Alternative Minimum Tax - Example

Alternative Minimum Tax Table of Contents Introduction 3 The alternative minimum tax (AMT) 4 The accounting aspect of AMT 5 Preference items considered while computing alternative minimum taxable income 7 Adjustments made while computing the alternative minimum taxable income 8 Adjusted current earnings adjustment 9 Other Rules 11 Calculation of alternative minimum tax 11 The effect of AMT rule 13 Who are liable to pay the alternative minimum tax? 15 Reason behind upper middle and middle income groups paying the AMT 16 AMT patches 17 Changes in the AMT 17 Works cited 19 Name of the Student Name of the Professor Course Number Date Introduction The consequence of corporate income taxes on corporate investment is a chronic issue that is included and outlined in the tax policy. The fact that capital investment is a stimulant that acts as a driving force, as far as performance of the economy is concerned, so lowering the income taxes might boost investment and henceforth, the economy. On the other hand, raising the taxes might slow down the economy. In addition to that, if the income is taxed in a different manner for different types of investment, then the disparity in the tax treatment might persuade the corporations to acquire more assets which are tax favored, instead of acquiring assets which are economically efficient. In the context of taxes and investment, a critical matter, however, is whether taxes affect investment decisions enough to raise a concern for the tax policymakers. In order to have a stable taxation framework, the American Government policymakers formulated the Tax Reform Act of 1986, which transformed the Internal Revenue Code of US in several ways. The Tax Reform Act of 1986 (TRA 86) created the alternative minimum tax (AMT) in order to prevent corporations from paying very little or virtually no tax, by using tax deductions and income deferrals (Billings and Hamilton 423-452). The authors observed firm level asset acquisition behavior and concluded that both the AMT tax rules, as well as the changes made in the regular tax rules, have affected corporate asset leases and purchases. The magnitude of the effect of these tax laws is apparently sufficient enough to raise a concern, as far as formulating tax policy is concerned. The alternative minimum tax (AMT) The AMT was first introduced in the year 1969, when it was incorporated in the US tax code, in order to prevent the wealthy from availing several tax deductions, eventually through which they would wind up paying no tax. This tax code was formulated with an underlying objective to minimize or abolish the use of certain tax deductions, which were quite frequently used by the wealthy tax payers (Cummins and Hassett 243-251; Givoly et al. 331-355). However, for a number of reasons, an elevating number of middle-income tax payers found themselves coming under the slab specified within the AMT, over the past few years. This was precisely because the dollar amounts that were used in order to calculate the AMT were not indexed for inflation. Moreover, more and more allowances that minimize the regular tax liabilities, but are not deductible under the AMT, have been incorporated into the tax code specified under the latter (Graham 41-73). The AMT represents a framework that is completely different from the regular tax framework and it has its own sets of rules (Burman 555-595). The rule was laid down in order to assess the minimum amount of tax that is required by an individual, with a certain income level, to pay. Nevertheless, if the regular taxable amount exceeds the calculated amount, then the AMT does not have to be paid. If the amount does not exceed, then in such cases, the individual taxpayer makes up the difference by paying the AMT. Credits and deductions, that are yet to be included under the AMT tax code, but are frequently used by the middle-income tax payers, include the personal exemptions, state and local taxes, standard deduction, mortgage interest, medical expenses, miscellaneous itemized deductions, income generated from exercising incentive stock options and accelerated depreciation. In order to calculate the AMT, a taxpayer would start from regular taxable income, before exemptions are applied. Thereafter, the taxpayer will include back the deductions that are not allowed within the AMT tax code (Hicks and Feibelman, “What is the alternative minimum tax and are you in danger of paying it?”). The accounting aspect of AMT In order to be able to understand the accounting aspect of AMT, we need to understand how it is calculated. Let’s assume that a firm, whose regular taxable income is Y, pays an amount of tY as tax. The alternative minimum taxable income, in this case, is denoted by AMTI and is the summation of Y and D, where D is the set of adjustments that are largely based on the disparities between the regular tax rules implemented, in order to calculate Y, as well as the AMT rules. The statutory AMT tax rate (ta) is 20%. Thus, the tentative tax rate denoted by TAMT = 0.20(AMTI). If the tentative AMT is higher than the regular tax tY, then the corporation must pay the AMT which is calculated using the following formula. AMT = TAMT – tY In addition to the AMT calculated above, the corporation also has to pay regular tax, tY. Thus, in essence, the total tax paid by a corporation is the greater of the two, i.e. tY or TAMT. Nonetheless, the tax payer can claim the AMT payment as a tax credit in order to be able to compensate for the regular tax liability in the subsequent years. The AMT tax rules differ from the regular tax codes from three particular aspects that eventually affects the taxpayer’s (in this case, a firm) cost of capital. First of all, AMT applies the alternative depreciation system, instead of using the modified accelerated cost recovery system, because the alternative depreciation system has a lower rapid rate of recovery. As a consequence, the present value of the depreciation allowances, specified within the AMT tax code, is smaller than the slab specified under regular tax code. Secondly, the statutory AMT tax rate (ta) is much lower than the regular tax rate. The lower AMT tax rate minimizes the taxes required to be paid on incremental savings, resulting from new investments. Contrarily, the lower AMT tax rate also minimizes the tax savings that can be generated on interest deductions, thereby increasing the firm’s financial cost of capital. Lastly, given the fact that a taxpayer can claim the AMT payments against a firm’s future regular tax liability, the AMT can only modify the timing arrangement of the firm’s tax liabilities instead of increasing them. Within the framework of the TRA 86, there is a factor termed as the book income adjustment (BIA), which is a component of D (AMT adjustments). The value of the BIA is 50% of net book income, which is the financial reporting income generated after adjustments less the AMTI. The budget reconciliation act, formulated in the year 1989, brought about a modification in the way the AMT was computed, thereby replacing the adjusted current earnings in place of the BIA. The adjusted current earnings adjustment is 75% of adjusted current earnings less the pre adjustment AMTI. As explained above, the current law imposes an alternative minimum tax on a corporation to the degree at which the tentative minimum tax liability of the corporation exceeds its regular tax liability. The tentative minimum tax has been set at 20% of the alternative minimum taxable income of the corporation, exceeding a $40,000 exemption. Thereafter, the exemption amount is reduced by an amount, which equals 25% of the amount, in case the firm’s alternative minimum tax surpasses $150,000 and the exemption amount is fully reduced in case the corporation’s alternative minimum taxable income exceeds $310,000 (Butrica 211-234; Ashby 381-385). The alternative minimum taxable income is in essence a corporation’s taxable income that is calculated over certain preferential items and henceforth, adjusted according to the tax treatment of the items included within the tax code. The adjustment is done in a manner that cancels out the income deferral, those results from the regular tax treatment of those items. Suppose a corporation has average gross receipts which is less than $7.5 million for the last three years and thus, is exempted from the corporate minimum tax. Henceforth, the $7.5 million limit is minimized to $5 million, for the first three year taxable period, for a new corporation (Schnur 1). Preference items considered while computing alternative minimum taxable income The preferential items to be included, while calculating the alternative minimum taxable income are as follows: The amount that exceeds after the deduction for percentage depletion for the adjusted basis of the property has been done at the end of the taxable year. However, this preference is not applicable to percentage depletion, which is allowed with respect to oil and gas properties. The amount by which the intangible drilling cost, in a particular taxable year, exceeds 65 percent of the net income, generated from gas, oil and geothermal properties. However, the preference is not applicable to an independent producer to the threshold that the preference would not actually reduce the alternative minimum taxable income of the produce by more than 40 percent. Interest income on private activity bonds (apart from the qualified 501(c) (3)), bonds that are exempted from the tax code and has been issued after August 7, 1986. Accelerated amortization or depreciation on those particular properties which were placed in service before January 1, 1987. Adjustments made while computing the alternative minimum taxable income The adjustments that the corporations need to index, while computing the alternative minimum taxable income, are outlined as follows: The depreciation on properties that have been placed in service, after 1986 and before January 1, 1999, is required to be computed by applying the longer class lives stated by the alternative depreciation system. The method to be used depends on the type of property. The straight line method is to be applied in case the property is subject to the regular tax code. The 150 percent declining balance method is to be implemented in case of all other property types. The regular tax recovery period and alternative minimum tax method are to be applied in case of computing the depreciation on properties which have been placed in service after December 31, 1998. The development and exploration costs of mining should be amortized and capitalized over a 10-year time period. The taxable income that resulted from a long-term contract must be calculated by applying the percentage of completion method of accounting. The contract type can be anything, other than home construction contract. The amortization deduction that is permitted for pollution control facilities, placed in service before January 1, 1999, are evaluated using a 60-month amortization rate for a portion of the cost of the facility specified under the regular tax rules. However, an adjustment has been made in the method that should be used to calculate the amortization deduction. Now, it must be calculated by applying the rules specified under the alternative depreciation system, which generally used the straight-line method and longer class lives. As far as pollution control facilities, placed in service after 31 December, 1998, are concerned, their amortization deduction is to be calculated using the straight-line method and regular tax recovery periods. The special rules, specified under the alternative minimum tax code, which are applicable to Merchant Marine construction funds, are not applicable for adjustments. The special deduction, that is allowable under the section 833(b) Blue Cross and Blue Shield organizations, is also not allowed for adjustments. The adjustments to be made in the adjusted current earnings. The adjusted current earnings adjustment is explained in the following section: Adjusted current earnings adjustment The adjusted current earnings adjustment is referred to as the amount that is equal to 75% of the amount by which a company’s adjusted current earnings exceeds its alternative minimum taxable income. This value is determined without including the alternative tax net operating loss deduction and adjusted current earnings adjustment. The rules that are applied in order to compute the adjusted current earnings are stated as follows: For a particular property that has been placed in service prior to 1994, the straight-line method is generally used in order to determine the depreciation, whereas the alternative depreciation system is used in order to determine the class life. In case of properties which have been placed in service, in and after 1994, no adjustment is done. The amount that is left out from the gross income under the regular tax rules, but is included in order to determine the earnings and profits, is included for the purpose of evaluating the adjusted current earnings. The inside build-up, resulting from a life insurance contract, is considered while calculating the adjusted current earnings and the related premiums for those life insurance contracts are tax deductible. The intangible drilling costs incurred by assimilated oil companies are required to be capitalized and henceforth, amortized over a 60-month time period. The regular tax codes, specified under the section 173, which allows the amortization of circulation expenses and section 248, that allows the amortization of organizational expenses, do not apply for adjustments. Fast in fast out (FIFO) and last in fast out (LIFO) methods should be applied in order to compute the inventory level. The installment sales technique may not be used in order to calculate the adjusted current earnings adjustment. The loss incurred on the exchange of a particular band of debt obligations cannot be recognized for another band of debt obligations, with effectively the same maturities and interest rates. The depletion for properties (apart from oil and gas) must be computed using the percentage method, instead of the cost method. The assets of a corporation, which has gone through a change of the ownership, must be calculated using their fair market values. However, that is a specific case. Other Rules The integration of the net operating loss carryover of the taxpayer and the foreign tax credits cannot minimize the tentative minimum tax of the corporation by more than 90 percent of the amount that has been evaluated, without considering the items mentioned above. The different types of non-refundable business credits, permitted under the regular tax code, are generally not allowed against the rules specified under the alternative minimum tax policy. If a particular corporation is liable to alternative minimum tax in a taxable year, then the amount of tax that exceeds the corporation’s regular tax liability is allowed as a credit, termed as the AMT credit. The AMT credit can be claimed in the subsequent taxable years to the limit the regular tax liability of the corporation exceeds its tentative minimum tax (Joint committee on taxation, “Background materials on alternative minimum tax and capital cost recovery prepared for the house committee on ways and means tax policy discussion series”). Calculation of alternative minimum tax The alternative minimum tax, introduced in the year 1969, is mainly applicable to corporations and limited liability partnership firms. It has been witnessed quite often that big corporations and small limited liability partnership firms avail all the benefits that are available in the tax laws and henceforth, end up paying a trifling sum of money as tax or virtually no tax at all. This is a result of an efficient and effective tax planning, done by their accountant or tax lawyers. The government has been reporting meager tax collections and as a consequence of that, they are not being able to invest in fruitful projects and even if they make an investment initially, they tend to face greater deficits down the line than what was anticipated. If these deficits are not met appropriately and at the right time, then it would lead to inflation within the economy, which might prove to be disastrous for upper-middle and middle income group people. This is precisely the reason why governments throughout the world have introduced the concept of levying minimum amount of tax, which is to be collected regardless of the benefits that are availed or received by the tax payers. The tentative tax is levied at 40% on the total taxable income and is computed as per the alternative minimum tax law for corporations. The alternative minimum tax is calculated at a rate of 20% on the book profit of a corporation. Book profit, also known as the corporate profit, is referred to as the profit which indicates the net income of the company as per the accounting records and is calculated by using several measures. The fact that the government is going back on the commitments, enunciated in the finance or tax laws, should not be misunderstood. The extra amount that is being collected by applying the provisions stated under the alternative minimum tax code, compared to the regular tax, can be adjusted in the subsequent taxable years, when the regular tax exceeds the alternative minimum tax. The extra payment that is made is referred to as the Alternative minimum tax credit. The following table explains the way the alternative minimum tax and alternative minimum tax credit are calculated. 1 2 3 (30% of total taxable income) 4 5 (20% of corporate profit) 6 (whichever is greater between the values in column 3 & 5) 7 (difference between the values in column 6 & 3) 8 Financial year Total taxable Income (in dollars) Tax at regular rates Corporate profit Minimum Alternate Tax Tax Liability AMT credit Cumulative AMT credit 1 100 30 350 70 70 40 40 2 200 60 500 100 100 40 80 3 300 90 300 60 60* -30 50 4 400 120 250 50 70** -50 NIL *The alternative minimum tax credit amount, in the financial year 3, is difference between the tax at regular rate and the actual alternative minimum tax liability (in this case, $90 – $60 = $30). This is the alternative minimum tax credit that is availed and is, henceforth, deducted from the total cumulative AMT credit of $80. The available balance of $50 is adjusted in following year. The effect of AMT rule The magnitude of the effect of AMT tax code on the cost of capital of firms depends largely on the timing and duration of the period of the liability that comes under the AMT tax code. A study conducted by Lyon (451-458), which focused on the investment incentives under the alternative minimum tax, revealed that firms are only periodically subject to AMT, instead of being perpetually subjected. The model implemented by the author highlighted that the effect of AMT on the cost of capital of the tax payer is quite distinct when the AMT liability is temporary, compared to the effect on the firm’s cost of capital when the AMT liability is permanent. The author considers firms that are subject to the AMT tax code at the time of acquiring assets, but in the subsequent periods, they are not considered. The way a firm finances its investments and activities, significantly affects the AMT that it is liable to pay. If a firm finances its investments through external debt and is initially liable to pay AMT, then its cost of capital is higher than what it would have been in case of regular tax rules, for both structures and equipments. As a consequence, the weighted average cost of both structures and equipments is also higher. Longer the expected period of AMT liability, higher is the rise in cost of capital of the firm. In the context of a firm which finances all its activities and investments through equity and no debt, it is also initially liable to pay the AMT and later is exempted from it. However, the effect of AMT is quite different, as far as the structures and equipment is concerned. The cost of structures of the firm is lower under the AMT rules, than that under the regular tax rules. Unlike the firm that is financed through external debt, in an all equity firm, the cost of capital is lower for a longer expected period of AMT liability. The effects are vice-versa in case of equipments. The cost in this case is higher under the AMT regulations, than that under the regular tax rules. Even so, this increase in not monotonic as far as length of the expected period of AMT liability is concerned. The firms cost of capital is certainly higher for a longer expected period of AMT liability. Nonetheless, the increase is limited to a certain extent. Beyond that certain limit, the users’ cost of capital starts to reduce for a longer expected period of AMT liability. Who are liable to pay the alternative minimum tax? This sometimes is a tough part to figure out. A taxpayer can be liable to pay the alternative minimum tax because of several reasons. The individual can be liable because of one big item on a tax return or maybe due to an amalgamation of many small items. Any particular individual can be a potential candidate to fall under the slabs of alternative minimum tax. It is widely suggested that any individual or a couple, who are filling a joint return with an annual income slab of $75,000 or more, are required to figure out the alternative minimum tax calculations. The taxpayers who are most vulnerable are the ones with children or tax dependants, who take home equity loan deductions and have significantly high capital gains. In addition to that, they bear high local and state taxes. The items mentioned are not deductible from the alternative minimum tax and thus, eventually expose taxpayers to the risk of incurring a high alternative minimum tax bills. However, it needs to be kept in mind that interest payments for home mortgage are certainly deductible under the AMT rules, but the limit is $1 million. The most important factor that the taxpayers or their accountants have to calculate is whether their regular tax is greater than that of the alternative minimum tax. If such is the case, then they are not liable to pay the alternative minimum tax. However, if the calculated regular tax comes out to be lower than the alternative minimum tax then the taxpayer alongside paying the regular tax will also have to pay the differential amount between the alternative minimum tax and the regular tax. The average alternative tax normally falls between the range of $2,000 and $15,000 (Koba, “The Alternative Minimum Tax Changes: CNBC Explains”). Reason behind upper middle and middle income groups paying the AMT The major reason than can be attributed to the upper-middle and middle income group individual, paying the alternative minimum tax, is inflation. Initially, the alternative minimum tax code was formulated in order to eliminate the usage of tax deductions and income deferrals and prevent corporations from paying very little or virtually no tax. Nevertheless, later on, the lower and middle income group individuals also started falling under the tax code specified under the alternative minimum tax policy. While non-AMT and regular tax brackets have had their share of exemptions and standard deductions, they were adjusted annually in order to consider the inflation. The alternative minimum tax brackets as well as exemptions were not adjusted for inflation, until very recently. So more and more people, whose income cultivated gradually with the growth of the economy, got included within the tax slabs specified under the alternative minimum tax rules and regulations each year. Given the fact that the alternative minimum tax exemptions and brackets were not adjusted in order to account for inflation, the tax policy in the US was severely criticized because of this. However, since then, rules under the alternative minimum tax code have transformed severely. Another fact, as highlighted by Koba (“The Alternative Minimum Tax Changes: CNBC Explains”), is that inflation was not the only reason that had led to more and more individuals to fall within the alternative minimum tax zone each year. The revisions, which were made in the AMT code during the 80s and 90s, had removed many deductions and as a consequence, many individuals had to pay the alternative minimum tax. In the recent past, the tax cuts in the Bush administration, between 2001 and 2006, reduced the regular tax rates for the majority of the income group, but the policymakers in that particular administration did nothing to change the rates and introduced more exemption policies for the alternative minimum taxes. This was also another reason that contributed significantly towards including more and more individuals, belonging to the upper-middle and middle income group, into the AMT zone. AMT patches In order to help the middle and lower income group avoid being hit by the alternative minimum tax, the United States Congress had passed temporary policy, during each of the previous seven years, by enacting what is called a patch. These one year patches have introduced certain exemption rules, which have significantly brought down the number of individuals falling under the alternative minimum tax zone. Changes in the AMT The changes, which have been made in the alternative minimum tax code, will result in a reduced number of individuals included under the zone of the tax code. The alternative minimum tax has been permanently indexed for inflation. This modification was done through the American Tax Payer Relief Act of 2012. The law came into effect on January 1, 2013; however, it was moderately active in the financial year 2012 as well. The changes that have been made in the Alternative minimum tax code include increased exemptions level for individuals with annual income up to $51,900 and for married couples with annual income up to $80,800, who will be filing jointly in the upcoming financial years. From now onwards, the exemptions will be indexed according to the inflation rate. This means that with rising inflation rate, the exemptions will also increase accordingly. Consequently, more and more people will be eliminated from the radar of the alternative minimum tax code. It had been estimated that if this modification had not been made, then nearly 34 million taxpayers would have been subjected to the alternative minimum tax code and this number was likely to increase in the subsequent years (Koba, “The Alternative Minimum Tax Changes: CNBC Explains”). Taxpayers can adopt various measures in order to avoid or minimize the effect of alternative minimum tax. The first and foremost step that can be considered is to accelerate income. Although this may seem an odd step, but as far as avoiding the alternative minimum tax is concerned, higher the income that an individual has relative to deductions, the better off he is. If the recipient knows beforehand about the time when he/she is supposed to receive annual bonuses and finally when he/she receives it, the individual has the option to run the numbers and then decide whether to receive the annual bonuses before or after the start of the following year. After deciding, the individual may act accordingly. Another strategy, which can be adopted by tax payers, involves planning itemized deductions. A great opportunity, in order to defer a deduction from one year to the next year, is the payment made for property tax. If the individual thinks that he/she might be in the danger of falling into the zone of alternative minimum tax, then deferring the property tax payment may solve the problem. Works cited Ashby, Robert. Comments to national taxpayer advocate on simplification issues. Tax Executive 53.5 (2001): 381-385. Print. Billings, B. Anthony and James L. Hamilton. Taxes and the acquisition of depreciable assets: The Tax Reform Act of 1986 and the alternative minimum tax. Journal of Accounting and Public Policy 21 (2002): 423-452. Print. Burman, Leonard E. The individual AMT: problems and potential solutions. National Tax Journal 55.3 (2002): 555-595. Print. Butrica, Barbara A. The implicit tax on work at older ages. National Tax Journal 59.2 (2006): 211-234. Print. Cummins, Jason G. and Kevin A. Hassett. The effects of taxation on investment: New evidence from firm level panel data. National Tax Journal 44.3 (1992): 243-251. Print. Givoly, Dan, Carla Hayn, Aharon R. Ofer and Oded Sarig. Taxes and capital structure: Evidence from firms’ response to the Tax Reform Act of 1986. The Review of Financial Studies 5.2 (1992), 331-355. Print. Graham, John R. Debt and the marginal tax rate. Journal of Financial Economics 41.1 (1996): 41-73. Print Hicks, Kenneth E. and Katie Feibelman. What is the alternative minimum tax and are you in danger of paying it? Accounting Notes. American Optometric Association, 3 December. 2006. Web. 14 January 2014. Joint committee on taxation. “Background materials on alternative minimum tax and capital cost recovery prepared for the house committee on ways and means tax policy discussion series.” Joint committee on taxation. JCT, 8 March. 2002. Web. 15 January 2014. Koba, Mark. “The Alternative Minimum Tax Changes: CNBC Explains.” CNBC Explains. CNBC, 22 March. 2013. Web. 15 January 2014. Lyon, Andrew B. Investment incentives under the alternative minimum tax. National Tax Journal 43.4 (1990): 451–458. Print. Schnur, Joyce. Today’s alternative minimum tax affects many more. Pennsylvania CPA Journal 76.4 (2006): 1. Print. Read More