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.

Finally, be aware of AMT's ramifications for investing. You'll want to keep private-activity municipal bonds issued after August 7, 1986, out of the portfolios of alt min clients, since the interest income is taxable under the alternative regime.

It's also probably wise to revisit the benefit of muni investing for clients who pay a lower marginal rate under AMT than when the regular tax applies. Suppose a client historically in the 35% regular bracket is struck by AMT and falls in its 28% bracket. Ignoring state taxes, the taxable equivalent yield of a muni paying 4.75% is only 6.60% when this client is in AMT (4.75% tax-free yield, divided by 100% minus 28% tax rate paid), versus 7.31% under the regular tax. Depending on bond market conditions, that could influence how you invest.

Rising Deficit, Rising Taxes?

Whether you're a Bush backer or a Bush whacker, it's no secret that the long-term capital gains rate and top ordinary tax bracket are at their lowest in most clients' lifetimes-15% and 35%, respectively. "The question is, what do you believe is going to happen to rates in the future?" says Susan Hirshman, a managing director and planning strategist at JP Morgan Fleming Asset Management, in New York. Like many planners, Hirshman believes taxes are more likely than not to rise as Washington grapples with war and a record deficit.

This camp of advisors touts acting to take advantage of the historically cheap rates. For instance, in some circumstances it may be worth accelerating ordinary income into 2004 "to lock in a lower tax rate," Hirshman says. Other practitioners are recommending that clients consider realizing gains on low-basis assets.

Freedman, for example, recently recommended that a new client, age 62, sell an appreciated real estate investment rather than defer the tax with a Section 1031 exchange, which the client had done in the past. Freedman says, "I delved into his goals and risk tolerance and said to him, 'The opportunity to pay about 23% combined federal and state tax on significant gains is a small price for ending up with $700,000 of after-tax money that can be diversified.'"

Not all planners agree, however. "I'm not going to make recommendations based on a hunch about tax rates," scoffs one. You and your clients will have to make up your own minds.

Tax Planning Tidbits

Parents' medical costs. With many middle-aged clients now caring for elderly parents, you should be aware that a taxpayer can deduct medical expenses paid for someone who is not a dependent-provided the only reason the individual cannot be claimed as a dependent is due to earning more than $3,100 in 2004, according to Thomas. But of course, to be deductible the total medical expenses paid by the client must exceed 7.5% of AGI (10% when alt min applies), so plan the timing of payments carefully. To avoid gift-tax issues, the client should pay the medical provider directly, Thomas advises.

The $160,000 cliff. The above-the-line deduction for college tuition is now available to joint filers with incomes as high as $160,000 and singles earning $80,000 (vs. $130,000 and $65,000, respectively, last year). One dollar of income above the threshold eliminates the deduction entirely. Don't go there.

Rethink qualifying dividends for margin clients. Itemizers may deduct investment interest up to the amount of their investment income, a category that does not include dividends taxed at the 15% rate introduced by the 2003 tax act, says Jon S. Chernila, managing partner of Chernila & Pesin LLP, a CPA and business consulting firm in Fountain Valley, Calif. Chernila had one client who fared better last year by electing to forego the 15% rate on $1,000 of dividends (and instead pay tax at his ordinary rate) in order to deduct $1,000 of margin interest. Opting out of the 15% rate saved the client $150 in federal income tax, demonstrating that the break isn't always beneficial for margin investors. Keep that in mind when devising investment plans.

Last call for bonus depreciation. Business owners who place new equipment in service by year-end are entitled to deduct 50% of its cost-so-called bonus depreciation. This is the final year this goodie is allowed.

Review 2003 business tax returns. A new Internal Revenue Service regulation lets business owners amend their tax returns to include or increase the code Section 179 deduction (write-off of equipment purchases, including off-the-shelf software). Under prior rules, you couldn't change the amount of the deduction on an amended return, says Andy Biebl, a principal in the New Ulm, Minn., office of LarsonAllen, a CPA, consulting and business advisory firm. "However, the new opportunity only applies to tax years beginning in '03, '04, and '05," Biebl says. A review of clients' 2003 returns could identify opportunities to increase the deduction post hoc and get a refund of tax.

Last-minute charitable gifts. A contribution sent to a charity by U.S. mail is deductible in the year mailed. But when a private carrier is used, you get the deduction in the year the charity received it-"argument being that you can call the carrier until the moment they deliver the package and tell them not to deliver it," says Jeffrey Lauterbach, chairman, president and CEO of The Capital Trust Company of Delaware. "You can't do that with the U.S. mail," he says. Bottom line: Let the postal service deliver eleventh-hour contributions for you.