What it means
Tax codes contain many breaks designed to encourage certain behaviour, such as investing in particular assets or making deductions for certain costs. Used heavily, these can reduce someone's regular tax bill to a very small amount.
Each break has a policy aim, but their combined effect can be larger than lawmakers intended. To stop this, some systems run a second calculation called a minimum tax.
The calculation starts with taxable income and adds back the preference items, producing a larger base on which a different set of rates is applied. Because the rates and exemptions differ, the result can be higher or lower than the regular tax.
Examples of preference items include interest on certain private activity bonds and the excess of accelerated depreciation over straight-line depreciation on some property. The list is set by law and has changed over time.
Accountants keep a schedule of these items each year, so the minimum tax calculation is ready. The taxpayer then pays whichever is higher, the regular tax or the minimum tax.
In practice only a minority of taxpayers are affected, but those who are can face a surprising bill. The first sign of trouble is often an unexpectedly large balance due when the return is prepared.
Planning around it means looking at the whole picture. Before buying a bond, or choosing a depreciation method, an adviser will estimate whether the preference could trigger the minimum tax.
In some years it can be sensible to accept a smaller regular tax break to avoid a larger minimum tax. The nuance is that the rules are technical and change with legislation.
Thresholds, exemptions and rates are updated from time to time, so always use the current rules for the year in question. A good adviser will confirm which items are preference items for the year in question.
In practice
Real-world examples.
Example
A professional invests in bonds funding a stadium, and the interest is exempt from regular tax. Under the minimum tax rules, part of that interest is a preference item and is added back. Her adviser flags this before she buys more. She decides whether the lower regular tax is worth the extra minimum tax exposure.
Example
A property investor uses fast depreciation on a building and reports a low taxable profit. The depreciation above the standard method is a preference item. The investor's accountant runs both tax calculations each year to see which one applies. The extra depreciation still brings some benefit, since it defers tax.
Example
A company director considers a large tax-advantaged investment late in the year. His adviser models the effect and finds that it would push him into minimum tax. He spreads the investment across two years instead. The delay lowers his minimum tax exposure and keeps the benefit of the investment.
Formula
Calculation
Alternative minimum taxable income = Regular taxable income + Adjustments + Tax preference items
Suppose a business owner has regular taxable income of $200,000. She has $25,000 of excess depreciation and $15,000 of interest from private activity bonds, which are both preference items. Alternative minimum taxable income = 200,000 + 25,000 + 15,000 = $240,000. The minimum tax is then calculated on this larger base after an exemption, and she pays whichever result is higher.Case study
Seen in the real world.
Whitlock Holdings is an illustrative, fictional family company whose owner invested heavily in assets with generous depreciation. For two years, the regular tax bill was very low, and the owner assumed this would continue.
In the third year, the accountant ran the minimum tax calculation and found that preference items of $120,000 raised the tax base so much that the minimum tax exceeded the regular tax by $18,000.
In this illustrative story, the owner had not set aside any cash for the extra bill. The accountant now runs both calculations in the autumn, which gives the family time to adjust purchases before the year ends.
Watch out
Common mistakes.
- Assuming a tax break is always a saving, when it can trigger a minimum tax that cancels the benefit.
- Checking only the regular calculation, when the minimum tax calculation can produce a higher bill.
- Using old thresholds, since exemptions and rates change over time.
Questions
People also ask.
Who is most likely to be affected?
Taxpayers with large deductions or investments in tax-favoured assets, particularly those with high incomes.
Is a preference item a deduction?
No, it is the reverse, because it is an item that is added back to income in the minimum tax calculation.
Can I get relief for minimum tax paid?
In some systems, tax paid under the minimum can be recovered as a credit in later years, so ask your adviser about the rules.
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