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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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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The Tax Benefits of Incorporation to the Entertainer (Part 2)

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This is the part 2 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.

The only difference between a corporation and an individual taxpayer is the application of the rate of tax to the taxable income.” Section 1(c) applies to the individual taxpayer and requires taxation at the highest level of 39.6%. Section 11, which applies to the corporate taxpayer, requires taxation at the highest level of 35%. While it may seem that the 4.6% difference in maximum taxation rates is inconsequential, the §1(c) rate of 39.6% is applied to taxable income over $250,000. The §11 tax rate of 35% is applied to taxable income exceeding $10,000,000.

The foregoing analysis, though, is altered when applied to a personal service corporation (“PSC”) (also known as a loan-out corporation). Section 11(b)(2) states that the qualified PSC will be taxed at a rate of 35%.  “The [Internal Revenue] Code provides for the taxation of the taxable income of certain personal service corporations at the highest corporate [tax] rate, thereby depriving these corporations of the benefit of lesser, graduated tax rates on taxable income not in excess of $75,000″ (Ness and Vogel, 1991).  The corporation with very little taxable income will be taxed at the same rate as large corporation with a large amount of taxable income. Section 11(b)(2) only applies to those PSCs that are qualified as defined by Internal Revenue Code § 448(d)(2).

Therefore, a corporation which is substantially involved in the performing arts (among other specified industries, including accounting, law, and engineering), and where substantially all of the stock in the corporation is held either directly or indirectly by an employee performing the services in which the corporation is substantially involved, then the corporation is a qualified PSC.

* For specific inquiries regarding a tax planning legal matter that you may have, you are welcome to visit our Woodland Hills Tax Lawyer services page.

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