AMT Calculation: How to Master Tax Strategies

Navigating taxes can be tricky, especially when it comes to the Alternative Minimum Tax (AMT). Designed as a parallel tax system, the AMT ensures that high-income earners pay a fair share of taxes by recalculating income tax liability. It achieves this by adding back certain deductions and credits allowed under the regular tax system, targeting individuals, estates, and trusts with higher incomes.

For finance professionals, particularly in growth equity, venture capital, and private equity, understanding the AMT is essential, as it influences investment strategies and financial planning. Having invested across multiple Y Combinator batches, I’ve seen firsthand how AMT considerations can impact startup valuations and exit strategies.

Let’s discuss AMT further below.

How AMT is Calculated

Calculating the AMT involves determining the Alternative Minimum Taxable Income (AMTI), which starts with the taxpayer’s regular income. Certain disallowed deductions and credits are added back, creating a more comprehensive measure of taxable income that reflects the taxpayer’s true economic capacity. Key adjustments and preferences include:

Disallowed and Allowable Deductions and Adjustments

The AMT disallows several deductions permitted under the regular tax system, significantly increasing the taxable income of those affected. 

Among the most impactful are state and local tax deductions (SALT), including property, income, and sales taxes. The disallowance of SALT deductions under the AMT can significantly increase taxable income for affected taxpayers. However, the exact financial impact and percentage of affected taxpayers vary depending on individual circumstances 

Similarly, personal exemptions, which reduce taxable income based on dependents, are disallowed under the AMT, disproportionately impacting families with multiple dependents in high-tax areas. Together, these adjustments account for a substantial portion of AMT preferences, raising effective tax rates and liabilities.

Other key disallowed items include:

• Interest on Private-Activity Municipal Bonds: Typically tax-exempt under the regular tax system, this is added back under the AMT.
• Miscellaneous Itemized Deductions: These include unreimbursed employee expenses, investment fees, and legal fees are excluded, contributing 20% to total preferences.
• Net Operating Losses (NOLs): Only a portion of NOLs can offset AMTI, contributing 11.9% to adjustments.
• Incentive Stock Options (ISOs): The “bargain element” of ISOs is included in AMT as a preference item. It can lead to significant tax liabilities for taxpayers subject to the AMT. Equity Options like ISOs can be a valuable component of compensation packages, especially in high-growth industries. You can consider using a cashless exercise strategy to manage your stock options effectively.   

Despite these limitations, certain deductions remain permissible under the AMT. This offers taxpayers opportunities to reduce liability. These include:

• Mortgage Interest on Home Loans: Allowed for loans up to $750,000 of qualified debt (or $1 million for loans before December 16, 2017), provided the loan is used to acquire, construct, or improve a primary or secondary residence.
• Charitable Contributions: Fully deductible, including cash donations, non-cash assets like appreciated securities, and property donated to qualified charities, making philanthropy a strategic way to reduce taxable income.

Steps in the Calculation

Calculating the AMT involves a step-by-step process to determine the taxpayer’s liability under this parallel tax system. Below is an explanation of the steps and an example for clarity.

Step 1: Determine the Alternative Minimum Taxable Income (AMTI)

Start by adding back disallowed deductions and adjusting the taxpayer’s regular taxable income. This includes items such as SALT, interest on private-activity municipal bonds, and the bargain element of ISOs.

For example, Alice, a single taxpayer, earns $100,000 in W-2 wages and exercises ISOs with an options strike price of $100 and a fair market value of $200. This results in an additional $80,000 of bargain element added to her income. Her AMTI is calculated as follows:

AMTI = $100,000 (regular income) + $80,000 (bargain element) = $180,000

Step 2: Subtract the Exemption Amount

A specific exemption, based on the taxpayer’s filing status and income, is subtracted from the AMTI. This exemption is higher than the regular income tax exemption and is adjusted annually for inflation. However, the exemption phases out for higher income levels, reducing its benefit.

For example, for single taxpayers in 2019, the exemption amount is $71,700. Subtracting this from Alice’s AMTI:

Taxable AMT Income = $180,000 – $71,700 = $108,300

Step 3: Apply the AMT Tax Rates

As per the Tax Policy Briefing Book, the AMT uses two tax rates: 26% and 28%, depending on the level of taxable AMT income. The 26% rate applies to incomes up to a specified threshold ($220,700 in 2023), while the 28% applies to amounts above the threshold.

For example, since Alice’s taxable AMT income of $107,100 falls within the 26% bracket, her AMT liability is:

AMT = $108,300 * 26% = $28,158

Step 4: Compare Liabilities

The AMT liability is then compared with the regular income tax liability. The taxpayer pays the higher of the two amounts.

For example, Alice’s regular federal income tax liability is $15,246, but her AMT liability is $30,246. Since the AMT is higher, she must pay the additional tax, effectively doubling her tax liability despite significant deductions and credits under the regular system.

Note: Keep in mind that taxpayers use Form 6251 to calculate their AMT liability, which provides specific instructions for including adjustments and disallowed tax breaks. 

Statistics and Examples

The AMT’s impact on taxpayers and federal revenue is noteworthy. In 2022, it raised billions and affected 0.1% of households. primarily those in higher-income households, including:

• Households with income between $200,000 and $500,000
• Those with incomes between $500,000 and $1 million
• Households with incomes greater than $1 million

For finance professionals, understanding the AMT is crucial, as it can influence investment decisions and tax planning strategies.

Consider a case study of a married couple filing jointly with two children, earning $200,000 in wages and having $10,000 in long-term capital gains. Their regular tax liability is $32,341, but they are subject to the AMT and must pay an additional $2,296 in tax. 

If they realize an additional $1,000 in long-term capital gains, their alternative minimum taxable income rises by $1,000, resulting in a $250 drop in their AMT exemption. 

Consequently, they pay 15% on the $1,000 gain and an additional 26% on the $250 no longer sheltered by the exemption. The family’s total income tax payment increases by $215, corresponding to a marginal tax rate of 21.5% on the additional $1,000 capital gain.

Strategies to Minimize AMT Impact

Minimizing the impact of the AMT is a critical aspect of financial planning, especially for high-income individuals and corporations. Effective strategies combine proactive tax planning with a deep understanding of available credits and carryforward provisions. Here are key approaches:

Leverage AMT Credits and Carryforwards

The AMT Credit offers an opportunity for taxpayers to offset future tax liabilities. For corporations, it allows them to carry forward unused credits from prior years and claim a portion as refundable.

Corporations can do this under the guidance of the Refundable AMT Credit provision. Corporations could claim 50% of their carryforward credit as refundable in taxable years beginning after 2017 and before 2022. 

Credit carryover as a refundable credit, unless they elect to take the entire refundable credit amount in 2018. The entire remaining carryforward becomes fully refundable in tax years beginning in 2021. This provided significant relief and an avenue for tax savings. For example, in 2018, a corporation with a $12 million AMT Credit carryover could only claim $6 million as refundable due to these limitations.

Section 383 Credit Limitation supports restricting the refundable portion based on taxable income, which can create challenges for taxpayers trying to maximize the credit. 

Proactive Tax Strategies

For finance professionals, especially those in high-income brackets or with complex financial portfolios, minimizing the 

impact of the AMT is a key strategy. Here are some effective approaches:

1. Defer Income to Future Years: By delaying income or bonus payments to the next tax year, taxpayers can reduce their Adjusted Gross Income (AGI) and potentially avoid triggering the AMT. This is particularly useful for individuals expecting substantial income increases in the current year.
2. Contribute to Retirement Plans: Contributions to traditional retirement accounts, such as 401(k) or 403(b) plans, reduce taxable income and can help minimize AMT liability. For self-employed individuals and small business owners, a Solo 401(k) provides similar benefits.
3. Utilize Charitable Remainder Trusts (CRTs): Donating assets to a charitable remainder trust can reduce taxable income while aligning with philanthropic goals. This strategy not only minimizes AMT liability but also supports long-term estate planning objectives.
4. Optimize Investment Timing: Consider realizing capital gains in years with lower income or deferring sales to avoid additional AMTI increases. Evaluating investment timing can help manage income levels and minimize exposure to AMT.

These strategies are not only effective in minimizing AMT impact but also align with broader financial planning goals, making them valuable tools for finance professionals.

When to Seek Professional Help with AMT

While proactive strategies can minimize AMT liability, certain situations call for expert advice:

• Complex Financial Situations: Taxpayers with diverse income streams, multiple investments, or ownership of businesses often face intricate AMT rules. Professionals can provide tailored advice to optimize tax strategies and manage liabilities effectively.
• High-Income Scenarios: High-income earners with significant deductions, such as SALT, are more likely to encounter AMT challenges. Tax professionals can identify potential pitfalls, help ensure compliance, and avoid unexpected liabilities.
• Understanding AMT Credits and Carryforwards: Navigating the limitations and refundability of AMT credits can be challenging. Professionals can assist in maximizing these benefits and planning for future tax liabilities, especially for corporations or individuals with significant carryforward amounts.
• Approaching Exemption Phase-Out Thresholds: Taxpayers nearing the income thresholds where AMT exemptions phase out may face higher liabilities. Expert advice can help mitigate the impact and develop strategies to manage income levels and deductions effectively.

For finance professionals, knowing when to seek help is as critical as understanding the tax rules themselves. Partnering with experts not only simplifies navigating the complexities of the AMT but also enhances financial planning and decision-making, ensuring optimal outcomes for personal and professional objectives.

As part of that process, asking the right questions for startups can provide valuable context when evaluating equity structures, stock options, or exit strategies.