By John Battaglia, CPA, Deloitte & Touche, and Alan Levine, CPA, Deloitte & Touche

Taxpayers often think of the alternative minimum tax (AMT) as a negative, add-on tax that comes right out of their pocket. Therefore, the following advice has applied: If teetering on the brink of or already in the dreaded AMT at year-end, defer deductions and accelerate income. Nevertheless, sometimes it can be beneficial to accelerate certain deductions often considered detrimental, allowing the benefit of the IRC section 53 credit against regular tax for prior year minimum tax.

Using the IRC Section 53 Benefit

The key to appreciating the actual benefit of paying the AMT is the distinction between exclusion preferences and deferral preferences. Exclusion preferences, such as state and local income taxes, real estate taxes, and allowable miscellaneous itemized deductions, are not caused by timing differences and yield no IRC section 53 benefit by themselves. Deferral preferences, on the other hand, result from timing differences and yield a potential benefit in the form of a tax credit if they result in AMT. A taxpayer liable for AMT resulting from both exclusion and deferral preferences can benefit from a full credit carried to future years if the deferral preferences are large enough.

Individuals in certain industries are most likely to benefit from the IRC section 53 credit. Real estate and other investors whose depreciation choices create timing differences often generate AMT and the corresponding IRC section 53 credit. Oil and gas professionals, publishers incurring circulation expenses, Internet service providers, and investors incurring research and experimental expenditures may also benefit from this credit. While corporate executives exercising a significant number of incentive stock options make up only a handful for whom the advice of deferring expenses may not apply, investors in a trade or business that incurs some of the above expenses should carefully reexamine their year-end tax planning to determine whether deduction acceleration would positively affect their AMT credit. In many cases, not adhering to the conventional deduction deferment wisdom may yield significant benefits. For maximum benefit, an individual should have large deferral preferences and border on the AMT in year one but should be deep in the AMT in year two with no significant deferral preferences.

Example

A taxpayer with current year adjusted gross income of $9.1 million, comprising approximately 50% long-term capital gain and 50% ordinary income, had state tax liability of about $953,000 (See the Exhibit). In addition, there were deferral preferences of $2 million in the current year. Neither the capital gain nor the deferral preferences were expected to recur in succeeding years. A projection of two years’ income, deductions, tax, and credits yielded the following results: By prepaying $803,000 of state and local income taxes (usually thought of as an exclusion preference) 3.5 months early, the taxpayer created a credit of $367,879 through the nonrecurring $2 million “deferral” preferences. If the taxpayer followed conventional wisdom and postponed the state payment until the following year, the AMT credit of $367,879 would not have been generated and no benefit would have been derived from approximately $593,000 of the $803,000 state and local tax deduction. By accelerating payment of the state taxes to the years with significant deferral differences, the taxpayer generated a much larger credit to be used in future years than if she had waited to pay the taxes in the year they were due.

Discussion

Generally speaking, the minimum IRC section 53 tax credit is the difference between the regular tax and the tentative minimum tax. Under the prepayment strategy, the credit would be utilized in full unless the taxpayer has exclusion preferences and significant negative deferral preferences in future years, producing a hypothetical “negative” tentative minimum tax. In such a situation, the credit may be reduced in future years. However, once the credit is utilized, there is no mechanism in the IRC to recapture it or any part thereof.

Significant savings can be derived by carefully matching deductions with deferral preferences occurring in the same year. Contrary to conventional wisdom, prepayments of expenses that are not deductible in calculating the AMT may create a credit of significant value if paid in that year. In the example, the taxpayer was faced with a remaining state tax payment of $803,619, due in 3.5 months. She and her advisors felt certain that she would be paying an AMT in the current year. In spite of the conventional wisdom indicating a deferral of the state tax payment until due, the analysis identified an alternative strategy of accelerating the payment to take advantage of the section 53 credit.

This strategy also applies to the fairly common tax scenario of corporate executives that receive incentive stock options. When these options are exercised, they create a deferral (timing) preference, which, in turn, creates a potential IRC section 53 credit.