Alternative Minimum Tax

The second tax system known as the alternative minimum tax (AMT) is a federal policy subject to a basic tension: Congress believes taxes should be a shared burden, but at the same time, Congress has crafted the Internal Revenue Code so that wealthy individuals and large corporations can avoid or drastically reduce their tax liability. Add to this tension the tendency of Congress to soothe the public’s complaint about federal income taxes with the apparent saving power of attractive riders and supplements to the Code that are ultimately negated by the broad reach of the AMT.

This tension notwithstanding, the AMT is a second regime that subjects individuals and corporations to a broader at somewhat lower rates (26 or 28%) than the (top rate of 35%). (Note: In this article I focus on the AMT for individuals.) To determine whether a taxpayer is at risk for the AMT, it is first necessary to determine the AMTI, abbreviation for alternative minimum taxable income.

The first step in calculating AMTI is to make several adjustments to regular taxable income. Under the AMT system, on a 40 year schedule substitutes for under the (MACRS) for real property acquired before 1998, and a 150 percent method replaces other methods for property not subject to straight line depreciation under the regular system. In short, under the AMT, the taxpayer loses the substantial deferrals associated with accelerated depreciation under the regular tax system. In calculating AMTI, the taxpayer also substitutes the for other methods, including the and the ; adds back ; adjusts for the excess of the stock’s at (pdf file) over the amount paid; refigures any (pdf file) and any gain or loss on ; removes ; takes out (pdf file); and recomputes (pdf file) to reflect the higher 10% of for these expenses under the AMT system. For a complete listing of adjustments to regular taxable income see (pdf file) and (pdf file).

Second, add back tax preference items forbidden by the AMT to regular taxable income. These tax preference items include (pdf file) in excess of (pdf file) for oil, gas, and all other mineral resources; in excess of 65% of net income from oil, gas, and geothermal wells; interest earned on (pdf file); accelerated depreciation or amortization on properties acquired before 1987; and the exemption for gains on small business stock.

Third, subtract the exemption amount to arrive at net alternative minimum taxable income. For married taxpayers filing jointly and surviving spouses, the exemption amount is $62,550; for single individuals, $42,500; and married taxpayers filing separately, $31,275. The exemption is phased out or reduced 25% of the amount by which AMTI exceeds $150,000 for surviving spouses and married filing jointly (exemption completely phased out at $400,200), $112,500 for single individuals (exemption exhausted at $282,500), and $75,000 for married filing separately (exemption ends at $200,100).

Fourth, multiply the net AMTI by either a 26 or 28% rate. The first $175,000 of AMTI is taxed at 26% and AMTI over $175,000 at 28%. But the AMT system uses the same rates as the regular tax system for dividends (15%) and (15% or 25%).

Fifth, from this subtotal, subtract any and the . Compare this amount, the tentative minimum tax (TMT), with the regular tax. If the TMT is greater than the regular tax, the result is known as the AMT. Add this net amount to the regular tax to show the taxpayer’s new, and greater, tax liability for the year.

Several additional resources on the alternative minimum tax for individuals follow below:

Many happy returns, Roger

Legal Fees

At first glance, the topic of deductions for legal fees (attorneys’ fees) would appear to be simple, or so one would think. In Commissioner v. Banks, a consolidated Supreme Court case dealing with the deductibility of legal fees in two separate employment discrimination lawsuits filed and won by complainants Banks and Banaitis, the Court affirmed the decision rendered by the in the Sixth and Ninth Circuits that legal fees under a contingency fee arrangement are includible in gross income and deductible only as an itemized (below the line) deduction. Because the facts are similar, I will focus on the tax issues in Banaitis’ case.

To pay his attorneys, Banaitis signed a (pdf file). After winning the discrimination action, the entire judgment, including , was included in Banaitis’ gross income. Banaitis was able to take a deduction for legal fees but only as a miscellaneous itemized deduction. At issue is the fact that itemized or are treated unfavorably when compared to : unlike their above the line cousins, many miscellaneous itemized deductions, including legal fees, are deductible only to the extent they exceed a 2% of (AGI) floor. But of greater significance for Banaitis, below the line deductions for legal fees paid to attorneys under a contingency fee arrangement are added back to income when calculating the (AMT). In short, these restrictions negated the deductibility of Banaitis’ legal fees. Banaitis’ share of the discrimination judgment was about $4.9 million but after adding back to income the miscellaneous itemized deduction for legal fees in order to calculate the AMT, the judgment on which he would be taxed grew to $8.4 million.

In an attempt to fix the arguably faulty tax logic in Banks v. Commissioner, Congress, in the (pdf file), now allows taxpayers to take an above the line deduction for contingent attorneys’ fees in employment discrimination lawsuits and other causes of action related to, for example, the Employee Polygraph Protection Act of 1988, section 105 of the Family and Medical Leave Act of 1993, various sections of the Fair Housing Act, the Americans with Disabilities Act of 1990, and section 510 of the Employee Retirement Income Security Act of 1974 (the list could continue; consult the American Jobs Creation Act for additional details). It is important to note that this new law does not apply to noncontingent (viz., hourly or fixed) attorneys’ fees. Several sources of secondary authority on taxation law suggest that in the type of employment discrimination action pursued by Banks and Banaitis, attorneys’ fees, contingent or noncontingent, are in substance a cost of producing taxable income and should be allowed as an above the line deduction. That is to say, the origin and nature of the claim should determine deductibility, not the type of billing arrangement negotiated with attorneys.

Although the federal income tax is a tax on and not , above the line deductions, with several exceptions (a nonexhaustive list including alimony, qualified higher education expenses and interest on qualified education loans, retirement plan payments, and medical and health savings accounts), are allowed only for expenses incurred while producing nonexempt (taxable) income in a trade or business or managing income-producing property. In other words, as a general rule, deductions are allowed only if the related income is taxable. In addition, deductions for personal, living, or family expenses are not allowed but Congress, through legislative grace, has granted several exceptions, many of which are below the line deductions and subject to a 2% of AGI floor: home mortgage interest and state and local taxes on the home (not subject to the 2% of AGI floor), medical and dental expenses (but subject to a higher 7.5% of AGI floor), bad debts and worthless securities, expenses related to tax advice and litigation, nonbusiness or personal casualty losses (each loss most be over $100 and is subject to a higher 10% of AGI floor), state and local taxes, charitable contributions (not subject to the 2% floor but restricted nonetheless), and, of course, legal fees to protect future employment or produce income.

In Banks and similar cases, complainant’s cause of action is based on employer’s violation of employment discrimination law; because of wrongful discharge, complainant incurs attorneys’ fees in suing for the production of current and future income. In Francis Lawrence and Kathryn Tenopir Remkiewicz v. Commissioner (Tax Court Memorandum Ruling 2001-01), petitioners Lawrence and Remkiewicz asked, and the Tax Court granted, an allocation and deduction for legal fees related to the production of nonexempt income (salaries and wages). In brief, taxpayers contesting termination of employment or pursuing an employment discrimination action may deduct that portion of attorneys’ fees associated with the production or recovery of nonexempt income (in the case of Lawrence, current and future compensation from employment).

Additional writings on the legal fees deduction are detailed below:

Many happy returns, Roger

Gross Income

Textbooks on the law of federal income taxation routinely make reference to Section 61(a) of the Internal Revenue Code and its definition of as “all income from whatever source derived, including (but not limited to) the following items: (1) Compensation for services, including fees, commissions, fringe benefits, and similar items; (2) Gross income derived from business; (3) Gains derived from dealings in property; (4) Interest; (5) Rents; (6) Royalties; (7) Dividends; (8) Alimony and separate maintenance payments; (9) Annuities; (10) Income from life insurance and endowment contracts; (11) Pensions; (12) Income from discharge of indebtedness; (13) Distributive share of partnership gross income; (14) Income in respect of a decedent; and (15) Income from an interest in an estate or trust.”

And, on the whole, these same textbooks take note that the is not so generous when it comes to deductions. In fact, deductions exist only as a result of “legislative grace.” Put differently, unlike gross income, there is no all-inclusive concept of exclusions or deductions from income. The reason for this apparent disparity is that Congress, through its drafting of a pervasive concept of income in the Code, brings into play its power to raise revenues for, ideally, public goods. Structurally, the Code does allow for ordinary and necessary business expenses and certain , but, in general, one should make the assumption that a desired deduction is not allowed unless granted and placed in the Code, for reasons sound or obscure, by Congress.

Several landmark Supreme Court cases reinforce the Code’s all-encompassing (egregious?) concept of income and add substance to its necessarily incomplete listing of items of income. First, in , taxpayer’s company pays not only salary and commissions but also, and directly to the Bureau of Internal Revenue (renamed in 1953 as the Internal Revenue Service), his estimated federal income taxes. Taxpayer argues he never received monies sent on his behalf to the Bureau; therefore, he shouldn’t be taxed. The Supreme Court disagrees: the payment is not a gift but rather an increase in the taxpayer’s wealth.

Second, deals with the portion of damage awards that are punitive in nature and, more generally, the definition of income in a previous landmark case, . In Glenshaw Glass, taxpayer argues that punitive damages are a windfall and accordingly not income under Macomber’s definition of income as “gain derived from labor, from capital, or from both combined.” The Court rules that sources of funds other than labor, capital, or combinations thereof also constitute ““; in brief, punitive damages fit the category of accessions to wealth and are fully taxable.

Third, in (pdf file), the taxpayer, a corporation, purchased its own bonds at a discount thereby increasing its net worth. The Court ruled that the taxpayer realized a clear economic benefit and, without an exclusion in the Code, such accessions to wealth are taxable. After the decision in Kirby Lumber Co., Section 108 was created leading to the Code’s general rule that, except for cases of bankruptcy or insolvency, discharge of indebtedness results in cancellation of debt income.

There are many other cases that document the concept of gross income but these examples should give the reader a feel for the all-embracing character of this key concept in federal income taxation.

For the interested reader, several additional resources on the concept of gross income are listed below:

Many happy returns, Roger

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