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SPRING 2002 THE JOURNAL OF WEALTH MANAGEMENT 1
I
n recent years, many high-net-worth tax-
payers have found that they are subject to
the alternative minimum tax even though
they do not have a significant amount of
traditional preference items. For instance, the
Wall Street Journal recently reported that the
Treasury Department estimates that nearly
one-third of all individual taxpayers will be
affected by the alternative minimum tax in
2010, up from only about 1% who were
affected last year. Additionally, the 2001 tax law
has exacerbated this problem, more than dou-
bling the number of individual taxpayers
expected to be subject to this tax by 2010.1
This situation undoubtedly comes as a
surprise to many investors, for whom “pref-
erence items” mean deductions such as accel-
erated depreciation and depletion, interest
income on certain special purpose municipal
bonds, or, most prominently, the bargain ele-
ment (or built-in gain) on incentive stock
options.2
By adjusting their investment allo-
cations, or by selectively timing the exercise of
their incentive stock options, these investors
have attempted to avoid or minimize the alter-
native minimum tax.
There are good reasons to engage in
these efforts, because the alternative minimum
tax can have a substantial negative impact on
the after-tax returns of an otherwise well-
planned investment strategy. For instance, bond
yields differ in part due to the taxability of the
bond. This difference in yields inevitably
reflects the highest potential income tax rates.
The conventional wisdom is that investors in
the highest tax brackets should buy municipal
bonds, since their after-tax returns are gener-
ally higher than the returns available on fully
taxable corporate bonds or state-tax-exempt
U.S. Treasuries or Agencies. However, if that
investor is subject to the alternative minimum
tax, his effective tax rate will be lower and a
substantial gain in after-tax yield can be
obtained by holding corporate bonds or U.S.
Treasuries instead.
The problem which many investors con-
front is that despite their best efforts to plan
around the preference items mentioned above,
they still find themselves unexpectedly and
unpredictably subject to the alternative mini-
mum tax. In many cases, it is the combination
of a significant proportion of long-term cap-
ital gains and high state income tax rates that
has produced this result. These taxpayers have
found that the alternative minimum tax has
applied despite the existence of an exemption
of the first $49,0003
of regular income from
that tax and despite the fact that long-term
capital gains are taxed at 20% for both ordinary
income tax purposes as well as alternative min-
imum tax purposes.
As will be explained in greater detail
below, this result occurs primarily for two rea-
sons. First, although long-term capital gains are
taxed at the same 20% rate for purposes of both
the regular tax calculation and the alternative
minimum tax calculation, and therefore do
not directly cause a taxpayer to be subject to
Capital Gains and the
Alternative Minimum Tax
PETER M. SUSKO
PETER M. SUSKO
is the president of Capital
Strategies Group, Ltd. in
Greenbrae, CA.
Psusko@aol.com

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the alternative minimum tax, the state tax liability on these
gains is deductible for regular tax purposes but not for
alternative minimum tax purposes. Consequently, in states
with high state income tax rates (e.g., California and
New York) the very presence of a significant amount of
long-term capital gains can cause a taxpayer to be subject
to the alternative minimum tax.4
Second, as the difference
between the regular federal income tax rate and the alter-
native minimum tax rate declines, the effect of this dif-
ference in the deductibility of the state tax grows more
important. The Economic Growth and Tax Relief Rec-
onciliation Act of 2001 (the “2001 Tax Act”) will exac-
erbate this effect as it reduces the maximum federal rate
from 39.6% to 35% over the next five years, while leav-
ing the alternative minimum rate at 28%. Consequently,
the difference between the ordinary rate and the alterna-
tive minimum rate will decline from 11.6% to 7%, a
reduction in relative terms of about 40%.
If a reliable method could be developed to predict the
probability that the alternative minimum tax will apply
based on the proportion of income that is represented by
long-term capital gains and the effective state income tax
rate, investors’ ability to properly plan their investment
strategies would be greatly increased. In pursuit of this
objective, this article will analyze the combined effect of
long-term capital gains and state income taxes as they
relate to the probability that a taxpayer will be subject to
the alternative minimum tax. By focusing solely on these
two issues, it is possible to develop a model which will accu-
rately forecast whether a taxpayer will be subject to the alter-
native minimum tax based solely on the percentage of
total income that is represented by long-term capital gains.
The discussion will begin with a summary of the
alternative minimum tax, describing the manner in which
it is calculated and providing an example of its applicabil-
ity. The analytical framework will then be developed, and
the key formula on which the analysis is based will be
derived. This framework will then be applied, and the
effect of changes in state tax rates, as well as the effect of
future reductions in the federal income tax rates, will be dis-
cussed. Finally, a number of strategies to mitigate the adverse
effect of the alternative minimum tax will be described.
BACKGROUND OF THE
ALTERNATIVE MINIMUM TAX
The alternative minimum tax was originally enacted
to ensure that taxpayers who had significant economic
income did not avoid paying most or all of the income
tax due on that economic income through the use of var-
ious tax shelters or “preference” items. The most high pro-
file of those items in recent years has been the untaxed
appreciation on stock acquired through the exercise of
incentive stock options, although there are numerous
other preference items as well. One of those items, and
the one which is key to this discussion, is the itemized
deduction for state income taxes.
Taxpayers are subject to the alternative minimum tax
if their regular tax liability is less than their alternative min-
imum tax liability. In general, the regular tax liability is
calculated by separating income into two classes: long-term
capital gains and all other income (ordinary income). For
most high-net-worth taxpayers, long-term capital gains
are taxed at a rate of 20%. To calculate the tax on ordi-
nary income, however, the taxpayer is first allowed to
deduct a variety of other items, including itemized deduc-
tions. Particularly in states with high state income taxes,
the largest itemized deduction is frequently the deduction
for state income taxes paid.5
After subtracting these deduc-
tions from the ordinary income, the tax on the net ordi-
nary income is calculated. The tax rate on this income is
graduated. The maximum tax on ordinary income is cur-
rently 39.1%, and will decrease in stages to 35% by 2006.
For instance, if a taxpayer has $500,000 of long- term
capital gains taxed at 20%, $1,000,000 of ordinary income,
and $150,000 of itemized deductions, the total federal reg-
ular tax liability will be approximately $432,350 (ignor-
ing the effects of the graduated tax rates). We will assume
in this example that all of the $150,000 of itemized deduc-
tions were attributable to state income taxes at a rate of
10% on the total income of $1,500,000. Note that of the
taxpayer’s total income of $1,500,000, 33% is represented
by long-term capital gains.
To determine if this taxpayer is subject to the alter-
native minimum tax, a separate calculation must be per-
formed.6
For purposes of that calculation, long-term
capital gains are again taxed at 20%. Consequently, there
is no difference between the tax liability incurred as a result
of the long-term capital gains for regular tax purposes or
for alternative minimum tax purposes. However, to cal-
culate the alternative minimum tax on the ordinary
income, a number of deductions are disallowed, includ-
ing the deduction for state income taxes. This adjusted
amount is then taxed at the alternative minimum tax rate
of 28%. While there is an exemption amount of $49,000
allowed for purposes of this calculation, the exemption is
phased out for high-income taxpayers. Thus, the alter-
native minimum tax would be $380,000: 20% of the
2 CAPITAL GAINS AND THE ALTERNATIVE MINIMUM TAX SPRING 2002

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long-term capital gains of $500,000, plus 28% of
$1,000,000. Since the amount due under the regular tax
calculation was greater, the taxpayer owes the regular tax
of $432,350.
However, what would have happened if the taxpayer
continued to have $500,000 of long-term capital gains, but
had only $200,000 of ordinary income rather than
$1,000,000? In this case, of the taxpayer’s total income of
$700,000, 71% is long-term capital gains. The state income
tax deduction would be reduced to $70,000 (10% of the total
income of $700,000), the taxpayer would have $130,000 of
taxable ordinary income, and the regular tax liability would
be approximately $150,830. However, the alternative min-
imum tax liability would be $156,000, and the taxpayer
would be subject to the alternative minimum tax.7
This simple example illustrates the problem which
confronts many high-net-worth taxpayers today. The
combination of a large proportion of long-term capital
gains and a high state income tax can cause them to be
subject to the alternative minimum tax, regardless of
whether they make use of more esoteric provisions of the
tax code.
ANALYTICAL FRAMEWORK
The goal of this analysis is to determine what ratio
of long-term capital gains to total income (adjusted gross
income) will cause a high-income taxpayer to be subject
to the alternative minimum tax. This ratio will be calcu-
lated as a function of the average state income tax rate to
which the taxpayer is subject.
In performing this analysis, a number of simplify-
ing assumptions will be made. First, we will assume that
the only deduction available to the taxpayer is the deduc-
tion for state income taxes. Since any other itemized
deductions that a taxpayer might have (i.e., charitable
and miscellaneous deductions, real estate taxes) simply
increase the likelihood that the alternative minimum tax
will apply, eliminating them from the analysis gives us a
“best-case” scenario.8
Second, any state income tax lia-
bility is paid in the year the income is recognized. Third,
there is an average rate of state income tax which applies
to all income, regardless of whether it is ordinary or long-
term capital gains. Fourth, all ordinary income is taxed at
the maximum rate for federal purposes, rather than receiv-
ing the benefit of the graduated tax rates which are in
place. Since these graduated rates reduce the regular tax
liability but not the alternative minimum tax liability,
including them in the analysis would increase the likeli-
hood that the alternative minimum tax would apply, and
eliminating them from the analysis once again tends to give
us a “best-case” scenario. Finally, for purposes of these cal-
culations, we have also ignored the base amount of adjusted
gross income (currently $128,950) that is excluded in
calculating the allowable itemized deductions, as well as
the 26% alternative minimum tax rate that applies to the
first $175,000 of alternative minimum taxable income.
These two adjustments tend to offset each other, so elim-
inating their effects greatly simplifies the calculations
without changing the results materially.
The bottom-line effect of these assumptions is to
allow us to create a formula in which all of the variables
and all of the calculations are a function of the current
year’s taxable income. The formulas that are used to make
these calculations are:
(1)
and
(2)
which simplify to:
(3)
where C is the dollar amount of long-term capital gains,
O is the dollar amount of ordinary income (so that C + O
is equal to I, which is the taxpayer’s total, or adjusted gross,
income), tC is the federal capital gains tax rate (currently
20%), tO is the federal ordinary income tax rate (currently
39.1% but decreasing to 35% by 2006), tA is the federal alter-
native minimum tax rate (currently 28%), and tS is the state
tax rate (which will vary). It is worth noting that tC does
not appear in Equation (3). The practical significance of this
is that changes in the long-term capital gains tax rate have
no effect on the conclusions reached in this discussion.9
Conceptually, Equation (3) states that when long
term capital gains exceed a percentage of total income
which is equal to the ordinary tax rate (grossed up for the
3% disallowed itemized deductions) minus the alternative
minimum tax rate and minus the tax benefit of the state
tax deduction, all divided by the difference between the
ordinary tax rate and the alternative minimum tax rate,
C
t t t t
t t
IO A O S
O A
>
− −
−
1 03.
C O I+ =
Ct t O Ct t O t C OC A C O S+ > + − − +( ( . )( ))03
SPRING 2002 THE JOURNAL OF WEALTH MANAGEMENT 3

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then the alternative minimum tax will apply. Since all of
the federal tax rates are known, by solving for C as a func-
tion of I, Equation (3) allows us to determine the ratio
of long term capital gains to adjusted gross income at
which the alternative minimum tax will apply, given var-
ious assumptions about the average state income tax rate.
APPLYING THE ANALYTICAL FRAMEWORK
Exhibit 1 summarizes the results of this analysis. For
instance, the first column, which reflects the current
year’s marginal tax rate of 39.1%, shows that a taxpayer
whose average state income tax rate is 4% would be sub-
ject to the alternative minimum tax only if 96.5% or more
of his adjusted gross income consisted of long term cap-
ital gains.10
Thus, if the taxpayer had an adjusted gross
income of $1,000,000, the alternative minimum tax
would apply only if that income consisted of $965,000
of long term capital gains and $35,000 of other ordinary
income.
The reader’s initial reaction to this result might be
to wonder why there is a problem. Looking further down
the same column, the problem begins to become more
apparent. At a 10% average state income tax rate (similar
to the combined state and city tax rate paid by New York
City residents), the percentage of capital gains at which
the alternative minimum tax becomes effective is 75.3%.
That is, if a taxpayer subject to a 10% state and local
income tax rate has an adjusted gross income of
$1,000,000, of which $753,000 is long term capital gains,
the alternative minimum tax will apply.
The next two columns of Exhibit 1 summarize the
allowable percentages of capital gains at the various federal
tax rates that will be in effect between 2001 and 2005, and
the last column of the Exhibit shows the percentages for
year 2006 and subsequent years. For instance, in 2004 and
2005, when the maximum federal tax rate has been reduced
to 37.6%, a taxpayer whose average state income tax rate
is 10% will be subject to the alternative minimum tax if his
long term capital gains exceed 72.6% of his adjusted gross
income. That is, if a taxpayer subject to a 10% state and local
income tax rate has an adjusted gross income of $1,000,000,
of which $726,000 is long term capital gains, the alterna-
tive minimum tax will apply. For many wealthy taxpayers,
this type of breakdown between ordinary income and long
term capital gains is not unusual.
However, the real significance of the problem
becomes apparent from the last column in Exhibit 1,
which reflects the allowable percentages of capital gains
beginning in 2006. Two significant changes occur in that
year. First, the highest federal tax rate is reduced by 2.6%
from 37.6% to 35%. This reduction alone is larger than
the total of all the reductions which will occur from 2001
through 2005. Second, and even more significantly, the
3% phaseout of itemized deductions is eliminated. As a
result, even taxpayers who reside in states with low state
income tax rates (i.e., 3% or below) may potentially be
subjected to the alternative minimum tax solely as a result
of long term capital gains.11
The combination of these two changes has a dramatic
effect on the proportion of capital gains which will cause
the alternative minimum tax to apply. This effect can be
4 CAPITAL GAINS AND THE ALTERNATIVE MINIMUM TAX SPRING 2002
Average
State Tax
Rate 39.1% 38.6% 37.6% 35.0%
1% 100.0% 100.0% 100.0% 95.0%
2% 100.0% 100.0% 100.0% 90.0%
3% 100.0% 100.0% 100.0% 85.0%
4% 96.5% 96.4% 96.1% 80.0%
5% 93.0% 92.7% 92.2% 75.0%
6% 89.4% 89.1% 88.3% 70.0%
7% 85.9% 85.4% 84.3% 65.0%
8% 82.4% 81.8% 80.4% 60.0%
9% 78.9% 78.2% 76.5% 55.0%
10% 75.3% 74.5% 72.6% 50.0%
Federal Regular Tax Rate
E X H I B I T 1
Ratio of Long-Term Capital Gains to Total Income at Various Federal and State Tax Rates

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the ratio of long term gains to adjusted gross income at
which the alternative minimum tax applies. For instance,
a taxpayer who is subject to a 10% state income tax rate
will find that the alternative minimum tax applies in 2006
if as little as 50% of his adjusted gross income is in the form
of long term capital gains. A taxpayer with an adjusted gross
income of $1,000,000 will be subject to the alternative min-
imum tax if more than $500,000 of that income is long term
capital gains. Contrast this to the same taxpayer the prior
year, who would have needed $726,000 of capital gains
before the alternative minimum tax would have applied.
It is worth repeating at this point that this analysis
makes a number of restrictive assumptions, and, therefore,
the percentages shown in Exhibit 1 reflect the maximum per-
centage of long term capital gains that can be recognized
before the alternative minimum tax applies. If the gradu-
ated tax rates were to be considered, or if a taxpayer has
other itemized deductions that are not deductible for alter-
native minimum tax purposes, the alternative minimum tax
would become applicable at percentages which could be
substantially lower than those shown in the Exhibit.
STRATEGIES FOR MINIMIZING
THE TAX LIABILITY
There are a number of strategies which can be
employed by an investor to minimize the total amount of
income taxes owed.12
These strategies fall into two pri-
mary categories: the acceleration or deferral of itemized
deductions into taxable years in which the deductions will
have more value, and the acceleration or deferral of
income (whether ordinary or long term capital gains)
into taxable years in which the effective rate on that
income will be less.
Before discussing these strategies, it is worth noting
that being subject to the alternative minimum tax does have
some positive implications. The most notable of these
implications is that incremental dollars of ordinary income
will be taxed for federal purposes at the 28% alternative
SPRING 2002 THE JOURNAL OF WEALTH MANAGEMENT 5
1% 2%
3% 4%
5%
6%
7%
8%
9%
10%
35.0%
37.6%
38.6%
39.1%
40%
50%
60%
70%
80%
90%
100%
LongTermCapitalGain
asa%ofTotalIncome
State Income Tax Rate
Federal Ordinary
Tax Rate
E X H I B I T 2
Ratio of Long-Term Capital Gains to Total Income Which Causes the Alternative Minimum Tax to Apply

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minimum tax rate rather than at the ordinary rate then in
effect (ranging from 39.1% in 2001 down to 35% in 2006).
However, the downside of this result is that any state
income tax deductions generated by that additional income
will not provide any federal deduction if they are taken in
the same year, since the alternative minimum tax does not
allow those deductions. This leads to the first strategy
which can be used to minimize the effect of this problem,
which is to either accelerate or defer the state income tax
deductions into a year in which the taxpayer will not be
subject to the alternative minimum tax.13
For instance, if a taxpayer is not subject to the alter-
native minimum tax this year but knows that he will have
a large amount of long term capital gains next year which
(looking at Exhibit 1) will surely cause the alternative min-
imum tax to apply, the taxpayer should prepay all of his cur-
rent year’s state income taxes, rather than waiting until the
following April 15 to make the necessary tax payments.14
Additionally, since federal tax rates are being reduced under
the new tax act, this strategy also conforms to the general
strategy which taxpayers should be using now, which is to
accelerate deductions into the current year.
Similarly, if a taxpayer is subject to the alternative
minimum tax this year but believes that he will not be sub-
ject to it next year, it will be worthwhile to pay as little
as possible in state income taxes in the current year and
defer as much as possible into the following year. In fact,
depending on the level of certainty that a taxpayer has that
he will not be subject to the alternative minimum tax in
the following year, it may even be worthwhile to under-
pay the current year’s state income taxes and incur a
penalty for that underpayment.
For instance, assume that a taxpayer has a $100,000
state estimated tax payment which is due on April 15 of
this year. The taxpayer is absolutely certain that the alter-
native minimum tax will apply this year, and equally cer-
tain that it will not apply next year. Consequently, any
additional state income taxes that are paid this year will
generate no federal income tax deduction, but if paid next
year will generate a $100,000 deduction which is worth
$35,000 if the federal tax rate is 35%. By not making this
payment until January 1 of next year, the taxpayer will
incur a non-deductible penalty which will be in the range
of 6% of the amount due, or $6,000.15
Clearly, the $35,000
benefit outweighs the $6,000 cost.
There are two difficulties with implementing this
strategy. First, very few taxpayers can say with absolute cer-
tainty that they will, or will not, be subject to the alter-
native minimum tax in a future year. To the extent there
is uncertainly in this prediction, it should be taken into
account, since an error in this regard would cause the
$35,000 deduction to be lost, resulting in a net cost of
$6,000 rather than a net savings of $29,000. Second,
underpayment of estimated taxes could result in some
additional risk of a tax audit by the state tax authorities
involved. The probability and cost of this risk are diffi-
cult to quantify, and should be viewed not only in terms
of the dollars at risk but also the time, effort, and stress
which tax audits necessarily involve.
The second set of available strategies relate to the
recognition of additional ordinary income up to an
amount at which the regular tax and alternative minimum
tax liabilities are equal. As was mentioned above, each dol-
lar of additional ordinary income will be taxed for fed-
eral purposes at the alternative minimum tax rate of 28%,
rather than at the higher regular tax rate then in effect.
Of course, it will also be taxed at the marginal state rate
as well with no federal deduction for the additional state
income tax incurred (assuming that the taxpayer isn’t able
to pay the state tax in another year when the alternative
minimum tax doesn’t apply). While there are hypothet-
ical circumstances when the taxpayer could be worse off
using this strategy, currently those circumstances are inap-
plicable regardless of the taxpayer’s state of residence.16
The more difficult task is to determine the appro-
priate amount of additional ordinary income to recognize
to equalize the regular tax and the alternative minimum
tax in a particular year. While the ratios shown in Exhibit
1 represent a good starting place, the taxpayer must take
into account all the other itemized deductions, graduated
rates, credits, hurdle amounts, and other tax items (which
have been ignored in this article) in order to reach the most
economical amount of income to be recognized.
A special case involving this strategy occurs when a
taxpayer holds a large equity position in a single company,
part of which consists of highly appreciated stock eligi-
ble for long term capital gains treatment, and part of
which consists of non-qualified options which have a
significant intrinsic value.17
Because of the undiversified
nature of the position, the taxpayer may be in the process
of selling significant amounts of the position in order to
diversify his portfolio. The normal course of action would
be to sell the stock, since it qualifies for long term capi-
tal gains treatment.
Depending on the expected future tax situation of
the taxpayer, this may not be the most appropriate course
of action. In particular, if the taxpayer expects to be sub-
ject to regular taxes rather than the alternative minimum
6 CAPITAL GAINS AND THE ALTERNATIVE MINIMUM TAX SPRING 2002

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tax in the future, and expects to be continuing a program
of regular sales of this position, then it may make sense
to exercise the non-qualified options and sell that stock,
resulting in the recognition of ordinary income in the
current year.
For instance, assume that the taxpayer holds 10,000
shares of XYZ stock, with a tax basis of $0, and a fair mar-
ket value of $1,000,000 ($100 per share). He also holds
10,000 non-qualified options with a nominal strike price.
Based on the Exhibit 1 ratios and other relevant tax items,
the taxpayer is already certain to be subject to the alter-
native minimum tax this year. He wants to liquidate his
entire position in XYZ in the next two years, but because
of a large compensation award to be received next year,
expects not to be subject to the alternative minimum tax
next year. The federal regular tax rate is 35% and the state
income tax rate is 10%.
If the taxpayer sells the 10,000 shares of stock this
year, and exercises the options next year (assuming the
price remains at $100 per share), he will realize
$2,000,000 in gross proceeds. Taxes due this year will be
$300,000 ($200,000 in federal capital gains and $100,000
in state taxes, which produce no offsetting federal tax
deduction). The taxes due next year will be $415,000
($350,000 in federal ordinary income taxes and $100,000
in state taxes, which produce an offsetting federal tax ben-
efit of $35,000). The total taxes due will be $715,000 and
the net proceeds from the two transactions will be
$1,285,000.
Alternatively, if the taxpayer reverses the order in
which the transactions take place, the $1,000,000 of pro-
ceeds from the exercise and sale of the non-qualified
options this year will create a tax liability of $380,000
($280,000 in federal alternative minimum tax and
$100,000 in state taxes, which produce no offsetting fed-
eral tax deduction). The total taxes due next year will be
$265,000 ($200,000 in federal capital gains and $100,000
in state taxes, which produce an offsetting federal tax
benefit of $35,000). The total taxes due will be $645,000,
and the net proceeds from the two transactions will be
$1,355,000, or $70,000 more.18
The final set of strategies which might be used relate
to reducing the percentage of long term capital gains by
either accelerating or deferring the recognition of those
gains into a year in which the taxpayer is not subject to
the alternative minimum tax. On a stand alone basis, this
strategy does not accomplish any tax savings. For instance,
if a taxpayer is exactly at the point at which the alterna-
tive minimum tax applies, and he decides to defer some
long term capital gains into the following year, then the
year in which the capital gains taxes will be paid will
change, but the combined tax liability will not be reduced.
There is, of course, the advantage of deferring the tax lia-
bility on the deferred capital gains, and there may be
some benefit if other itemized deductions can then be used
to reduce the regular tax liability.
A clearer benefit to this strategy occurs when the tax-
payer has the ability to substitute short term capital gains
for long term capital gains, in a manner similar to that
described with respect to the exercise of non-qualified
options. For instance, assume the same facts as in the
example above, except that rather than holding non-
qualified options on 10,000 shares of stock, the taxpayer
holds 10,000 shares of XYZ stock which qualify for short
term capital gains treatment, as well as the 10,000 shares
of stock which would produce a long term capital gain if
they were sold now. If the taxpayer is subject to the alter-
native minimum tax in the current year, and does not
expect to be subject to it in a future year, it is possible to
realize the same $70,000 tax saving as was described above
in the discussion of non-qualified options by recognizing
the short term capital gain this year while deferring the
long term gain until next year.
CONCLUSION
The combination of a significant amount of long
term capital gains, combined with high state income tax
rates, can frequently cause a taxpayer to become subject
to the federal alternative minimum tax, despite the fact
that capital gains are taxed at 20% for federal purposes
under both the regular tax and the alternative minimum
tax regimes. This result occurs because the long term cap-
ital gains generate a state tax liability which cannot be
deducted for purposes of the alternative minimum tax.
The gradual reduction in regular tax rates over the next
several years, as part of the 2001 Tax Act, will exacerbate
this problem since there is no similar reduction in the alter-
native minimum tax rate.
It is possible, however, to derive a formula which will
calculate the ratio of long term capital gains to total
income that causes the alternative minimum tax to apply.
This analysis allows taxpayers to determine whether they
will be subject to the alternative minimum tax at an early
stage, perhaps in time to defer or accelerate other income
or deductions and substantially reduce their overall income
tax burden as a result.
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ENDNOTES
1
Wall Street Journal [December 5, 2001, p. A1, col. 5].
2
The bargain element of an incentive stock option is the
difference between the fair market value of the stock and the
strike price of the option at the time the option is exercised.
For instance, if an executive exercises incentive stock options
to purchase 1,000 shares of stock at a time when the stock price
is $20 per share and the strike price of the options is $1 per share,
the bargain element would be $19 per share times 1,000 shares,
or $19,000.
3
The 2001 Tax Act increased the amount of this exemp-
tion for married couples filing jointly to $49,000 from $45,000.
However, any adjusted gross income, including capital gains,
above a threshold amount of $150,000 causes this exemption
to be phased out. Consequently, for most high net worth tax-
payers, the exemption is irrelevant.
4
See Everett and O’Neill [2000, p. 798]. This result is
ameliorated to some extent by the fact that an amount of item-
ized deductions equal to 3% of a taxpayer’s adjusted gross
income is not deductible for purposes of calculating the regu-
lar tax. However, this reduction is eliminated in 2006, the
same year the maximum tax rate is reduced to 35%.
5
Other typical itemized deductions include real estate
taxes, charitable contributions, interest expense, investment
portfolio expenses, and medical and dental expenses.
6
A much more comprehensive discussion of the calcu-
lations involved can be found in Everett and O’Neill [2000, pp.
788-794] and Khokar [2001, pp. A12-13].
7
Technically, the taxpayer is obligated to pay the regu-
lar tax of $150,830 plus the difference of $5,170, which is the
amount of the alternative minimum tax.
8
By “best case” scenario, the author means that the cal-
culated percentages in Exhibit 1 are the highest percentages
which could occur without the alternative minimum tax apply-
ing. If any of the assumptions were not true, the alternative min-
imum tax could apply even if the percentage of capital gains
was lower.
9
After the 3% phaseout of itemized deductions ends in
2006, the simplified version of this formula will be:
10
Because of the assumption we’ve made that there are
no other itemized deductions, if the state tax rate is 3% or less,
there is no deduction for state income taxes for ordinary tax pur-
poses due to the 3% phaseout currently in effect. Consequently,
the alternative minimum tax will not apply to these taxpayers
based on the assumptions made in this analysis.
C
t t t t
t t
IO A O S
O A
>
− −
−
11
The effect of the elimination of the 3% floor on item-
ized deductions is an exact parallel shift in the numbers in the
table. For instance, prior to the elimination of the 3% floor, tax-
payers subject to a 13% state tax rate would have been subject
to the alternative minimum tax if more than 50% of their
income is capital gains. After the elimination of the 3% floor,
taxpayers subject to a 10% state tax rate (13% – 3% = 10%) will
be subject to the alternative minimum tax if more than 50% of
their income is capital gains.
12
See Everett and O’Neill [2000, pp. 794-799].
13
This strategy is a subset of a broader set of strategies relat-
ing to the acceleration or deferral of itemized deductions gen-
erally. Because this article is focused solely on the relationship
of capital gains and state income taxes to the alternative mini-
mum tax, these other strategies will not be discussed further.
14
Technically, paying the current year’s taxes rather than
deferring them into the following year does not solve the alter-
native minimum tax problem discussed in this article. However,
if as a result of a good faith estimate, a taxpayer overpays the
current year’s taxes, it will accelerate the deductions and help
to reduce the potential problem. This strategy also assumes that
the taxpayer uses the cash method of accounting, which is a rea-
sonable assumption for most individuals.
15
Current late payment penalties are approximately 8%
per year. Since the payment would be made nine months late,
the penalty would be approximately _ of 8%, or 6%.
16
At very high state income tax rates, it would be possi-
ble for a taxpayer to be worse off losing the deduction for state
taxes rather than receiving the benefit of paying the alternative
minimum tax rather than the regular tax. The formula is:
which simplifies to:
that is, if the state income tax rate exceeds one minus the ratio
of the alternative minimum tax rate to the regular tax rate, then
it would be disadvantageous to recognize additional ordinary
income. However, since the highest ratio of alternative mini-
mum taxes to regular taxes will be 80% (28% divided by 35%),
a taxpayer would need to be subject to a marginal state income
tax rate in excess of 20% for this to occur.
17
The decision process when a taxpayer has incentive
stock options is much less clear. If the other requirements for
holding periods are met, the bargain element of an incentive
stock option (that is, the difference between the option exer-
t
t
t
S
A
O
> −1
t t t t t tA S O S O S+ > + −
8 CAPITAL GAINS AND THE ALTERNATIVE MINIMUM TAX SPRING 2002

9. FinalApprovalCopy
cise price and the fair market value on the date of exercise) is
a tax preference item. For instance, if the 10,000 non-quali-
fied options in the example above were incentive stock options
instead, then on the date of exercise the $1,000,000 difference
between the strike price and the fair market value would be a
preference item which would produce a $280,000 alternative
minimum tax liability if the taxpayer was already subject to the
alternative minimum tax. If the other holding period require-
ments are not met, then the incentive stock option effectively
converts to a non-qualified option.
18
The $70,000 difference is equal to the 7% rate differ-
ential between the ordinary tax rate and the alternative mini-
mum tax rate, multiplied by the $1,000,000 income on the
exercise of the non-qualified options.
REFERENCES
Everett, John O., and Cherie J. O’Neill. “AMT Planning
Strategies.” The Tax Adviser, November 2000, pp. 788-799.
Khokar, Javed A. “Alternative Minimum Tax.” 288—4th
T.M., Tax Management, 2001.
“Tax Report.” The Wall Street Journal, December 5, 2001, p. A1.
SPRING 2002 THE JOURNAL OF WEALTH MANAGEMENT 9