With few new rules taking effect in 2004, end-of-year tax planning is-guess what?-more complicated than ever. The inscrutable alternative minimum tax tops the list of concerns for advisors, with uncertainty about tax rates a respectable second. Careful, well-informed analysis in these and other areas can set you apart from your competitors.
AMT Planning
The alternative minimum tax-which, as you undoubtedly know, is a set of tax rules that apply when they produce a higher IRS bill than would the regular rules-isn't so alternative anymore. Between 2.5 million and 3 million taxpayers will pay the tax for 2004, recent estimates suggest. The figure is expected to quadruple in '05 and continue rising if Congress doesn't act.
"You should do multiyear tax projections, beginning with 2004, for every client who itemizes and earns $75,000 or more annually" to see when they'll owe AMT, says Mitchell Freedman, a CPA/PFS and president of MFAC Financial Advisors Inc., in Sherman Oaks, Calif. Unfortunately, little can be done to help clients who are perennially in the alt min soup. With others, however, you may be able to play the AMT years against the non-AMT years, Freedman says.
One way to game the system is for itemizers to pay, in the non-AMT years, deductions that are lost under alt min, including state income taxes, property taxes and miscellaneous deductions such as advisory fees and unreimbursed employee business expenses. Freedman urges advisors to be proactive in telling clients that procedures they may have followed in the past, such as remitting fourth quarter state estimated taxes in December, or paying a full year of real estate taxes before they are due, may now be damaging, rather than beneficial.
Whether it pays to shift income depends upon the relationship between the client's tax bracket in AMT and non-AMT years. On the face of it, alt min's published rates-26% on the first $175,000 taxable, 28% thereafter-may appear lower than the client's regular bracket. And long-term capital gains ostensibly continue to be taxed at 15% under alt min. But don't be fooled.
The alternative tax system gives its victims an exemption from income. However, if their income lies within a certain range the exemption is reduced, which exposes additional dollars to taxation. One dollar of incremental income actually renders $1.25 taxable. So the effective tax rate is 25% higher than the nominal rate for clients subject to phase-out, says Kaye A. Thomas, a tax attorney and author who maintains a free online tax guide, www.fairmark.com. (See sidebar, The Structure of AMT.)
Consider the case of a married couple with alternative minimum taxable income of $250,000. The couple is $100,000 into the phase-out range, so their exclusion is reduced by $25,000, to $33,000 ($58,000 maximum exemption, minus $25,000 phased out). So they're taxed on $217,000 ($250,000 AMTI, minus $33,000 exemption).
Now throw in $1,000 more income. That would trigger tax of $280 (since the couple is in the 28% AMT bracket), plus 28% on another $250 that is taxable because the exemption is reduced further (equals a $70 tax), for a total of $350, or 35%.
Similarly, when a client has landed in alt min because of a large capital gain, even though the gain itself is assessed 15% it lowers the income exemption. "As a result, you can pay six-and-a-half or seven percentage points more tax on a capital gain under the AMT than you would under the regular income tax," Thomas says. Clearly, long-term gains should be taken in non-AMT years whenever possible.
AMT clients with an income above the phase-out range, however, truly are taxed at 28% on the margin. If that's lower than their regular tax bracket, consider pushing income into AMT years. Or, shift deductions allowed under both tax regimes (such as charitable contributions) to non-AMT years, when they'll offset income taxed at a higher rate.