AMT & Capital Gains

[Anarchrist]

Client has AGI of $500k which includes $355k of LTCG. Due to the income level, he is being hit by the AMT. He doesn't understand why the capital gains are subject to AMT and states I'm the first person who ever told him that the gains may be taxed higher than the 15% rate. I think I got him to understand that the gains were still taxed at 15% in the AMT calculation. However, the income level causes the AMT exemption to be phased out. He claims this causes his capital gains to be taxed twice and all his legal and financial advisors have always told him they are never taxed more than 15%.

His eyes didn't glass over as is usually the case when I start explaining tax law to clients, but I just couldn't figure out a way to simply explain the AMT so he understood what was happening. Since he thinks I'm wrong he plans on getting a second opinion. That doesn't bother me, but I think he is going to go to a big 4 or other large firm for the second opinion which will probably cost him a couple grand. If I can explain this satisfactorily to him, I could save him the large fee.

Any ideas on how to explain the AMT and how capital gains are affected by it to a client?

Thanks,
Dave

[JoshinNC]

No, let him pay a couple grand

to get the same answer. At least it will be tax deductible and you look just as smart as a Big 4, Harvard educated tax accountant.

[veritas]

I may have asked this before

But what is an Anarchrist?

[Anarchrist]

to get the same answer. At least it will be tax deductible and you look just as smart as a Big 4, Harvard educated tax accountant.

Well, yeh. Like I said, it certainly doesn't bother me for him to get a second opinion, but I feel I should be able to provide a satisfactory answer to the client.

[Burke]

At that income level, his itemized deductions and exemptions are also subject to being phased out, you could point that out to him, as well as his AMT exemption. I just had one approximately the same situation and figures as yours, and I went down the 1040 and the 6251 and pointed it out to him line by line.

[Roland Slugg]

Hello Anarchrist

The explanation in your original post was correct ... and probably better than many could provide.

You might wish to add that in figuring the AMT his personal exemptions are lost and so are all his deductions for taxes ... state income and real estate likely being the two largest. He may also be losing some credits. Be careful, though, because at $500k of income he may already be losing his personal exemptions and a large portion of all his itemized deductions.

The capital gains rate when AMT kicks in can (and often does) exceed 15%. This is because during the AMT phase-out stage every $400 of additional income causes the AMT exemption to be reduced by $100. This, in turn, causes the effective tax rate on LTCGs to be 18.75% (15% x 1.25). At the current AMT exemption levels ($44,350/$66,250) that 18.75% rate can apply to up to $177.4k or $265.0k of capital gains.

The AMT also has the affect of eliminating the 10%, 15% and 25% tax rates on ordinary income, taxing it instead at 26% or 28%. The latter phenomenon works in reverse when a T/P gets into the 33% and 35% brackets (as well as the 28% bracket some of the time), but in your client's case he was below the 28% bracket for most or all (depending on his filing status) of the ordinary income portion of his taxable income

One of congress's stated objectives regarding the AMT and capital gains was to maintain the 15% tax bracket. As you can see that objective is not met by the current law.

[WD Kebschull]

Re-check the Effective Marginal Capital Gains Rate

Roland Slugg wrote:

"The capital gains rate when AMT kicks in can (and often does) exceed 15%. This is because during the AMT phase-out stage every $400 of additional income causes the AMT exemption to be reduced by $100. This, in turn, causes the effective tax rate on LTCGs to be 18.75% (15% x 1.25). At the current AMT exemption levels ($44,350/$66,250) that 18.75% rate can apply to up to $177.4k or $265.0k of capital gains."


Actually, while capital gains are reducing the AMT exemption the effective marginal LTCG on capital gains is 15% plus 26%/4 for a total of 21.5%.

Cheers,

WDK

[Roland Slugg]

Huh????

No, the effective tax rate on ordinary income is increased by 6.5% (to 32.5%) if the AMT exemption is being phased out, but the effective rate on LTCGs is 18.75%. That's because the phase out adds 25% to the AMT tax rate applied to the different classes of income.

If you have trouble seeing this intuitively, it can easily be proven (if you have access to tax prep software) by taking a single taxpayer, under 65, with no dependents and taking the standard deduction. Assume his only income is a LTCG of $275,000. His tax is $39,120, which includes some AMT. Now increase that LTCG by $10,000 to $285,000. The tax becomes $40,995 ... an increase of $1,875, or 18.75% of the $10,000 higher gain ... and the AMT exemption is in the phase out stage for both gains.

[WD Kebschull]

Bad me!

Roland:

You are correct. A year or so ago I did some test cases that revealed that capital gains were taxed at a higher rate under the AMT but I apparently missed the fact that the increased rate was only 18.75%, not 21.5%.

Cheers.

WDK

[WD Kebschull]

Need to look at the Internal Reveue Code on This One

Client has AGI of $500k which includes $355k of LTCG. Due to the income level, he is being hit by the AMT. He doesn't understand why the capital gains are subject to AMT and states I'm the first person who ever told him that the gains may be taxed higher than the 15% rate. I think I got him to understand that the gains were still taxed at 15% in the AMT calculation. However, the income level causes the AMT exemption to be phased out. He claims this causes his capital gains to be taxed twice and all his legal and financial advisors have always told him they are never taxed more than 15%.

His eyes didn't glass over as is usually the case when I start explaining tax law to clients, but I just couldn't figure out a way to simply explain the AMT so he understood what was happening. Since he thinks I'm wrong he plans on getting a second opinion. That doesn't bother me, but I think he is going to go to a big 4 or other large firm for the second opinion which will probably cost him a couple grand. If I can explain this satisfactorily to him, I could save him the large fee.

Any ideas on how to explain the AMT and how capital gains are affected by it to a client?

Thanks,
Dave

I think that I would complete the client's return according to the client's understanding, attach a Form 8275 or 8275-R and a copy of section 55(b)(3) of the Internal Revenue Code. I looks to me like the client is on to something. As I read section 55(b)(3), the capital gains should not contribute to the reduction in the AMT exemption amount.

Several years ago Form 6251 resulted in all capital gains being taxed at the higher rate under the AMT when the the regular taxable income excluding capital gains was negative. That was the result of a drafting error by Congress. The effect of that was an extra tax of over $6000 for someone filing MFJ (10% of the taxable income threshold for the 25 percent tax rate). As I recall this was fixed by legislations contained in the Working Families Tax Relief Act of 2004. Also, as I recall, this issue uncovered by Deloitte and Touche and was reported in Forbes.

Cheers,

WDK

[WD Kebschull]

Maybe Not So "Bad Me"

No, the effective tax rate on ordinary income is increased by 6.5% (to 32.5%) if the AMT exemption is being phased out, but the effective rate on LTCGs is 18.75%. That's because the phase out adds 25% to the AMT tax rate applied to the different classes of income.

If you have trouble seeing this intuitively, it can easily be proven (if you have access to tax prep software) by taking a single taxpayer, under 65, with no dependents and taking the standard deduction. Assume his only income is a LTCG of $275,000. His tax is $39,120, which includes some AMT. Now increase that LTCG by $10,000 to $285,000. The tax becomes $40,995 ... an increase of $1,875, or 18.75% of the $10,000 higher gain ... and the AMT exemption is in the phase out stage for both gains.

Roland:

You are right based on the results produced by the 2007 Form 6251. However, when
I recalculated the AMT on my 2002 Federal Income Tax Return after adding $10,000 of LTCG the effective tax rate on the additional capital gains was 26.5%. That was $2000 ($10,000 X 20%) for the capital gains plus $650 ($10,000/4 X 26%) as a result of the reduced exemption amount. On the recalculated 2002 Form 6251 the amount reported on Line 42 increased $650 and the amount of Line 52 increased $2000.

Form 6251 has been rejiggered twice since 2002. See my prior post of today regarding one of these rejiggerings.

I think the question now is, "Are the instructions related to capital gains on Form 6251 consistent with section 55(b)(3) of the Internal Revenue Code?" .

Cheers,

WDK

[outwest]

I think how I would explain it is..

First, I would note that in lower income ranges, everyone has some income taxed at 0% due to standard/itemized deductions and their personal exemptions.

However, as income grows, some of that 0% income becomes taxable due to the phaseouts. The consquence is that $100 of extra capital gains may raise taxable income by $125.

$125 * 15% = $18.75.

So, you are both right. The legal rate is 15% but the effective rate is 18.75% due to the effect of the phaseouts.

Doug

[Anarchrist]

attach a Form 8275 or 8275-R and a copy of section 55(b)(3) of the Internal Revenue Code. As I read section 55(b)(3), the capital gains should not contribute to the reduction in the AMT exemption amount.

Interesting idea. 55(d)(3) states the exemption is phased out based on alternative minimum taxable income exceeding $150,000. I believe the AMT taxable income includes the capital gains, so the exemption would be phased out by the gains. Am I wrong in my thinking? I'm a far cry from a AMT expert.

[FEDUKE404]

Use the Cheshire Cat comparison

I've found this approach is understood by most folks, unless they are absolute number crunchers and/or lawyers:

At a sufficiently high income level, certain things you think are deductible slowly start to fade away. The income tax rates may not go up, but instead your allowable itemized deductions shrink. (Challenge: Tell them to add the numbers on a high-income Sch A and compare them with the number on the bottom of the form!) You may think you get a fixed personal exemption for each of those little dearies in the household, away at college, or whatever, but make too much moola and guess what?!? ......nothing but a smile remains!

I'm sure you can elaborate further......

As for the AMT, the simplest explanation is the guvment doesn't think you paid enough tax in the first place!

FE

[WD Kebschull]

Interesting idea. 55(d)(3) states the exemption is phased out based on alternative minimum taxable income exceeding $150,000. I believe the AMT taxable income includes the capital gains, so the exemption would be phased out by the gains. Am I wrong in my thinking? I'm a far cry from a AMT expert.

Hey, you are right! I tripped over "taxable excess" in section 55(b)(3)(A). But it still makes no sense, philosophically, to use capital gains in calculating the exemption amount.

Cheers,

WDK