Beware of the Alternative Minimum Tax

This week, Gail explains why you should always try to minimize your exposure to the Alternative Minimum Tax -- the Number One problem facing individual taxpayers today in the United States.

Gail,

The S-Corporation I am 50% owner in just won a $400,000 settlement in a lawsuit. After paying lawyers and legal bills, I should get about $150,000 as my share before taxes.

First: Is the settlement taxable? Second: How can I minimize taxes so that I do not lose $60,000 of it off the top?

Appreciate your help

John

Dear John-

Sorry to be the bearer of bad news, but you're toast. And your tax bill could actually be a lot higher than you think.

According to Martin Nissenbaum, National Director of Personal Income Tax Planning at Ernst & Young, "In general, any settlement is taxed, unless it is for personal injury." By definition, a corporation cannot have a "personal" injury, so the proceeds would be taxable.

In addition, as you clearly understand, an S-corporation is a "pass-through" business structure. That is, the gains or losses are passed through to the owners and taxed at the income tax rates that apply to individuals as opposed to corporate tax rates. So your portion of the settlement is taxable to you personally. The only thing that would reduce this would be higher company expenses. In either case, you end up with less in your own pocket.

But your real concern should be whether you become subject to the "Alternative Minimum Tax" (AMT) as a result of the settlement proceeds. I've railed against the AMT in previous columns (in my June 18 column, for instance, or in October 2002). It's actually a parallel, but separate tax system, except you don't get all of the deductions allowed under the regular income tax system.

For instance, under the AMT you don't get to subtract any personal exemptions (including those for dependants such as your children), state income taxes, interest from certain municipal bonds (oh, you thought that was tax-free? Too bad!...), or property taxes. Of course, this makes your "taxable" income for AMT purposes a lot higher.

At 26% and 28%, the tax rates under the Alternative Minimum Tax are, in some cases, lower than your ordinary income tax rate. However, since more of your income is subject to tax, you often end up with a bigger tax bill under the AMT. And the law says that, after calculating your income taxes both the traditional and AMT way, you have to pay whichever results in the higher tax amount.

When it was introduced in 1969, the Alternative Minimum was theoretically supposed to catch the "fat cats," i.e. the wealthiest taxpayers who could avoid paying any income tax at all because they took advantage of so many write-offs and tax shelters. Trouble is, in recent years a number of tax breaks, such as the education tax credit, have been introduced specifically to help lower and middle-income taxpayers. But the more tax breaks you take advantage of, the more likely you will be caught by the AMT! It's Catch-22.

In addition, while Congress has occasionally altered the numbers, the income levels at which the AMT kicks in are not adjusted for inflation.* But salaries have been. So someone who might have been considered "rich" back in the 70's, is more likely to be classified as "middle class" today. The result is, more and more Americans are being ensnared by this tax every year.

I call it a "stealth" tax because while it reels in more tax revenue each year, conveniently, our elected representatives in Congress do not have to go on record and actually vote to raise taxes. After all, what politician interested in retaining his/her job would do that? The lack of an inflation adjustment in the AMT takes care of it for them.

The number of taxpayers subject to the AMT reached one million in 1999, and it is expected to TRIPLE in 2004. According to the federal government's own projections more than 12 million taxpayers will get hit with the Alternative Minimum Tax in 2005. By 2010 -- just 6 years from now -- more than 31 million Americans will pay more income tax, thanks to the AMT.

No wonder IRS Taxpayer Advocate Nina Olson recently declared the Alternative Minimum Tax the Number One Problem facing individual taxpayers.

Sorry for the detour through AMT-land, John, but here's your problem: since the AMT does not allow you to deduct state income taxes, Nissenbaum says you want to "pay any state taxes associated with your company's legal settlement [in the same year you received the money] in order to minimize your exposure to the Alternative Minimum Tax." That's because under the convoluted logic of the AMT, the higher your income, the less likely you are going to be subject to the AMT. The more income you have, the more likely you will fall into the 30% or 35% tax bracket, which means that calculating your income tax the regular way will result in a higher tax bill.

Unfortunately, in your case, you missed the deadline. Since the money was received in the fall of 2003, you needed to have written a check for your state taxes by Dec 31, 2003.

On the other hand, consider yourself lucky that this was a business-related lawsuit. According to Nissenbaum, non-business, i.e. personal, legal expenses are not deductible under the Alternative Minimum Tax. As with income, expenses of an S-corporation flow through to the individual owners, so you get to deduct your share of the costs associated with the lawsuit.

Without a lot more information, there's no way to know whether the regular tax system or the AMT will result in a higher tax bill for you, John. The problem is, you will have to figure your income taxes both ways -- or pay someone else to do this for you -- and compare the results.

The Alternative Minimum Tax ought to be on the top of your list of questions when your Congressional representatives ask for your vote next year.

Gail

*The Jobs and Growth Tax Relief Reconciliation Act passed this year made some minor adjustments to the AMT, but these expire at the end of 2004.

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