On occasion a frustrated taxpayer will go to Tax Court in an attempt to convince a judge that the Alternative Minimum Tax was never intended to apply to them. As in the case of Fritz v. Commissioner, however, no sympathy is ever found there - if the calculations are done correctly the Court simply confirms that the tax is owed. The facts in these cases present interesting lessons, however, because they reveal both the terrible feeling of frustration when getting blindsided by the AMT as well as the simple, yet missed, planning opportunities that could have allowed many of these folks to avoid paying the AMT.
Facts of the case
Mr. and Mrs. Fritz filed their tax return without attaching Form 6251, "Alternative Minimum Tax – Individuals." They promptly received a notice from the IRS informing them that they owed exactly $7,007 more in AMT. The Fritz’s tax return was relatively simple - $329,000 of total income, the majority of which - $283,000 – was long-term capital gain and qualifying dividends. The Fritzes took the standard deduction, apparently because this was greater than their itemized deductions, as well as the deduction for their personal exemptions.
Alternative Minimum Tax problem
Two AMT issues caused the Fritz’s Alternative Minimum Tax problem.
Loss of the standard deduction and the deduction for personal exemptions
As has been discussed in many previous articles, under the AMT the standard deduction is disallowed in total, as are the deductions for personal exemptions. Because of this, Alternative Minimum Taxable Income (AMTI) is always higher than Regular Tax taxable income by these amounts. For 2011, the standard deduction for a married couple filing jointly is $11,600, and each personal exemption is $3,700. In a case like the Fritzes, their AMTI for the current year would be $19,000 higher.
Loss of the AMT Exemption due to the large capital gain
When a married couple’s AMTI exceeds $150,000 the AMT exemption begins to be phased out. The exemption amount for 2011 is $74,450, but this is phased out at the rate of $1 of exemption for every $4 of AMTI in excess of $150,000. In the Fritz’ situation, they would lose $44,672 allowing them an AMT exemption amount of only $29,778.
The Fritz’ argument
The argument made to the Tax Court by the Fritzes was that capital gains and qualifying dividends should be taxed at the 15 percent tax rate, as specified in the tax law for both the AMT as well as for the Regular Tax. By operation of the AMT calculations, they alleged, their effective tax rate on this income actually was higher than this.
The Tax Court’s answer
The Tax Court judge was direct in his response: "Petitioner’s position in this case misses the point. In reality, the tax on the capital gains was limited to 15 percent and the ‘additional tax’ was attributable to the elimination of preferences." Judgment in favor of the IRS.
Planning opportunities the Fritzes missed
There are several things the Fritzes could have done to reduce, and likely eliminate, their Alternative Minimum Tax.
Itemizing deductions instead of taking the standard deduction - If the Fritzes had home mortgage interest, or if they had made any charitable contributions, they could have reduced their AMT by itemizing deductions instead of taking the standard deduction. This, unfortunately, is a common error for AMT payers. If they had had, for example, just $1,000 in interest or contributions, they would have directly reduced their Alternative Minimum Tax by $280. They weren’t required to take the standard deduction; they did it because it was larger than their itemized deductions, and they just didn’t think about the AMT.
Spread the capital gain over two or more years – The timing of when to sell securities and realize capital gains is entirely within the control of a taxpayer. Not spreading their very large gain of $246,000 over just two years was a costly mistake on the part of the Fritzes. If they had instead recognized half of their capital gain in the current year and pushed the other half to the following year, they would have lost over $30,000 less of their AMT exemption, most likely removing them entirely from the AMT!
As the Fritzes learned the hard way, paying the Alternative Minimum Tax is a penalty that often can be avoided with just a little awareness of the AMT. Had Mr. & Mrs. Fritz done this, they would have $7,000 more in their bank account today instead of having to put this amount in the mail to the US Treasury. Lesson learned the hard way!