Understanding Tax Preference Items
A tax preference item is a type of income that, when received, is usually exempt from taxation but can trigger the alternative minimum tax (AMT) for taxpayers. Examples of tax preference items include interest from private activity municipal bonds, specific exclusions for small business stock, and excess intangible drilling costs for oil and gas. These items become relevant if they exceed 40% of the taxpayer’s AMT income. In the IRS tax formula, tax preference items are added to the total AMT income.
Understanding Tax Preference Items
The alternative minimum tax (AMT) serves as a supplementary tax that individuals or corporations must pay, ensuring a minimum tax payment after all legitimate deductions and credits have been applied. AMT functions as an alternative to standard income tax, particularly affecting high-income earners by limiting certain deductions. Individuals earning above the AMT exemption amount must calculate both regular income tax and AMT, choosing the higher of the two for payment purposes.
Items considered in AMT calculations are known as tax preference items, which are incomes subjecting individuals to the AMT. While these items are excluded in regular tax computations, they are included in AMT calculations, increasing tax obligations for individuals.
Essentially, tax preference items are typically deductible under regular tax circumstances but not for the purpose of AMT. When these items exceed a specified percentage of a taxpayer’s income, they must be added back to the taxable income to determine the final tax owed, resulting in a higher tax liability. Some examples of tax preference items include deductions for accelerated depreciation, net income from oil and gas properties, and investment tax credits.
Tax preference items, much like the AMT itself, aim to prevent high-income individuals from minimizing their tax obligations through certain financial activities. For instance, investors holding private-activity bonds issued post-August 1986 must declare all related income, thereby preventing them from sheltering this income source to avoid tax liabilities.
Key Takeaways
- Tax preference items are specific types of income that can impact the alternative minimum tax calculation.
- The AMT is designed to prevent high-income taxpayers from avoiding tax liabilities through preferential tax breaks.
- Examples of tax preference items include income from oil and gas properties, accelerated depreciation deductions, stock option gains, and investment tax credits.
Calculating AMT
To determine if AMT is owed, individuals can utilize tax software or complete IRS Form 6251. This form considers various deductions like medical expenses and home mortgage interest to determine if they exceed the IRS-prescribed limit. Additionally, it requires details on specific incomes such as investment interest and capital gains, using IRS formulas to calculate the final Alternative Minimum Taxable Income (AMTI).
Form 6251 also prompts information on types of income like tax refunds and interest from private activity bonds, along with numbers related to capital gains or losses from property transactions. The IRS employs specific formulas to ascertain which figures taxpayers should report on the form, guiding them to the final AMTI calculation.