More Alternatives in the Complex World of the Alternative Minimum Tax: The Election to Itemize Deductions

Transcription

1 From the SelectedWorks of Francine J. Lipman Winter 2004 More Alternatives in the Complex World of the Alternative Minimum Tax: The Election to Itemize Deductions Francine J. Lipman Nathan Oestreich James E. Williamson Available at:

2 MORE ALTERNATIVES IN THE COMPLEX WORLD OF THE ALTERNATIVE MINIMUM TAX: THE ELECTION TO ITEMIZE DEDUCTIONS Francine J. Lipman, Nathan Oestreich, and James E. Williamson When AMT enters the mix, smaller deductions may be advantageous. AS A GENERAL RULE, when the standard deduction is greater than a taxpayer s itemized deductions, claiming the larger standard deduction for regular income tax purposes will generate a lower tax liability. However, if the taxpayer is subject to the alternative minimum tax ( AMT ), the decision to take the standard deduction in lieu of itemizing her deductions could cost unnecessary tax dollars. An additional set of calculations is necessary to deter- Francine J. Lipman is a professor at Chapman University School of Law in Orange, California. Nathan Oestreich and James E. Williamson are professors in the School of Accountancy of San Diego State University. 7

3 8 The Practical Tax Lawyer Winter 2004 mine the most tax-favorable alternative under the AMT. The additional calculations answer the question of whether the taxpayer s tax liability would be reduced by electing to itemize her deductions even though the total thereof is less than the standard deduction. Tax professionals must include this additional analysis in their AMT planning strategies or risk imposing unnecessary tax dollars on their clients. Arecent projection estimates that by 2010, the AMT will affect 33 million taxpayers, or onethird of all taxpayers. Much of this increase is in middle-class households with income levels of less than $100,000. This group of taxpayers will then account for more than 50 percent of AMT taxpayers compared to less than 10 percent today. As a result, all taxpayers must include AMT issues in their routine tax-planning decisions. THE ELECTION TO ITEMIZE DEDUC- TIONS Technically, a taxpayer may elect to deduct her itemized deductions even if the resulting amount is less than the amount of the taxpayer s applicable standard deduction. The tax laws do not dictate that the largest dollar amount must be claimed. In fact, the procedure for selecting this alternative is stated explicitly in the Internal Revenue Service s instructions for preparing an individual income tax return. The instructions state that a taxpayer may deduct either her itemized deductions or the applicable standard deduction. The instructions advise taxpayers that in most cases, your Federal income tax will be less if you take the larger of your itemized deductions or your standard deduction. However, the instructions also acknowledge that some taxpayers may find an advantage to Electing to Itemize for State Tax or Other Purposes. If taxpayers elect to itemize their deductions even though their total itemized deductions are less than the standard deduction, they are instructed to enter IE on the line on their tax form next to their allowable itemized deductions. Thus, the government acknowledges the election to itemize a lesser amount of itemized deductions in lieu of the greater amount of the standard deduction in its instructions and cautions taxpayers that this election may be advantageous. Making The Election On An Amended Return Moreover, claiming the standard deduction on an original return is not binding but may be changed at a later date through an amended return. Treasury Regulation provides that a taxpayer may change her election to itemize her deductions for any taxable year (subject to applicable statute of limitations provisions) after she files her tax return for that year. Accordingly, calendar-year taxpayers, who were subject to the AMT and claimed the standard deduction, have until April 15, 2004, to amend their 2000 tax returns and elect to itemize their deductions for any 2000 tax refund. Tax professionals should revisit 2000, 2001, and 2002 tax returns for their AMT taxpayers to see if legitimate tax refunds are waiting to be harvested. TAXPAYERS CLAIMING THE STANDARD DEDUCTION FOR REGULAR INCOME TAX PURPOSES CANNOT ITEMIZE THEIR DEDUCTIONS UNDER THE AMT A taxpayer s decision to claim the standard deduction or elect to itemize her deductions is binding for calculating both regular taxable income and alternative minimum taxable income ( AMTI ). AMTI is computed by making AMT-required adjustments to taxable income as a result of certain deductions and preferences claimed under the regular income tax system. In Marx v. Commissioner, 2003 WL (U.S. Tax Ct. Mar. 19, 2003), Tax Court Special Trial Judge Stanley J. Goldberg confirmed that a taxpayer s decision to itemize his deductions or claim the stan-

4 Alternative Minimum Tax 9 dard deduction for regular income tax purposes is binding for purposes of the AMT. When preparing his 1999 tax return, the taxpayer in Marx determined that he had paid $9,250 of state and local income and personal property taxes during 1999 that qualified as itemized deductions. However, because his adjusted gross income ( AGI ) was greater than $1 million, the three percent cutback of his itemized deductions reduced his allowable itemized deductions to $1,850. (Because his AGI was more than $126,000, Code section 68 required the taxpayer to reduce his total itemized deductions by three percent of the amount of his AGI in excess of this threshold but not less than 20 percent of the original amount (.20 $9,250 = $1,850)). Therefore, the taxpayer decided to claim the standard deduction for a single taxpayer of $4,300 instead of electing to deduct the lesser allowable amount of his itemized deductions of $1,850. He did not calculate his AMT (nor did he include Form 6251) with his original tax return as filed. However, when the IRS asked the taxpayer to prepare and file a Form 6251 so that his return could be processed accurately, he attempted to comply. He used Form 6251 to compute his AMTI by increasing his regular taxable income by his state taxes of $9,250 and subtracted the cutback of his itemized deduction of $7,400, neither of which had been used in computing his regular taxable income because he claimed the standard deduction. The taxpayer did not add back his standard deduction of $4,300 as required under the AMT. As a result of these adjustments, Marx determined that he was not liable for the AMT. After reviewing his Form 6251, the IRS and the Tax Court disallowed his adjustments to AMTI for itemized deductions that were not claimed in computing his regular taxable income. The Tax Court stated that taxpayers who claim the standard deduction for regular tax purposes could not use itemized deductions for AMT purposes. Although the facts in the Marx case are confusing and the taxpayer s attempt to compute his AMT was nonsensical, it is clear that to deduct itemized deductions for AMT purposes, taxpayers must have elected to itemize deductions for calculating regular taxable income. Although the taxpayer could have amended his 1999 return to elect to itemize his deductions, it would not have reduced his 1999 tax liability because his state and local income and personal property taxes, which constituted his itemized deductions, are not allowable under the AMT. The taxpayer had attempted to claim the standard deduction for regular income tax purposes and then use the standard deduction and his definition of AMT-itemized deductions to derive his AMTI. This nonsensical calculation illustrates how an apparently intelligent and educated taxpayer became thoroughly confused and mired in intricate calculations trying to compute (and not succeeding) the complex and obscure calculations required under the AMT provisions. WEIGHING THE AMT COSTS AND BENE- FITS OF THE ITEMIZED DEDUCTION ELECTION Because the AMT can affect each client differently, it is important to analyze each case on its own facts and circumstances. The following examples demonstrate how the election for itemized deductions may or may not be beneficial when the standard deduction is a greater dollar amount. Election Is Beneficial In 2002, Ken and Lee Senior were forced to surrender their commercial property under a condemnation proceeding by a government authority that took their property for public use. Because the taxpayers did not want to replace the property, they reported the entire gain of $315,347 on their 2002 income tax return. This capital gain added to their investment income

5 10 The Practical Tax Lawyer Winter 2004 and the taxable portion of their social security benefits generated an AGI of $362,416. Taxpayers with significant capital gains and relatively low or no ordinary income are especially vulnerable to the AMT. In addition, the Seniors made 2002 charitable contributions of $15,000 to qualifying donees. The Seniors had paid off their home mortgage and paid no state taxes so they had no additional itemized deductions. Because of the three percent cutback on itemized deductions for taxpayers with a 2002 AGI in excess of $137,300, their allowable itemized deductions were only $8,246. Under the regular income tax system, the Seniors would have taken the standard deduction of $9,650 available for a married-filing-jointly couple when both taxpayers are at least 65 years old. However, taking the standard deduction (rather than electing to take the lesser amount of itemized deductions) would have been a mistake because not electing to take the itemized deduction would have increased their AMT by more than claiming the standard deduction would have decreased their regular tax. This complex set of calculations is illustrated below: Election Is Beneficial Standard Itemized Deduction Deductions AGI $362,416 $362,416 Deductions 9,650 8,246 Taxable income 352, ,170 Regular tax 67,377 67,756 AMT 7,814 3,704 Total tax $75,191 $71,460 Explanation: The total itemized deductions of $15,000 are reduced by the three percent cutback based on their AGI in excess of $137,300 ($15,000 - [($362,416 - $137,300 = $225,116).03 = $6,754] = $8,246). The tax calculations reflect that the gain is qualified five-year gain and the unrecaptured Code section 1250 gain is $5,867. For AMT under the standard deduction alternative, the only adjustment to regular taxable income is the addition of the standard deduction, which is not allowed under the AMT. For the itemized deductions alternative, AMTI is taxable income reduced by the amount of the three percent cutback of itemized deductions for regular income tax purposes. As illustrated, if the Seniors had not elected to deduct the smaller amount of itemized deductions and had deducted the larger amount of their standard deduction, they would have paid an additional $3,731 in tax. Under section 53 of the Code, a minimum tax credit is available for part or all of AMT previously paid to reduce regular income tax down to (but not below) AMT until exhausted. For individual taxpayers, the minimum tax credit is equal to AMT paid for AMT-regular income tax timing adjustments (e.g., depreciation and incentive stock option differences). In the foregoing example, the $3,704 AMT paid does not generate a minimum tax credit (because the AMT is a result of the tax rate differences between the AMT (26 percent) and the regular income tax in the lowest tax brackets (10 and 15 percent) and the itemized deduction cutback, which is not a timing difference). Therefore, the Seniors will not receive any future tax benefit from the AMT they paid in Election Is Not Beneficial The election to take itemized deductions rather than the standard deduction is not always beneficial for taxpayers subject to the AMT. There are situations when claiming the standard deduction rather than electing to itemize deductions will result in a smaller AMT. The following example is based on 2003 tax laws. Jonathan and Jane Higgins plan to file a 2003 married-filing-jointly tax return, claiming their two 18-year-old twin daughters as dependents.

6 Alternative Minimum Tax 11 Their only income, for regular tax purposes, is Jane s salary of $150,000. In addition, during 2003 Jane exercised incentive stock options resulting in a positive AMT adjustment of $10,000. The Higgins had planned to claim the standard deduction because their only 2003 itemized deductions were $2,315 of home mortgage interest. However, because claiming the standard deduction resulted in AMT of $1,065, they decided to recalculate their 2003 tax liability, hoping that it would be reduced, by electing to use their lower amount of itemized deduction instead of the standard deduction. In this case, although their AMT disappeared when they elected to itemize their deductions, their regular tax using the smaller amount of itemized deduction was greater than their total tax (including AMT) when claiming the standard deduction. As a result, even though the Higgins must pay AMT, they should not elect to take the lesser amount of their itemized deductions rather than their applicable standard deduction. Election Is Not Beneficial Standard Itemized Deduction Deductions AGI $150,000 $150,000 Deductions 9,500 2,000 Personal & dependency exemptions 12,200 12,200 Taxable income 128, ,800 Regular tax 26,105 28,205 AMT 1,065 None Total tax $27,170 $28,205 Explanation: Itemized deductions are reduced by the 2003 three percent cutback based on an AGI in excess of $139,500 ($2,315 [($150,000 - $139,500 = $10,500).03 = $315] = $2,000). The 2003 personal and dependency exemptions are $3,050 4 = $12,200. AMTI under the standard deduction alternative is $150,000 plus $10,000 for the ISO adjustment, of $160,000. Thus, after reducing AMTI by the partially phased-out 2003 exemption [$58,000 (($160,000 - $150,000).25) = $55,500], AMT is $1,065 [($160,000 - $55,500].26 = $27,170 (tentative minimum tax; $27,170 - $26,105 = $1,065]. AMTI under the itemized deductions alternative is $148,000 plus the $10,000 ISO adjustment minus $315 for the itemized deduction cutback, or $157,685. Thus, after reducing AMTI by the partially phasedout exemption [$58,000 (($157,685 - $150,000).25) = $56,079], AMT is zero, because the tentative minimum tax is less than the regular tax [($157,685 - $56,079).26 = $26, 418 TMT; regular tax = $28,205]. As illustrated, if the Higgins had elected to itemize their deductions, their tax would have been $1,035 higher. Therefore, they should not make the election and take the higher amount of the standard deduction. Additionally, because the $1,065 AMT is attributable to a timing difference (the ISO adjustment), it generates a minimum tax credit that will be available to reduce the Higgins regular income tax to (but not below) any AMT in 2004 and thereafter until exhausted. The combined tax benefit from claiming the standard deduction is $2,100. However, the $1,065 minimum tax credit is at best a deferred tax benefit that under certain circumstances may never be realized. Although these two examples do not begin to illustrate all of the possible scenarios that could require multiple AMT calculations, they demonstrate that analyzing each situation is a necessary step in ongoing AMT planning strategies. CONGRESS COULD ADDRESS THE PROB- LEM BY AMENDING THE AMT Congress could simplify this analysis by amending the AMT to modify the calculation of AMTI. The simplest approach would be to eliminate the AMT provision that adds back the standard deduction to regular taxable income to calculate AMTI. With this amendment, a taxpayer s deci-

7 12 The Practical Tax Lawyer Winter 2004 The failure of Congress to adjust the AMT for inflation is a primary cause of the increased number of middleincome households subject to the AMT and its complex calculations. Tax Relief Reconciliation Act of 2001 ( EGTR- RA ), the AMT exemption amounts were $45,000 for married-filing-jointly taxpayers and $33,750 for single and head of household taxpayers. EGTRRA increased these exemptions to $49,000 and $35,750, respectively, for 2001 through The Jobs and Growth Tax Relief Reconciliation Act of 2003 increased the exemption amounts to $58,000 for married-filing-jointly taxpayers and $40,250 for single and head of household filing taxpayers in 2003 and However, in 2005 the exemptions revert to their pre-egtrra levels. sion to claim the greater of the applicable standard deduction or itemized deductions for regular tax purposes would in most cases result automatically in the lowest tax liability for AMT and regular federal income tax purposes. Another approach would be to move certain itemized deductions above the line and allow them as a deduction for rather than from AGI. As a result, a taxpayer will not have to elect to itemize these deductions or determine if the election is tax favorable versus the standard deduction because the deductions will be allowed automatically under both the regular tax and AMT systems. Members of Congress have proposed legislation to make charitable contributions an above-the-line deduction for AGI rather than an itemized deduction. Although this legislation never made it into law, if enacted in the future, taxpayers who would take the standard deduction would benefit from their charitable contributions under both the AMT and regular income tax systems. Alternatively, Congress could address the problem by making retroactive inflation adjustments to the AMT. The failure of Congress to adjust the AMT for inflation is a primary cause of the increased number of middle-income households subject to the AMT and its complex calculations. Before the Economic Growth and Benefits Gained From Amending The AMT Although when enacted, the AMT applied to a small number of wealthy taxpayers, the current AMT is projected to apply to a significant number of taxpayers, transforming it from a high-income targeted tax to one affecting taxpayers of nearly all income levels. Leonard E. Burman, William G. Gale and Jeffrey Rohaly, The AMT: Projections and Problems, 100 Tax Notes 105 (July 7, 2003). By 2010, unless amended the AMT is projected to affect 33 million taxpayers as compared to one million in More than 92 percent of households with income between $100,000 and $500,000 will be subject to the AMT. Most notably, households with incomes under $100,000 will account for 52 percent of AMT taxpayers in Of these households, the AMT will affect 73 percent with income levels between $75,000 and $100,000 and 37 percent with incomes between $50,000 and $75,000 (compared to about one percent for each of these groups in 2002). With the exploding number of AMT taxpayers, the government and taxpayers would benefit if the AMT provisions were amended to make the most tax-efficient decision regarding the standard deduction or itemized deduction election automatic for both tax systems. If Congress simplifies the AMT calculation, tax-

8 Alternative Minimum Tax 13 payers would not unknowingly pay more tax than the laws require. Moreover, ongoing tax planning strategies would be simplified and more transparent. Tax scholars project that, unless the AMT is modified: By 2008, it would cost less to repeal the regular income tax (leaving the AMT in place) than to repeal the AMT. The AMT will continue to penalize families. Couples with children are projected to be more than 20 times as likely as their single counterparts to owe AMT. The AMT will raise marginal tax rates. By 2010, the AMT will impose higher marginal tax rates than under the regular income tax for 93 percent of AMT taxpayers. Unfortunately, amending the AMT will be expensive. Tax scholars project that repealing the current AMT would cost about $600 billion for years 2004 through If the non-amt provisions of recent tax cuts were made permanent (instead of sunsetting as scheduled), repealing the AMT would cost more than $1 trillion over the next decade. The enactment of the AMT is an example of how a seemingly innocuous attempt to bring 155 high-income individuals (who paid no regular tax) into the taxpayer arena can explode into a major but stealthy part of our tax system. If left unchecked by 2010, one third of all taxpayers (or about as many taxpayers as claim the home mortgage interest deduction) will be subject to the AMT. If the AMT is not amended, tax professionals will have to run numerous obscure tax calculations to assist the majority of their clients in their ongoing AMT planning strategies. In either case, tax professionals should review 2000, 2001, and 2002 AMT taxpayers returns as filed to ensure that they used the most tax favorable alternatives. Taxpayers with significant capital gains and relatively low or no ordinary income will continue to be vulnerable to the AMT, especially with the acceleration of the decrease in regular tax rates. CONCLUSION No taxpayer is expected to pay more tax than the tax laws exact. However, the complexity of the AMT may result in situations where taxpayers and their professional tax counselors fail to consider obscure alternatives and inadvertently pay unnecessary tax dollars. One such situation is when a taxpayer s allowable itemized deductions are less than the applicable standard deduction for regular tax purposes, but the election to deduct itemized deductions results in a lower AMT liability. With the increase in the standard deduction amounts in 2003 to double the single standard deduction, or $9,500 for married-filing-jointly taxpayers and to $11,400 if both taxpayers are 65 or older, this situation will be more prevalent. However, this result is not absolute. Tax counselors must examine each and every situation thoroughly and perform numerous tax calculations to see whether claiming the standard deduction or electing to itemize deductions results in the lowest tax liability. Taxpayers with significant capital gains and relatively low or no ordinary income will continue to be vulnerable to the AMT, especially with the acceleration of the decrease in regular tax rates.

9 14 The Practical Tax Lawyer Winter 2004 PRACTICE CHECKLIST FOR More Alternatives In The Complex World Of The Alternative Minimum Tax: The Election To Itemize Deductions As a general rule, when the standard deduction is greater than a taxpayer s itemized deductions, claiming the larger standard deduction for regular income tax purposes will generate a lower tax liability. However, if the taxpayer is subject to the alternative minimum tax ( AMT ), the decision to take the standard deduction in lieu of itemizing her deductions could cost unnecessary tax dollars. An additional set of calculations is necessary to determine the most tax favorable alternative under the AMT. The additional calculations answer the question of whether the taxpayer s tax liability would be reduced by electing to itemize her deductions even though the total thereof is less than the standard deduction. Tax professionals must include this additional analysis in their AMT planning strategies or risk imposing unnecessary tax dollars on their clients. To purchase the online version of this article, go to and click on Articles and Forms Online ALI-ABA TAX CLE CALENDAR Date Place Subject Feb. 12 Various cities Annual Winter Estate Planning Practice Updates (ALI-ABA Video Law Review) Feb Scottsdale, AZ Representing the Professional and Closely Held Business: Qualified Plans, Welfare Benefits, and Tax Planning Feb Maui, HI Advanced Estate Planning Techniques Feb Orlando, FL Fundamentals of Employee Benefits Law Mar San Francisco, CA Pension, Profit-Sharing, Welfare, and Other Compensation Plans Mar. 18 Various cities Limited Liability Entities (ALI-ABA Video Law Review) Apr New York, NY Planning Techniques for Large Estates Apr. 29-May 1 New Orleans, LA Partnerships, LLCs, and LLPs: Uniform Acts, Taxation, Drafting, Securities and Bankruptcy To register or to obtain further information, call CLE-NEWS, see our Web site at or write to ALI-ABA Courses of Study, 4025 Chestnut Street, Philadelphia, PA Usually, detailed announcements are ready about three months before the scheduled date of the course. Earlier inquiries will be acknowledged immediately and printed announcements will be sent as soon as they are available. For e- mail notification of courses in particular subject matter, go to ABA SECTION OF TAXATION CLE CALENDAR Date Place Subject May 6 Washington, D.C. May Meeting For additional information, please write to ABA Section of Taxation, th Street, N.W., 10th Floor, Washington, DC , or call