Some Prior-Year MTCs Will Be Refundable Beginning in 2007

Editor: Joel E. Ackerman, CPA, MST

A growing number of individual taxpayers have been subject to tax under the alternative minimum tax (AMT). Sec. 53(a) provides a minimum tax credit (MTC) for AMT paid in prior years that was attributable to deferral adjustments. The MTC is carried forward to offset regular tax liability in future years. Frequently, however, little or none of the MTC is allowable because in subsequent years the individual’s tentative minimum tax under Sec. 55(b) is close to (or exceeds) the individual’s regular tax.

Some individuals have large amounts of MTC, frequently caused by AMT resulting from the exercise in past years of incentive stock options (ISOs). Many of those taxpayers exercised their ISOs and paid significant AMT in the year of exercise but were caught in the “tech bust” of the early 2000s and saw the value of the exercised shares plummet so quickly that they were lucky to receive enough in the shares’ sale proceeds to cover the previous year’s AMT. Given the nonrefundable nature of the MTC and the limitations of Sec. 53(c), many of these individuals are unlikely to recoup much of the MTC during their lifetimes.

In December 2006, Congress added Sec. 53(e) to address this situation. New Sec. 53(e)(4) states that the MTC allowed under Sec. 53(e) “shall be treated as if it were allowed under subpart C,” which refers to the refundable credits of Secs. 31–36. Thus, MTC generated by Sec. 53(e) is refundable, even when it exceeds the taxpayer’s liability. Many individuals will begin in 2007 to draw down a portion of the accumulated unused MTC, but in many cases planning will be needed if they are to maximize the amount of refunds allowed by this new provision.

The New Rules

The changes cover tax years beginning after December 20, 2006, but before January 1, 2013. Taxpayers who have long-term unused MTC are entitled to an MTC equal to the greater of the AMT refundable credit amount or the amount of allowable MTC under the preexisting Sec. 53(c) limitations, but subject to important adjusted gross income (AGI) phaseouts. “Long-term unused MTC” is defined as unused MTC from tax years before the third tax year immediately preceding the tax year in which the credit is taken. The “AMT refundable credit amount” is equal to the greater of (1) the lesser of $5,000 or the amount of long-term unused MTC for the tax year or (2) 20% of the amount of long-term unused MTC. See exhibit.

AGI Phaseout

Sec. 53(e)(2) further limits the refundable MTC for high-income taxpayers by using the same phaseout rules (Sec. 151(d)(3)(C), as adjusted for inflation under Sec. 151(d)(4)(B)) that govern the phaseout of personal exemptions. In 2007 the MTC is reduced by 2%, but not below 0%, for each $2,500 or fraction thereof ($1,250 for marrieds filing separately) by which the taxpayer’s AGI for the tax year exceeds $234,600 for a joint return, $195,500 for head of household, $156,400 for single, and $117,300 for married filing separately. Also, for purposes of the AMT refundable credit, Sec. 53(e)(2)(B)(i) provides that AGI is determined without regard to the income exclusions of Secs. 911, 931, and 933.

Example: In 2007, D and J have a $250,000 total MTC, of which $200,000 is long-term unused MTC carried forward from tax years before 2004. Because their long-term unused MTC is greater than $25,000, their AMT refundable credit amount is $40,000 (20% of $200,000). Therefore, at this point the MTC they are allowed for 2007—before any AGI phaseout—cannot be less than $40,000.

D and J’s 2007 AGI is $261,600 ($27,000 above the $234,600 AGI phaseout threshold). Therefore, their allowable MTC is subject to a partial phaseout of $8,800 (22% of $40,000), leaving an allowable MTC of $31,200 ($40,000 2 $8,800) at this point.

D and J’s 2007 regular tax liability is $30,000, and their tentative minimum tax is $26,000. Assuming there are no other credits, their allowable MTC is $31,200—the greater of their AMT refundable credit amount ($31,200) or the amount of MTC otherwise allowable ($4,000 [$30,000 regular tax 2 $26,000 tentative minimum tax]).

Of the $31,200 allowable MTC, the “otherwise allowable” $4,000 portion of the credit is nonrefundable, leaving $27,200 as refundable. The remaining $218,800 of unused MTC is carried forward to future tax years.

Maximizing the Refundable MTC

Before the enactment of Sec. 53(e), individual taxpayers could obtain MTCs on their current returns only by using planning techniques that increased the spread between their regular tax and tentative minimum tax. For higher-income individuals, whose AMT exemption amounts are phased out under Sec. 55(d)(3), this might mean acceleration of ordinary income into the current year. With those individuals who had some or all of their AMT exemption, the opposite approach is commonly used. This latter technique can be particularly effective for taxpayers in the “AMT zone,” in which each dollar of reduced AMT income increases the AMT exemption amount by $1.25.

New Sec. 53(e) increases the importance of AGI, because AGI acts as a gatekeeper for the refundable MTC. Thus, individual taxpayers should attempt to keep AGI under the threshold in as many years as possible before 2013.

One uncertainty with the AGI phaseout is that Sec. 151(d)(3)(E) provides for reductions in the personal exemption phaseout amounts for the years 2006–2009. While Sec. 53(e)(2) incorporates the provisions of Secs. 151(d)(3)(B) and (C), which relate to the general phaseout percentages and amounts, it does not refer to the reduction of the phaseouts under Sec. 151(d)(E) for the years 2006–2009. If the Sec. 151(d)(E) reduction of one-third applies to the phaseout amount of the refundable MTC in 2007, D and J would have received an additional $2,933 ($8,800 3 1/3) in the above example.

Conclusion

New Sec. 53(e) provides an opportunity for many individuals to receive refunds from a liberalized definition of the MTC. Tax advisers should assess the availability of these refunds, which will often depend on planning for and monitoring their clients’ AGI.

EditorsNotes

Joel E. Ackerman, CPA, MST is with Holtz Rubenstein Reminick LLP, DFK International/USA Melville, NY.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

If you would like additional information about these items, contact Mr. Ackerman at (631) 752-7400 x262 or jackerman@hrrllp.com.