Beginning in 2007, certain taxpayers will be able to claim old unrecovered AMT credit even if it means getting a refund that exceeds the current year's tax.

Various aspects of the AMT credit relief provision are remarkable, but the phase-out rule is positively mind-boggling. People affected by this rule will have to be extraordinarily alert to planning opportunities. Some of those opportunities will slip away at the end of 2006. Failure to take advantage could be extremely costly.
    I'll start by laying out the rule, and then offer a discussion of the implications. Any conclusions will be at least somewhat tentative, partly because it takes some time to digest a rule that has such far-reaching consequences, and partly because it seems possible that Congress will take a second look at this rule when they become aware of the implications.

The rule

The phase-out rule has enormous, complicated consequences, but the rule itself is relatively simple. It says the amount of credit you can claim in any year is phased out over the same income range used to phase out personal exemptions. For 2007 those ranges are as follows:
 

If you're married filing jointly and your 2007 modified AGI is at or below 234,600, your refundable AMT credit won't be reduced under this rule. (Modified AGI for this purpose is your adjusted gross income increased to take into account certain foreign items that are otherwise excluded.) If your modified AGI is above $357,100, your refundable AMT credit is completely eliminated. You can still claim AMT credit under the regular rule, but the special rule is unavailable. Between those two levels you get to use the special rule on only part of the credit.
 

To get an idea where you stand, estimate your income, subtract the "begin" number from the table above and divide by $125,000 ($62,500 if married filing separately). Round up to the next higher 2%.

Example: You're single and expect your modified AGI to be about $200,000. Subtract $156,400 to get $43,600. Divide by $125,000 to get 34.9%. You can expect this rule to reduce your AMT credit recovery by about 36%.

As I mentioned, this rule is tied to the same phase-out range used for personal exemptions. The rule for phasing out personal exemptions is itself being phased out, but that will have no effect on the operation of the rule for AMT credit relief. The credit will be phased out in the same percentage as personal exemptions under the old rule, before we started phasing out the phase-out. Got that?

Huge consequences of added income

People who have large amounts of old AMT credit can expect to see huge consequences when their income rises into the phase-out range.

Example: You're a single filer and your modified AGI for 2007 is $218,000, which puts you at a level where you lose 50% of the credit. You have $1,100,000 of unused AMT credit, of which $1,000,000 is old AMT credit.

If your modified AGI had been at or below $156,400, you would have received a $200,000 credit. The added income that took you into the phase-out range reduced your credit (and refund) by $100,000. However, the amount of added income that caused that reduction was only $61,600. Earning another $61,600 reduced your refund by $100,000.
 

Even if your income isn't usually in the phase-out range, you could be hit by this phase-out rule because of an unusual event, such as a large capital gain. (Capital gains go into modified AGI the same as any other income.) Here are some thoughts on planning around the phase-out rule. These thoughts apply only to people whose old AMT credit is large enough so that a partial or complete phase-out would be more costly than whatever remedy you might select.
 

Before the end of 2006

As I write this, you have less than three weeks to implement any strategies that require action in 2006. Here are some possibilities.

• Capital gains. If you anticipate a large capital gain in 2007, you may want to accelerate the gain into 2006. For example, suppose you hold stock with a built-in gain of $100,000 and you want to sell it. Normally it might make sense to postpone the sale until January so you can pay tax on that profit a full year later. Under this new rule, that gain could phase out part of your AMT credit. Waiting until 2007 to sell the stock could cost you tens of thousands of dollars.
• Retirement income. Are you planning a taxable withdrawal from your IRA or 401k account after the end of this year? Planning a Roth IRA conversion? You should consider whether there's anything you might want to do by the end of this year, such as taking a large withdrawal or doing the Roth conversion now.
• Deferred compensation. If your regular compensation or bonus for 2007 will take you into the phase-out range, you may want to consider entering into a deferred compensation arrangement. Generally those arrangements must be made before the start of the year to which they relate. If you want your employer to pay your 2007 bonus in 2013 rather than 2007, you have to put that deferral arrangement in place before the end of 2006.
• Stock options. Do you have nonqualified stock options or stock appreciation rights that you can exercise now, to avoid having that income fall into 2007 or a later year when it will phase out your AMT credit?

Some of these ideas will be costly if you don't get the payoff you anticipate from the AMT credit. Yet the phase-out rule is so punitive that some people could be better off with an ugly result in 2006 to avoid an even uglier result in 2007. For example, it's normally a bad idea to take money from an IRA if you'll have to pay a 10% early withdrawal penalty, but that 10% penalty could end up being less costly than phasing out your AMT credit if you take a withdrawal in the years when the credit can be recovered.

Other thoughts

There are countless ways the AMT credit phase-out can affect tax planning. Here are just some of the possibilities.

• Income bunching. You might recover more of your AMT credit if you take income that might otherwise be spread over a number of years and bunch it into a single year. For example, a Roth IRA conversion might wipe out your AMT credit for a single year, but prevent it from being reduced or eliminated in other years by annual distributions from a taxable IRA.
• Filing separately. You have a big AMT credit and your spouse doesn't. You make $110,000 and she makes $250,000. If you file jointly the AMT credit recovery is phased out, but if you file separately it isn't. On a total AMT credit amount of $1,000,000, the tax savings from filing separately could be $200,000!
• Filing jointly. Again you have a big AMT credit and your spouse doesn't. This time, you make $180,000 and he makes $60,000. Filing jointly is almost sure to be a good idea in any case, but if you're going through a divorce the tax savings might not be big enough to make it seem worthwhile. In the AMT credit situation, though, the tax savings could be in six figures.
• Income shifting. You could be in a situation where it's crucial for you to get income off your return. One way is to give stock to a child before a sale transaction. Children with large amounts of investment income are taxed at the parents' rate up to age 18, but that doesn't mean the income appears on your tax return. Getting the income out of your AGI could produce big savings even if it means filing a gift tax return.
• Charitable gifts. The deduction for charitable donations does not affect your modified AGI, but if you give away appreciated property you can eliminate a capital gain from your tax return.
• Hedging. People sometimes use hedging strategies to reduce risk while postponing capital gains. For example, if you hold a stock that has gone up in value, and you're exposed to a lot of risk because this stock represents a big part of your net worth, you might use a "collar" or similar approach to gain downside protection without selling. These transactions can be expensive, and in many cases it's better to sell the stock and pay the tax. For someone trying to recover old AMT credit, though, the cost of hedging may be small compared with the tax cost of reporting a gain that will boost modified AGI.
• Planning around the FIFO rule. Suppose you have some old AMT credit and also some newer AMT credit from an ISO you exercised last year. You're ready to sell the ISO stock you bought last year and expect to recover some or all of the AMT you paid when you exercised that option. But the first-in, first-out rule will treat you as if you recovered the old AMT credit first. Then you'll be left with AMT credit that doesn't qualify for the special rule because it isn't old enough. You might be better off continuing to hold the ISO stock while you use the special rule to recover the old AMT credit, if you can bear the investment risk.

The consequences of this phase-out rule are potentially so powerful that some people might rethink their careers. What would you do with your life if a $100,000 cut in pay allowed you to recover an extra $150,000 per year in AMT credit over the next several years. Take a sabbatical? Switch to a more satisfying but lower paying job? Retire early?
 

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Related

• Buy the book: Consider Your Options
• Discussion forum: AMT and Equity Compensation
• Related guide: Guide to the AMT