The Tax Man's Surprise

Congratulations, doctor. You may be a member of an elite club. As an upper-middle-income taxpayer, you have a good chance of being snagged, perhaps for the first time, by something called the alternative minimum tax (AMT).

Never heard of it? You will. It's an alternative income tax structure -- a kind of bizarro-world assessment system, really -- created in 1970 to prevent the ¸ber-wealthy from hiding money in vast tax shelters that in many cases kept them from paying any tax at all.

It may have been a pretty good idea at the time. "Unfortunately it kind of sat out there and has sat out there for 35 years and has never been indexed for inflation," explains James Wilson, a financial planner based in Columbia, S.C. Over the years the AMT has been swallowing more and more taxpayers, oblivious to the higher prices and rising incomes that come with time in a normal economy.

"About two-thirds of our clients are physicians, and 15 percent to 20 percent were affected by the AMT at least somewhat in 2004," Wilson says. "Two or three years from now it's probably going to be double the percentage it is currently, and maybe even more. I've seen some estimates that say that by about 2010, a third of all taxpayers -- but more importantly, about 90 percent of taxpayers with adjusted gross incomes over $100,000 -- will be affected by the AMT."

Financial planners and tax advisers are just about unanimous in their distaste for the AMT. Wilson is no exception. But he sees little hope for reform as long as "the government is addicted to the money," and as long as most Americans view it as someone else's problem.

"Maybe it'll just have to take a mammoth number of people to be affected to rally the Congress to change this thing," he says. "But you can just see the headline: 'Congress considering changing AMT system, allowing more loopholes for rich and wealthy.' And that's not the case. If you just indexed the doggone thing for inflation, that would probably take it down to affecting just a teeny fraction of the people it's affecting now."

Is it you?

Determining whether you will or won't be affected by the AMT is a complex calculation. Unless you happen to be particularly skilled in tax preparation, it's not a good idea to try to figure it out on your own. But in general, here's how it works:

The AMT establishes a tax floor; anyone whose tax obligation falls below the minimum under the conventional income tax calculation must pay under the alternative system.

Curiously, the alternative minimum's tax rate -- 28 percent for most taxpayers -- is actually lower than the conventional system's top marginal tax bracket of 35 percent. Thus you might think it's no big deal.

The problem is that the AMT disallows all but the most basic deductions that most taxpayers are accustomed to taking. In fact, the only deductions you can still take under the AMT are those for the interest on your home mortgage and/or home-equity loan, and your charitable donations.

"You don't get medical deductions, you don't get employee business expenses, or investment interest, or casualty losses," says John Rodgers, a Los Angeles-area lawyer and accountant. High-income taxpayers in particular have come to rely upon these deductions to reduce their tax burdens to reasonable levels.

Rodgers offers this example: suppose you and your spouse have a combined income of $300,000; you file jointly. You have deductions of $56,500 for your mortgage-interest and charitable donations, and you get the standard personal exemption of $43,500. You'd pay 28 percent of the remaining $200,000 -- $56,000. That's the least you'd owe in taxes. If you have a bigger obligation under the conventional income tax system, then you'd pay that, but that's unlikely.

But the biggest difference: taxpayers who are accustomed to deducting their local and state property taxes from their federal income taxes will find to their horror that that's a no-no under the AMT.

And it's a huge no-no for homeowners who live in high-tax, high-property-value states, like New York and California. For them, the difference is colossal.

"Things like that go out the window, so it's a recalculation of what constitutes income," says Wilson. "A lot of people get confused about it because the AMT rates are actually lower than the top marginal tax rate right now. And so sometimes people say, 'Well, who cares?' And I always say, 'Whoa, wait a minute, you do care, particularly if you live in New York or California or some of the other high-tax states. It's going to affect you more ... than if you live in a lower-tax state like Florida or Texas.'"

Pick up the phone

What can you do about it? Not much. But not nothing, either. The most important thing is that you start planning now for the possibility that come tax time next year, you're going to get creamed. Don't wait until next February or March. If there's even the slightest chance that you'll be affected by the AMT -- and if you make a six-figure income, maybe less, there is -- you need to pick up the phone and call your tax adviser. Make an appointment, get an assessment, find out where you stand.

"In the fall of every year, sit down with your tax adviser and your financial adviser and really look at what your tax picture looks like that year and whether it looks like you're going to be subject to the AMT or not," Wilson urges. "If [physicians] take that hour or so every year in the fall, and they have the right adviser looking at it, it probably would be the best hour they spent all year. But they often don't, and I've heard accountants say, 'Yeah, if they had done that in the fall, we could probably solve it. But when they do it in March, it's too late.'"

Yet Wilson and others agree that "solve it" is too strong a promise. Short of Congressional action eliminating or reforming the AMT, there really is no solution. But there might be ways to avoid it, at least some of the time, and there might be ways to minimize its impact if it does hit you. "You can't make it go away," says Wilson. "But you can probably treat it."

How? For people on the cusp of being affected by the AMT, Wilson suggests a two-year approach, with the goal of avoiding it every other year.

Here's the plan: defer as much of your two-year income as possible into the year you know you'll be hit by the AMT. You're paying a flat rate, anyway, as opposed to a graduated income tax, so at least the tax penalty of having a higher income is slightly diminished.

Meanwhile, maximize your deductions in the year you hope to avoid the AMT; if you're lucky, your income deferral will have worked, and you'll pay your taxes under the regular system that year. In that case, those deductions will count.

Expecting a big year-end bonus? Find out if it can be paid in January. Planning to make a big gain by selling that stock your brother-in-law recommended? Maybe you could sell some of it this year, some of it next year.

"I always tell people, you really can't solve it one year at a time," says Wilson. "It may not be solvable anyhow, but ... you have to look at it this way: 'If I really can't make it go away' -- which is the reality; you really can't make it go away -- 'then can I push some of my deductions into a year when they'll actually count, and my income into the AMT year?' Some physicians, depending on their practice set-up, may have that ability; others, who work for large corporate practices where they have no control over how they're paid, may not have that ability."

Better be an owner

That's why Rodgers says partners and practice owners are in a much better position, AMT-wise, than employed physicians. Personal income tax deductions are largely disallowed under the AMT, so physicians who spend their own money on business expenses, such as travel, can't deduct those expenses from their income taxes.

But partners and business owners can deduct those expenses before determining their personal income for tax purposes.

For instance, suppose you own a practice and your annual revenue is $250,000. You would deduct normal business expenses such as the lease on your office, the car that takes you to work, etc., before figuring out what to put at the top of your income tax form.

"So, frequently you end up with $100,000 instead of a quarter-million" after the business expenses are deducted, says Rodgers. "Those two numbers are netted directly right off the bat before you start tinkering around with the AMT. That's a huge benefit."

Beyond that, the only strategies for mitigating the AMT's effects are to maximize the two deductions it allows you -- charitable donations and mortgage interest. Rodgers suggests making a habit of donating old personal items every year.

"Old furniture, appliances, sports equipment, consumer electronics -- those all go to Goodwill," he says. "Clean out your garage every year, and donate at least $5,000 worth of noncash charitables -- that's the limit before you need an appraisal."

And if you were planning to give a certain amount of money to a cause -- say, your church's building fund -- over several years, consider giving all the money in one year, particularly if your AMT problem is a one-year-only deal.

Meanwhile, consider your mortgage. "The refinancing boom over the last few years has probably kept the percentage of people affected by AMT down a little," says Wilson.

One of the perverse things about the AMT is that it encourages people to consider financial moves that under different circumstances might seem unnecessarily risky. You may think owning a lot of equity in your house is safe, but you might be better off heavily leveraged, with most of your mortgage payment going to interest.

"So," says Rodgers, "to sum up: first, don't be an employee. Second, if you are an employee, have a huge house. Third, maximize your charitables. Fourth, if you're a partner or self-employed, make sure your tax professional is maximizing your business expenses and netting them directly against your income."

And fifth: write your congressman.

Bob Keaveney,the executive editor of Physicians Practice, has been writing about healthcare and business for more than seven years. Before joining Physicians Practice, he was the senior writer at The Daily Record, a business and legal newspaper in Baltimore.

He can be reached at bkeaveney@physicianspractice.com.

This article originally appeared in the September 2005 issue of Physicians Practice.