the year cannot be less than the "AMT refundable credit amount" for the year. In other words, if the refundable AMT credit amount is higher than the amount otherwise allowed, you can claim the higher amount. If this higher credit amount is more than your regular tax liability, you can get a refund for the excess. But the amount of the refund is limited to the amount of the "extra" credit allowed under this rule.

Example (1): For 2007, Betty has an AMT refundable credit amount equal to $20,000. Her otherwise allowable AMT credit for 2007 is $15,000. Betty’s AMT credit for 2007 is $20,000, the higher AMT refundable credit amount. She can reduce her regular tax liability for 2007 by $20,000.

Example (2): As described in Example (1), Betty’s allowable AMT credit for 2007 is $20,000, the higher AMT refundable credit amount. Betty’s tax liability for 2007, before applying the credit, is $18,000. Thus, Betty needs to use only $18,000 of her available $20,000 AMT credit to completely eliminate her 2007 tax liability. She still has $2,000 ($20,000 - $18,000) of the credit remaining. The new rule allows Betty to secure a $2,000 refund. In other words, she receives the immediate benefit of a $2,000 refund now, instead of having to wait until a later year.

The AMT refundable credit amount is based on the amount of the long-term unused AMT credit and is reduced for high-income individuals. The AMT refundable credit (before reduction) is as follows:

1. For a long-term unused AMTcredit of less than $5,000, you may be able to claim 100% of the long-term unused AMT credit;
2. For a long-term unused AMT credit between $5,000 and $25,000, you may be able to claim $5,000;
3. For a long-term unused AMT credit greater than $25,000, you may be able to claim 20% of the longterm unused AMT credit.

Example (3): In 2010, John has a $1.1 million AMT credit, of which $1 million is a long-term unused AMT credit. Because John’s long-term unused AMTcredit ($1 million) is more than $25,000, he uses the formula described in (c), above, to compute his AMTrefundable credit amount. John’s AMT refundable credit amount for 2010 is $200,000 (20% of $1 million long-term unused AMTcredit). This means John’s AMT credit for 2010 cannot be less than $200,000.

If your adjusted gross income (AGI) for a tax year exceeds an annually-adjusted threshold amount, you must reduce your AMT refundable credit amount by an "applicable percentage" of that excess. For 2007, these AGI thresholds are: $234,600 for married individuals filing jointly and surviving spouses; $195,500 for heads of household; $156,400 for unmarried individuals (not surviving spouses); and $117,300 for married individuals filing separately.

The long-term unused AMT credit for any tax year means the portion of the AMT credit for tax years before the third tax year immediately preceding the tax year. Thus, your long-term unused AMT credit for 2007 takes into account your unused AMT credits from 2003 and earlier years. In this computation, the credits are treated as allowed on a first-in, first-out (FIFO) basis.

Under current legislation, the AMT refundable credit rules described above will not apply in determining your AMT credit for tax years beginning after 2012.

As you can see, the new AMT refundable credit rules may help soften the blow of the AMT. However, the potential benefits from the credit also add to the complexity of the AMT itself. If you have engaged Duane Morris’ Tax Accounting Group to prepare your tax returns, we will automatically determine if this credit is applicable to you. If you have not engaged us but would like to discuss how this new law impacts you and whether there is credit or refund opportunity available to you, please give us a call.

For additional information regarding this topic, please contact Michael Gillen at 215-979-1635 or one of the other members of the Tax Accounting Group of Duane Morris LLP with whom you are regularly in contact.

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