Alternative Minimum Tax: The Effect on Itemized Deductions

 

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This is also part of third section of  Anker Reed HSC’s blog series entitled “To Incorporate or Not to Incorporate? That is the Question” regarding the alternative minimum tax and its effect on medical and miscellaneous itemized deductions.

An additional issue with regard to the deductibility of both medical and miscellaneous itemized deductions is the imposition of the Alternative Minimum Tax. “Congress enacted the alternative minimum tax (AMT) in 1969 to make wealthy taxpayers pay their fair share instead of using tax shelters and other means to reduce, or even eliminate, their federal tax liability.” (Kern, 1999). “The alternative minimum tax generally can be described as a flat tax rate which is imposed on a broader income base than the taxable income yardstick used for the regular corporate tax.” (Lind, supra note 11 at 15).  “The tax is designed to ensure that all taxpayers pay at least a minimum amount of taxes.” (Blacks Law Dictionary, 1990). “Without the alternative minimum tax, some of these taxpayers might be able to escape income taxation entirely. In essence, the AMT functions as a recapture mechanism, reclaiming some of the tax breaks primarily available to high-income taxpayers, and represents an attempt to maintain tax equity.” (Commerce Clearing House, 1999).

The AMT is paid in addition to any other income tax imposed and calculated as the excess of the tentative minimum tax for the taxable year over the regular tax for the taxable year. The definition for tentative minimum tax, though, depends on the status of the taxpayer, whether noncorporate or corporate. The tentative minimum tax for the noncorporate taxpayer is the sum of 26% of so much of the taxable excess as does not exceed $175,000 plus 28% of so much of the taxable excess as exceeds $175,000. The Internal Revenue Code also provides for tax exemption status, evidencing the congressional intent of taxing the high-income taxpayers. If the taxpayer’s taxable income does not exceed $45,000 for taxpayers filing a joint return, $33,750 for the individual taxpayer, or $22,500 for the married taxpayer filing separately, the taxpayer is exempt from alternative minimum tax treatment. This means that, depending on the individual taxpayer, there could be an exemption from AMT for the lower income brackets. After the $33,750 exemption, the next $175,000 will be taxed at a rate of 26%. Taxable income exceeding this will be taxed at 28%. At the corporate level, the first $40,000 of taxable income is exempt from AMT treatment.

As previously discussed, the PSC will have little or no taxable income as a result of “zeroing-out.” Therefore, no discussion of corporate AMT is necessary.

When analyzing the application of AMT to the noncorporate taxpayer, the focus of the discussion turns to the medical and miscellaneous itemized deductions. For Regular Income Tax (“RIT”) purposes, medical expenses are deductible when they exceed 7.5% of adjusted gross income (“AGI“). For AMT purposes, medical expenses are deductible only when they exceed 10% of AGI. With regard to miscellaneous deductions, the difference between RIT and AMT is even more conspicuous. For RIT purposes, miscellaneous itemized deductions (specifically unreimbursed employee business expenses) are deductible to the extent they exceed 2% of AGI. Under AMT, however, miscellaneous itemized deductions are not allowed. This is significant since an employee working in a noncorporate structure will be considered an employee for whom she provides services.

Therefore, any business expenses she incurs will be considered unreimbursed employee business expenses, shown as miscellaneous itemized deductions subject to the 2% of AGI limitation and rendered non-deductible for AMT purposes. Under the PSC, these business expenses escape both the RIT limitation and the AMT exclusion.

* For specific inquiries regarding a business legal matter that you may have, you are welcome to visit our Tax Attorney in Los Angeles.

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Deduction Limitations of the Corporation and Individual

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This is the third section of Anker Reed HSC’s blog series entitled “To Incorporate or Not to Incorporate? That is the Question” regarding deduction limitations of the corporation and individual.

The corporation, on the other hand, is not affected by the § 67 limitation. A corporation will be allowed a one hundred percent deduction on itemized deductions. Therefore, in the foregoing example, the corporate taxpayer will be able to deduct the full amount of $50,000 without limitation. The corporation has effectively just saved the individual taxpayer approximately $4,000 in federal taxes and $1,000 in state taxes.

The subject of deduction limitations becomes more significant when addressing the issue of deductions allowed for medical expenses. An individual taxpayer can deduct the expenses for medical care of the taxpayer, his spouse, or a dependent to the extent that the expenses exceed 7.5% of the adjusted gross income. Using the previous example, if the individual had medical expenses of $25,000, they are not deductible because only those expenses that exceed 7.5% of the adjusted gross income are deductible. With an adjusted gross income of $500,000, the individual would need to have medical expenses of at least $37,500 before any deductions may be taken. In applying the applicable federal and state tax rates, the individual with $25,000 of medical expenses would pay a tax of approximately $12,500 ($10,000 to the federal government and $2,500 to the state government).

* For specific inquiries regarding a tax planning legal matter that you may have, you are welcome to visit our Los Angeles Business Attorney services page.

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The Tax Benefits of Incorporation to the Entertainer (Part 3)

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This is part 3 of the second section of Anker Reed HSC’s blog series entitled “To Incorporate or Not to Incorporate? That is the Question” regarding the tax benefits of incorporation to the entertainer.

In order to minimize the obvious deleterious effects of the higher tax rate applied to PSCs, it is common for the PSC to “zero-out” at the end of its tax year. This means that the net income of the corporation is paid to the shareholder-employees in the form of compensation and retirement benefits, leaving little or no taxable income for the imposition of tax. This also eliminates any risk of a taxing agency re-characterizing the income as constructive dividends, imposing taxes on shareholders and the corporation.

The most significant tax benefit of using a loan-out is the increased deductibility of their business, medical, and in some cases, even personal expenses.  As opposed to the individual taxpayer, the corporate taxpayer has more tax-beneficial requirements and limitations on deductible expenses. First, an individual taxpayer is limited in the amount of itemized deductions she may have. Section 67 of the Internal Revenue Code states that miscellaneous itemized deductions are allowable only to the extent that the aggregate of the expenses exceeds two percent of the adjusted gross income. This means that all of the itemized deductions over two percent of the adjusted gross income is deductible.

For example, if the adjusted gross income for an individual taxpayer is $500,000 and the miscellaneous itemized deductions are $50,000, the first $10,000 (2% of $500,000) will not be deductible. Therefore the individual taxpayer will be able to deduct only $40,000. Therefore, the taxpayer will still be taxed on the non-deductible $10,000 at the federal rate of 39.6%, approximately $3,960. When adding to this the state tax rate, the amount taxed could approach 50%.

* For specific inquiries regarding a tax planning legal matter that you may have, you are welcome to visit our Los Angeles Tax Planning Attorney services page.


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To Incorporate or Not to Incorporate? THAT is the Question (Part 5)

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This is part 5 of Anker Reed HSC’s blog series entitled “To Incorporate or Not to Incorporate? That is the Question”.

Partnerships and limited liability companies are treated for tax purposes as conduits whose income and deductions pass through to the partners or members as they are realized, with the various items retaining their original character in the process.” (Fundamentals of Corporate Taxation 703, 4th ed. 1997) The partnership will still file an income tax return with the government, but this tax return will solely be for informational purposes. The individual partners pay the actual tax.

For example, a partnership that has taxable income of $1,000,000 for the taxable year will pay no tax on this income. The partners will pay the tax. Should there be two partners, each partner will have taxable income before individual deductions of $500,000. It is important to note that percentage of control in a partnership may be negotiated amongst the partners, in that a partnership may not always be 50/50. For this analysis, and in the interest of simplicity, we will assume a 50/50 partnership. This amount does not include amounts paid by the partnership to the partners as compensation, or in any other form, received during the taxable year.

In applying § 1 (c) of the Internal Revenue Code, each partner’s assessed tax before individual deductions will be $77,485 plus 39.6% of all income over $250,000. Therefore, in the absence of any other personal deductions, each partner’s tax will be approximately $176,485.  The partnership itself will not be subject to tax, but “the persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities.” (I.R.C. § 701, Supp. 2000).

* For specific inquiries regarding a tax planning legal matter that you may have, you are welcome to visit our Los Angeles Tax Planning Attorney services page.

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