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As a result of the 2006 Tax Relief and Health Care Act, a new refundable Alternative Minimum Tax (AMT) credit may now be available to minimize the AMT hit. Starting in 2007, individuals who have unused minimum tax credits (AMT credits) from more than three years ago may be entitled to a reduction in income tax this year and possibly a greater refund.

Congress provided this refundable AMT credit, effective for tax years beginning after Dec. 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 incentive stock options (ISO) 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 an individual has a “long-term unused AMT credit” — an AMT credit from more than three years ago that has not been used — for the tax year, his or her 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, the higher amount can be claimed. If this higher credit amount is more than the individual’s regular tax liability, a refund for the excess can be obtained. But the amount of the refund is limited to the amount of the “extra” credit allowed under this rule.

Example one: For 2007, Barbara has an AMT refundable credit amount equal to $21,000. Her otherwise allowable AMT credit for 2007 is $14,000 (the excess of her regular income tax liability over her AMT liability). Barbara’s AMT credit for 2007 is $21,000, the higher AMT refundable credit amount. She can reduce her regular tax liability for 2007 by $21,000.

Example two: As described in the first example, Barbara’s allowable AMT credit for 2007 is $21,000, the higher AMT refundable credit amount. Barbara’s tax liability for 2007, before applying the credit, is $18,000. Thus, Barbara needs to use only $18,000 of her available $21,000 AMT credit to completely eliminate her 2007 tax liability. She still has $3,000 ($21,000 minus $18,000) of the credit remaining. The new rule allows Barbara to secure a $3,000 refund. In other words, she receives the immediate benefit of a $3,000 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:

For a long-term unused AMT credit of less than $5,000, the maximum claim is 100 percent of the long-term unused AMT credit;

For a long-term unused AMT credit between $5,000 and $25,000, the maximum claim is $5,000;

For a long-term unused AMT credit greater than $25,000, the maximum claim is 20 percent of the long-term unused AMT credit.

Example three: In 2010, Jim has a $1.1 million AMT credit, of which $900,000 is a long-term unused AMT credit. Because Jim’s long-term unused AMT credit ($900,000) is more than $25,000, he uses the formula described in the third option above to compute his AMT refundable credit amount. Jim’s AMT refundable credit amount for 2010 is $180,000 (20 percent of $900,000 long-term unused AMT credit). This means Jim’s AMT credit for 2010, before any limitation for high-income taxpayers as described below, cannot be less than $180,000.

If adjusted gross income (AGI) for a tax year exceeds an annually adjusted threshold amount, the AMT refundable credit amount must be reduced 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, the long-term unused AMT credit for 2007 takes into account 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 the AMT credit for tax years beginning after 2012.

The above discusses the new refundable credit. The following explains the basic nature of the AMT.

Exposure to the AMT affects many taxpayers, since everyone who files an income tax return is required to determine whether or not they have to pay AMT. However, taxpayers who prepare their own income tax returns often fail to compute AMT. In short, the AMT is a separately computed federal income tax that eliminates many deductions and credits otherwise available to taxpayers, thus increasing their 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 AMT certain deductions are not allowed.

The AMT now affects more and more people every year and was expected to affect about 4 million taxpayers this past tax season. Barring legislative changes by Congress, the number of taxpayers owing the AMT is expected to increase to 24 million in 2007 and to more than 30 million 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 reducing or 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 in the 1960s, was initially 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 percent to the current maximum tax rate of 35 percent), rising incomes and, perhaps most importantly of all, the failure of the government to increase the exemption amount by the rate of inflation. Consequently, more and more taxpayers have become subject to the AMT (and many may not even know it).

Taxpayers most likely affected by the AMT include taxpayers who claim child tax credits, exercise incentive stock options, incur significant unreimbursed employee business expenses or investment fees, pay high amounts of state and local taxes, pay large amounts of home-equity loan interest, recognize large capital gains, taxpayers with annual incomes between $100,000 and $500,000 and taxpayers with children.

Short of moving to a no- or low-tax state, there is not much that can be done to avoid AMT. Steps can be taken, however, to minimize it, primarily by controlling the triggers to AMT such as those noted above.

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 AMT to be paid on the value of the stock received (minus the amount paid for it) in the year an incentive stock option (ISO) is exercised, 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 an individual is already paying AMT in a particular year, no AMT credit is allowed. Also, prior to the change discussed above, the AMT credit was nonrefundable, i.e., any amount in excess of the limitation could not be refunded, although the excess could be carried forward (but not back) indefinitely.

BRUCE J. ROGERS is a manager in the tax accounting group at Duane Morris, where he concentrates his practice in federal, state and local taxation, with particular emphasis on income tax compliance and planning for individuals and corporations.Prior to joining the firm, he was a taxsupervisor with a regional accounting and consulting firm. He can be contacted at[email protected].

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