Tax Preference Items: Specific Deductions and Credits Impacting AMT Calculation

An in-depth look into tax preference items, which are specific deductions and credits that affect the calculation of the Alternative Minimum Tax (AMT).

Tax preference items are specific deductions, exclusions, and credits that are permitted under the regular tax system but may be added back to income when calculating the Alternative Minimum Tax (AMT). They are considered preferential because they could disproportionately benefit high-income taxpayers, thereby necessitating adjustments to ensure a minimum level of tax is paid.

How Tax Preference Items Affect AMT Calculation

When computing the AMT, taxpayers are required to add back certain tax preference items to their income. The AMT system is designed to ensure that individuals and corporations who benefit from these preferences pay at least a minimum amount of tax.

Common Tax Preference Items

• Exclusion of Tax-Exempt Interest:

  • Interest on certain private activity bonds is excluded from regular taxable income but must be added back for AMT calculation.

• Percentage Depletion Allowance:

  • The portion that exceeds the adjusted basis of the property for the tax year must be added back to income.

• Accelerated Depreciation:

  • Depreciation on real and personal property that is more favorable than the standard MACRS class life system.

• Incentive Stock Options (ISO):

  • The difference between the fair market value of stock and the option price on the exercise date.

Example of Tax Preference Items Calculation

Consider a taxpayer who earned substantial tax-exempt interest from private activity bonds and exercised incentive stock options during the year. This individual will add the tax-exempt interest and the ISO income to their taxable income to calculate AMT.

Historical Context of the AMT

The AMT was introduced in 1969 to prevent high-income taxpayers from using excessive deductions and credits to avoid paying taxes. It ensures that these individuals contribute a minimum amount, regardless of how well they manage their tax affairs under the regular tax system.

Special Considerations

Phase-Out and Exemptions

The AMT has exemptions and phase-out thresholds, which can vary annually and impact the extent to which tax preference items affect a taxpayer’s alternative minimum taxable income (AMTI).

Corporate Considerations

Corporations also have specific tax preference items, like the adjusted current earnings (ACE) and the elimination of certain credits which affect their AMT liability.

Related Terms

• Alternative Minimum Tax (AMT): A parallel tax system to the regular income tax system designed to ensure that high-income individuals and corporations pay a minimum amount of taxes.
• Adjusted Current Earnings (ACE): An adjustment made to corporate AMTI that accounts for certain preferences and adjustments.
• Depreciation Recapture: The gain realized from selling depreciated property, which may be subject to ordinary income tax rates.

FAQs

Are all tax-exempt interest incomes considered tax preference items?

No, only interest from private activity bonds issued after August 7, 1986, is considered a tax preference item.

How does the AMT exemption amount affect tax preference items?

The AMT exemption reduces the taxpayer’s AMTI. However, the exemption phases out for higher income levels, at which point all tax preference items contribute fully to the AMTI.

Can tax preference items affect both individual and corporate taxpayers?

Yes, tax preference items can affect both individual and corporate taxpayers subject to AMT calculations.

References

1. IRS Publication 925: Passive Activity and At-Risk Rules.
2. IRS Form 6251: Alternative Minimum Tax - Individuals.
3. Tax Policy Center: The Alternative Minimum Tax (AMT).

Summary

Tax preference items play a crucial role in ensuring that taxpayers pay a fair share of taxes under the Alternative Minimum Tax system. By adding back certain deductions and credits to calculate AMTI, the AMT prevents the undue benefit from preferential tax treatments and maintains the integrity of the tax system. Understanding these items is vital for taxpayers to accurately determine their tax liabilities and comply with the law.