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July 27, 2007 4:32 pm

Alternatives to minimum tax

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In certain financial planning circles, it is known as the stealth tax. In the language of the US Internal Revenue Service, it is known as Form 6251. But to investors like you, it is simply called the alternative minimum tax, or AMT.

The federal AMT – originally designed to correct a lopsided advantage for the ultra-rich, to ensure they could not use special tax benefits to pay little or no tax – is an additional tax that some investors must pay on top of income tax.

In light of the fact that the AMT is not indexed to inflation and recent tax cuts, it is affecting more and more people every year. In 2001, for instance, about 1.7m taxpayers were subject to AMT, and in 2005, that number rose to 13.4m. If the law stays the same, by the year 2010, 35.1m taxpayers will be subject to the AMT, according to figures from the Tax Policy Center, a Washington, DC-based think tank.

“The largest single reason why a taxpayer is subject to AMT is because of his or her state income tax rate – particualarly if you live in high rate states like New York, New Jersey, Massachusetts, or California – because it’s not deductible,” says Tim Speiss, a partner at Personal Wealth Advisors, an arm of the accounting firm Eisner, which offers financial planning and advisory services to high net worth individuals.

Today, the minimum tax rate for the AMT stands at 28 per cent and that, at least is some good news, according to Speiss. “The first thing to recognise is that the AMT rate is lower than the top 35 per cent rate, so you’re in a lower high-tax bracket,” he says.

But Robert MacIntosh, vice-president of Eaton Vance Management, says he is concerned that not only are investors unaware of the potential impact of the AMT, but so too are the professionals they rely on for advice. A recent investor survey conducted by Eaton Vance showed that only 47 per cent of investors knew what AMT was, and only 8 per cent of those were informed of any potential AMT liability.

“It should be the first question that advisers ask you: ‘Are you subject to the AMT?’ ,” says MacIntosh. For this reason, say experts, it is critical that taxpayers plan ahead. Investors must understand how the AMT may affect their tax situation – not just for the current tax year, but for future years, where increased income or deductions may trigger the AMT.

“Being subject to AMT is not such a precarious situation if you’re aware of it, and looking at the tax situation over a timeframe, not just a single year,” says Speiss.

For instance, he says, it is important to be aware of the impact that sales of highly appreciated securities may have on your tax situation. In spite of a long-term capital gain rate of 15 per cent, long-term share price gains may push you past AMT exemptions limits. In addition, incentive stock options often result in investors owing AMT – particularly if options are exercised and not sold. Under AMT rules, the difference in the initial option price and the fair market value of the security is considered income.

One way to lower your taxable income liability is to invest in tax-free municipal bond funds and tax-free money market funds, according to Thomas Farace, a partner in the asset protection planning practice at law firm Nixon Peabody. But, he says, because some municipal bonds – called “private activity” bonds – are subject to the AMT, investors need to carefully choose their particular investments.

“That particular information is usually contained in the prospectus, so read it carefully to see how much exposure there is to the AMT,” he advises.

MacIntosh adds: “If you are subject to the AMT, you don’t want to make it worse with investments that are also subject – instead, you need to buy bonds and funds that are free of AMT.” He says, “It goes to the tax code, and what’s permitted. If the issuer of the bonds is a private, for-profit company that for one reason or another can issue tax-
exempt bonds, that’s a smart way to go.”

There are also AMT-free funds. These funds – which are offered by Fidelity Investments, OppenheimerFunds and T Rowe Price Group – by and large avoid private-activity bonds.

Farace cautions that investors need not get too carried away here. “To be blunt, you can’t let the tax tail wag the dog. You might end up with a bond that markets itself as ‘AMT-free’ but then you’ve got more investment risk,” he says.

In more complicated cases, investors will be advised to accelerate income or defer deductions to reduce AMT liabilities, says Speiss. “The savvy investor will consult with his or her tax advisers,” he says. “It should be a collaborative process. The client can’t be passive; he needs to be engaged.”

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