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Chapter 31
How to figure your tax

What’s New

Standard deduction amount increased for 2017. The personal standard deduction amount for tax years beginning in 2017 is increased to $6,350 for unmarried taxpayers, $12,700 for married taxpayers filing jointly or certain surviving spouses, $9,350 for heads of household, and $6,350 for married taxpayers filing separately.

Alternative Minimum Tax (AMT) exemption amount increased. For 2017, the exemption amounts for AMT are increased to $54,300 for unmarried taxpayers, $84,500 for married taxpayers filing jointly or certain surviving spouses, and $42,250 for married taxpayers filing separately.

AMT exemption for a child with unearned income increased. The AMT exemption for a child whose unearned income is taxed at the parent’s rate may not exceed the child’s earned income for the tax year, plus $7,500.

TAXALERT

In recent years, Congress has repeatedly enacted temporary measures (typically called an “AMT patch”) that significantly raised the applicable exemption amounts above the level that last applied in 2000. The American Taxpayer Relief Act of 2012 enacted a permanent AMT patch and indexed it for inflation in future years. For 2017, the AMT exemption is:

$84,500 (up from $83,800 in 2016) for married couples filing jointly and surviving spouses;
$54,300 (up from $53,900 in 2016) for other unmarried individuals; and
$42,250 (up from $41,900 in 2016) for married individuals filing separate returns.

The exemption phases out at higher levels of alternative minimum taxable income (AMTI). A taxpayer’s exemption amount is reduced (but not below zero) by 25% of the amount by which AMTI exceeds the following:

For married taxpayers filing jointly or a surviving spouse, $160,900
For a taxpayer filing as single or as a head of household, $120,700
For a married taxpayer filing a separate return, $80,450

The exemptions fully phase out at: $498,900 of AMTI for married couples filing jointly and surviving spouses; $337,900 for other unmarried individuals; and $249,450 for married individuals filing separately. Those taxpayers with AMTI in the above phase-out income ranges can be subject to a marginal tax rate of as high as 27% (20% top statutory rate plus 7%, which is one-fourth of the 28% AMT rate) on capital gains and qualified dividends.

After you have figured your income and deductions as explained in Parts 1 through 5, your next step is to figure your tax. This chapter discusses:

The general steps you take to figure your tax,
An additional tax you may have to pay called the alternative minimum tax (AMT), and
The conditions you must meet if you want the IRS to figure your tax.

TAXPLANNER

As described later in more detail in the TAXALERT on How the AMT works, the AMT structure requires taxpayers to “add back” certain preference and adjustment items to arrive at AMT income, subject to tax at the 26% or 28% minimum tax rates.

Private-activity bonds. Interest received on private-activity bonds issued prior to 2009 and after 2010 is an AMT preference item. However, interest received on tax-exempt private-activity bonds issued in 2009 and 2010 is not an AMT preference item. You should consult with your investment advisor to see how the new provision may have affected the interest rate on private-activity bonds issued during this 2-year period (issuers may have been able to issue bonds with a somewhat lower interest rate than they otherwise would have had to do when interest paid was treated as a preference item), as well as the effect on market pricing for new and previously issued bonds. Interest received on private-activity bonds issued prior to 2009 and after 2010 is counted as an AMT preference.

Figuring Your Tax

Your income tax is based on your taxable income. After you figure your income tax and AMT, if any, subtract your tax credits and add any other taxes you may owe. The result is your total tax. Compare your total tax with your total payments to determine whether you are entitled to a refund or if you must make a payment.

This section provides a general outline of how to figure your tax. You can find step-by-step directions in the Instructions for Forms 1040EZ, 1040A, and 1040. If you are unsure of which tax form you should file, see Which Form Should I Use? in chapter 1.

Tax. Most taxpayers use either the Tax Table or the Tax Computation Worksheet to figure their income tax. However, there are special methods if your income includes any of the following items.

A net capital gain. (See chapter 16.)
Qualified dividends taxed at the same rates as a net capital gain. (See chapters 8 and 16.)
Lump-sum distributions. (See chapter 10.)
Farming or fishing income. (See Schedule J (Form 1040), Income Averaging for Farmers and Fishermen.)
Tax for certain children who have unearned income. (See chapter 32.)
Parents’ election to report child’s interest and dividends. (See chapter 32.)
Foreign earned income exclusion or the housing exclusion. (See Form 2555, Foreign Earned Income, or Form 2555-EZ, Foreign Earned Income Exclusion, and the Foreign Earned Income Tax Worksheet in the Form 1040 Instructions.)

Credits. After you figure your income tax and any AMT (discussed later), determine if you are eligible for any tax credits. Eligibility information for these tax credits is discussed in chapters 33 through 38 and your form Instructions. The following table lists some of the credits you may be able to subtract from your tax and shows where you can find more information on each credit.

CREDITS
For information on:	See chapter:
Adoption	38
Alternative motor vehicle	38
Alternative fuel vehicle refueling property	38
Child and dependent care	33
Child tax	35
Credit to holders of tax credit bonds	38
Education	36
Elderly or disabled	34
Foreign tax	38
Mortgage interest	38
Plug-in electric drive motor credit	38
Premium tax credit	37
Prior-year minimum tax	38
Residential energy	38
Retirement savings contributions	38

TAXSAVER

The tax law provides for certain nonrefundable personal tax credits. Nonrefundable personal credits are allowed to the extent of the full amount of the individual’s regular tax and alternative minimum tax. These credits include the dependent care credit, the credit for the elderly and disabled, the adoption credit, the child tax credit, the credit for interest on certain home mortgages, the lifetime learning and American opportunity credits (except for the refundable portion of the American opportunity credit), the savers credit for elective deferrals and IRA contributions by certain individuals, the credit for residential energy-efficient property, and the credit for qualified four-wheeled vehicles with plug-in electric drive motors. These credits are described in the section on Nonrefundable Credits, in chapter 38, Other credits including the earned income credit.

The nonrefundable credits for nonbusiness energy property alternative motor vehicles, hydrogen refueling property, and qualified plug-in electric drive two-wheeled motorcycles expired at the end of 2016. While Congress had previously extended these credits after they had expired in prior tax years, no such legislation to extend this credit again had been passed as of the time this book went to press. However, discussion of these credits is included in chapter 38 in case any are retroactively extended to the beginning of 2017. For updated information on these credits and any other tax law changes that occur after this book was published, see our website, ey.com/EYTaxGuide.

Some credits (such as the earned income credit) are not listed because they are treated as payments. See Payments, later.

There are other credits that are not discussed in this publication. These include the following credits.

General business credit, which is made up of several separate business-related credits. These generally are reported on Form 3800, General Business Credit, and are discussed in chapter 4 of Pub. 334, Tax Guide for Small Business.
Renewable electricity, refined coal, and Indian coal production credit for electricity and refined coal produced at facilities placed in service after October 22, 2004 (after October 2, 2008, for electricity produced from marine and hydrokinetic renewables). See Form 8835, Part II.
Work opportunity credit. See Form 5884.
Credit for employer social security and Medicare taxes paid on certain employee tips. See Form 8846.

Other taxes. After you subtract your tax credits, determine whether there are any other taxes you must pay. This chapter does not explain these other taxes. You can find that information in other chapters of this publication and your form Instructions. See the following table for other taxes you may need to add to your income tax.

You also may have to pay AMT or make a shared responsibility payment (both are discussed later in this chapter).

OTHER TAXES
For information on:	See chapter:
Additional taxes on qualified retirement plans and IRAs	10, 17
Net investment income tax	49
Household employment taxes	33
Recapture of an education credit	36
Social security and Medicare tax on wages	5
Social security and Medicare tax on tips	6
Uncollected social security and Medicare tax on tips	6
Social security and Medicare tax on self-employment income	5, 39
Additional Medicare tax	5
Repayment of first-time homebuyer credit	38

There are other taxes that are not discussed in this publication. These include the following items.

Text intentionally omitted.

Recapture taxes. You may have to pay these taxes if you previously claimed an investment credit, a low-income housing credit, a new markets credit, a qualified plug-in electric drive motor vehicle credit, an alternative motor vehicle credit, a credit for employer-provided child care facilities, an Indian employment credit, or other credits listed in the Instructions for Form 1040, line 62. For more information, see the Instructions for Form 1040, line 62.
Section 72(m)(5) excess benefits tax. If you are (or were) a 5% owner of a business and you received a distribution that exceeds the benefits provided for you under the qualified pension or annuity plan formula, you may have to pay this additional tax. See Tax on Excess Benefits in chapter 4 of Pub. 560, Retirement Plans for Small Business.
Uncollected social security and Medicare tax on group-term life insurance. If your former employer provides you with more than $50,000 of group-term life insurance coverage, you must pay the employee part of social security and Medicare taxes on those premiums. The amount should be shown in box 12 of your Form W-2 with codes M and N.
Tax on golden parachute payments. This tax applies if you received an “excess parachute payment” (EPP) due to a change in a corporation’s ownership or control. The amount should be shown in box 12 of your Form W-2 with code K. See the Instructions for Form 1040, line 62.
Tax on accumulation distribution of trusts. This applies if you are the beneficiary of a trust that accumulated its income instead of distributing it currently. See Form 4970 and its Instructions.
Additional tax on HSA, MSA, or ABLE account. If amounts contributed to, or distributed from, your health savings account, medical savings account, or ABLE account do not meet the rules for these accounts, you may have to pay additional taxes. See Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans; Form 8853, Archer MSAs and Long-Term Care Insurance Contracts; Form 8889, Health Savings Accounts (HSAs); and Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.
Additional tax on Coverdell ESAs. This applies if amounts contributed to, or distributed from, your Coverdell ESA do not meet the rules for these accounts. See Pub. 970, Tax Benefits for Education, and Form 5329.
Additional tax on qualified tuition programs. This applies to amounts distributed from qualified tuition programs that do not meet the rules for these accounts. See Pub. 970 and Form 5329.
Excise tax on insider stock compensation from an expatriated corporation. You may owe a 15% excise tax on the value of nonstatutory stock options and certain other stock-based compensation held by you or a member of your family from an expatriated corporation or its expanded affiliated group in which you were an officer, director, or more-than-10% owner. For more information, see the Instructions for Form 1040, line 62.
Additional tax on income you received from a nonqualified deferred compensation plan that fails to meet certain requirements. This income should be shown in Form W-2, box 12, with code Z, or in Form 1099-MISC, box 15b. For more information, see the Instructions for Form 1040, line 62.
Interest on the tax due on installment income from the sale of certain residential lots and timeshares. For more information, see the Instructions for Form 1040, line 62.
Interest on the deferred tax on gain from certain installment sales with a sales price over $150,000. For more information, see the Instructions for Form 1040, line 62.

Payments. After you determine your total tax, figure the total payments you have already made for the year. Include credits that are treated as payments. This chapter does not explain these payments and credits. You can find that information in other chapters of this publication and your form Instructions. See the following table for amounts you can include in your total payments.

PAYMENTS
For information on:	See chapter:
American opportunity credit	36
Child tax credit (additional)	35
Earned income credit	38
Estimated tax paid	4
Excess social security and RRTA tax withheld	38
Federal income tax withheld	4
Health coverage tax credit	38
Net premium tax credit	37
Credit for tax on undistributed capital gain	38
Tax paid with extension	1

Another credit that is treated as a payment is the credit for federal excise tax paid on fuels. This credit is for persons who have a nontaxable use of certain fuels, such as diesel fuel and kerosene. It is claimed on Form 1040, line 72. See Form 4136, Credit for Federal Tax Paid on Fuels.

Refund or balance due. To determine whether you are entitled to a refund or whether you must make a payment, compare your total payments with your total tax. If you are entitled to a refund, see your form Instructions for information on having it directly deposited into one or more of your accounts (including a traditional IRA, Roth IRA (including myRA), or a SEP-IRA), or to purchase U.S. savings bonds instead of receiving a paper check.

TAXPLANNER

You can elect to have your refund directly deposited into a traditional IRA, Roth IRA, or SEP-IRA, but not a SIMPLE IRA. You must establish the IRA at a bank or other financial institution before you request direct deposit.

Caution: The amount of any refund you choose to deposit into your IRA cannot, in combination with any other IRA contributions you have made, exceed the applicable annual limit on your IRA contributions. See How much can be contributed in chapter 17, Individual retirement arrangements (IRAs), for further details.
Caution: Any deposits into your IRA made on or before April 17, 2018, may be attributed to calendar year 2017 or 2018. Deposits made after April 17, 2018, may only be attributed to calendar year 2018. If you chose to deposit your 2017 refund directly into an IRA and your refund is deposited in the IRA after April 17, 2018, it will be attributed to calendar year 2018 and may result in an underfunding in 2017 or an overfunding in 2018. The determination of when the contribution to the IRA is made is when the money is deposited in the IRA account, not the date when you file your return directing the refund into the IRA account.

Alternative Minimum Tax

This section briefly discusses an additional tax you may have to pay.

The tax law gives special treatment to some kinds of income and allows special deductions and credits for some kinds of expenses. Taxpayers who benefit from this special treatment may have to pay at least a minimum amount of tax through an additional tax called AMT.

TAXALERT

Begun in 1970, the AMT was originally intended to ensure the “rich” paid at least some minimum amount of tax. Until recently the vast majority of taxpayers were not subject to the AMT. But the reduction in regular income tax rates in 2001 and 2003 without a corresponding reduction in AMT rates caused more people to become subject to this tax.

How the AMT works: The simplest way to understand the AMT is to think of it as a separate tax system with its own allowable deductions and exclusions, many of which are different from those allowed for regular income tax purposes. Thus, although it is in many ways parallel to the “regular income tax” computation, some of the applicable rules are different. You first calculate your regular income tax as you always have, then you calculate your tax under the AMT system and pay the greater of the two amounts. The following are some of the more common items treated differently under the two tax systems that can affect your exposure to AMT:

State and local income and sales taxes
Real estate and personal property taxes
Miscellaneous itemized deductions that exceed the 2%-of-AGI floor
Interest expense from a mortgage or home equity loan that is not used for the purpose of acquiring, constructing, or improving a principal residence or “second home”
The “spread” on the exercise of incentive stock options (ISOs)
Deductions for personal exemptions
The standard deduction

Most of these items consist of deductions that are allowed in computing your regular income tax liability but are not allowed when you figure your AMT. Take, for example, state and local income, sales, and real estate taxes that you pay. They are allowable as a deduction against your income for regular tax purposes but not for AMT. (You’ll find a more detailed explanation of how to figure your AMT later in this section.)

TAXALERT

If your deduction for state taxes is unusually high—for example, perhaps you made a large payment with your 2016 state tax return when you filed in April 2017, or perhaps you have substantial state tax withholding during 2017 on your regular income—you should take a closer look at the possibility of being subject to the AMT.

Example

The Smiths have two children, and gross wages totaling $250,000. Their itemized deductions consist of state and local income taxes and real estate taxes totaling $25,000 and mortgage interest of $17,500 (all related to the acquisition of their principal residence). Assume the Smiths have no interest, dividend, or capital gain income. Their regular tax will be $40,449. However, since their AMT tentative minimum tax is $43,134, the Smiths will pay the higher of the two taxes, effectively denying them some of their deductions for taxes paid and personal exemptions. On the Smiths’ Form 1040, they will report $40,449 in regular tax and $2,685 in AMT.

TAXPLANNER

The AMT can not only affect the amount of tax you pay, but it can also potentially affect the most tax-efficient way to invest your money.

For example, if part of your investment portfolio consists of municipal bond holdings, beware. Interest paid on private-activity bonds issued before 2009 and after 2010 is a preference item that can make it more likely that you will be subject to AMT. Generally, you earn a higher yield on such private-activity bonds than other municipals. However, if you are subject to the AMT, your effective yield on these bonds will be slashed. If you are not sure what type of municipal bonds you have, ask your investment advisor. On the other hand, a tax law enacted in early 2009 provides that interest received on tax-exempt private-activity bonds issued in 2009 and 2010 is not an AMT preference item. In 2017, long-term capital gains and qualifying dividends are subject to the same maximum rate, 20%, for AMT purposes as they are for regular tax purposes. But because these items of income are included in AMTI, which could reduce your allowable AMT exemption, the actual marginal AMT rate could be as high as 27%. Before deciding to invest in securities that generate these types of income, you should consider the effect of the AMT. In 2017 and beyond, tax and investment planning is further complicated for higher income taxpayers by the recent increases in the top tax rates on ordinary taxable income to 39.6% and on qualified dividends and net capital gains to 20%, as well as the additional 3.8% Net Investment Income Tax (NIIT) on certain net investment Iincome (NII) that was enacted as part of the Affordable Care Act.

Example

Consider the Smiths again. Assume that in addition to their other income ($250,000 in gross wages), the Smiths had a long-term capital gain from the sale of some stock investments in 2017 of $50,000. At first blush, you might expect that their federal tax bill would increase by about $7,500 (15% long-term capital gain rate on $50,000, given the Smiths’ taxable income and assuming no state income tax). However, because they are subject to AMT, the additional tax burden is actually $19,015. In addition, due to their income level, the 3.8% NIIT on NII applies, which increases their tax bill by $1,900 ($50,000 times 3.8%).

This estimate does not include any additional state income tax. Considering that most states do impose income taxes on capital gains, the Smiths would be liable for additional state tax. If, say, the Smiths lived in a state with an 8% tax rate, after taking into account the state tax itself, there would be a total of $24,915 of federal and state income taxes (or a combined effective tax rate of 49.8%) attributable to a long-term gain of $50,000!

You may have to pay the AMT if your taxable income for regular tax purposes, combined with certain adjustments and tax preference items, is more than a certain amount. See Form 6251, Alternative Minimum Tax—Individuals.

EXPLANATION

Individuals, trusts, and estates must pay the alternative minimum tax (AMT) if it exceeds their regular tax liability for the year. The amount subject to the AMT will be determined by adding a number of preference items to your taxable income and making various adjustments to your regular taxable income. This amount is further reduced by the exemption amounts, and the balance is subject to the following AMT rates:

Rate	Married Filing Separately	All Other Filers
26%	Up to $93,900 over exemption amount	Up to $187,800 over exemption amount
28%	Greater than $93,900 over exemption amount	Greater than $187,800 over exemption amount

	Exemption Amount
Filing Status	Base Amount	*Less 25% of the Amount by Which AMTI^ Exceeds**
Single	$54,300	$120,700
Married filing jointly and surviving spouses	$84,500	$160,900
Married filing separately	$42,250	$80,450

^* Alternative minimum taxable income.

TAXPLANNER

The chart below should provide you with a better understanding of whether you might be affected by the AMT. Look at where your taxable income falls—then see how much you would need to have in preferences and adjustments (state and local taxes, personal exemptions, miscellaneous itemized deductions, standard deduction, etc.) to determine whether you’d be subject to the AMT. For example, say your taxable income is $300,000, you claim four personal exemptions at $4,050 each ($16,200 in total), and take the standard deduction of $12,700. Your total preferences are $28,900, and you’d be subject to the AMT.

	Adjustments and Preferences Needed to Trigger AMT	Adjustments and Preferences Needed to Trigger AMT
Regular Taxable Income	Joint, 4 Exemptions	Single, 1 Exemption
$50,000	$43,101	$26,010
100,000	21,496	23,411
150,000	16,712	16,258
200,000	6,384	9,333
300,000	0^*	5,154

^* At this income level, no additional adjustments would be needed to trigger AMT.

Analysis assumes ordinary income, no capital gains or qualifying dividends.

Explanation

Once your alternative minimum taxable income (AMTI) increases above a certain level, your AMT exemption begins to phase out.

If you are married and filing a joint return, for every dollar that your AMTI exceeds $160,900 ($120,700 for single filers), you lose $0.25 of your exemption until it’s totally phased out at $498,900 in 2017 (for single taxpayers it’s totally phased out at $337,900).

Adjustments and tax preference items. The more common adjustments and tax preference items include:

Addition of personal exemptions,
Addition of the standard deduction (if claimed),
Addition of itemized deductions claimed for state and local taxes, certain interest, most miscellaneous deductions, and part of medical expenses,
Subtraction of any refund of state and local taxes included in gross income,
Changes to accelerated depreciation of certain property,
Difference between gain or loss on the sale of property reported for regular tax purposes and AMT purposes,
Addition of certain income from incentive stock options,
Change in certain passive activity loss deductions,
Addition of certain depletion that is more than the adjusted basis of the property,
Addition of part of the deduction for certain intangible drilling costs, and
Addition of tax-exempt interest on certain private activity bonds.

EXPLANATION

Besides accounting for tax preference items, certain adjustments (increases or decreases) must be made to taxable income to arrive at alternative minimum taxable income. The adjustments are as follows:

An alternative depreciation deduction (using less accelerated methods and longer depreciable lives) is substituted for the regular tax depreciation deduction for real and personal property and certified pollution control facilities placed in service after 1986 and before 1999. Recomputations are done in the aggregate; that is, the amount of the adjustment is not determined on a property-by-property basis. Note: This adjustment does not apply if you have elected to apply the alternative depreciation system (ADS) for regular tax purposes. For tax years beginning in or after 1999, the recovery periods over which property is depreciated are the same for regular and AMT purposes.
Mining exploration and development costs must be amortized over 10 years using the straight-line method. (There would be no AMT adjustment if the costs are amortized and not deducted for regular tax purposes.)
The percentage-of-completion method of accounting must be used for long-term contracts entered into on or after March 1, 1986. Certain small construction contracts entered into on or after June 21, 1988, must use separate, simplified procedures for cost allocations in the percentage of completion calculation.
An alternative tax net operating loss deduction replaces the regular net operating loss deduction.
The treatment of itemized deductions is modified as follows:
- Medical expenses are deductible only to the extent that they exceed 10% (instead of 7.5% if age 65 or older) of the taxpayer’s adjusted gross income.
- State, local, and foreign real property; sales and income taxes; and state and local personal property taxes are deductible for AMT purposes only if they are deductible for regular tax purposes in computing adjusted gross income. Note: These are taxes related to business, rental property, and farming that are deducted on Schedules C, Profit or Loss From Business; E, Supplemental Income or Loss; or F, Profit or Loss From Farming.
- Investment interest is deductible to the extent of net investment income that is adjusted for amounts relating to tax-exempt interest earned on certain private-activity bonds.
- Home mortgage interest is allowed as a deduction for AMT purposes. However, the definition of such interest is narrower than that of “qualified residence interest” for regular tax purposes. Refinanced home mortgage interest that is applicable to any mortgage in excess of the outstanding mortgage before refinancing is not deductible unless the excess was used for home improvements.
- No deduction is allowed for miscellaneous itemized deductions subject to the 2%-of-adjusted-gross-income limit.
No deduction is allowed for the standard deduction.
Circulation expenditures and research/experimental costs must be amortized over 3- and 10-year periods, respectively. (There would be no AMT adjustment if the circulation expenditures and research costs are amortized and the deduction is not taken in full for regular tax purposes.)
Deductions for passive losses from a tax shelter farm activity are denied, except to the extent that the taxpayer is insolvent or the activity is disposed of during the year.
Rules limiting passive loss deductions also apply to the AMT, except that (a) otherwise disallowed losses are reduced by the amount by which the taxpayer is insolvent, and (b) all AMT adjustments and preferences are taken into consideration in computing income and/or losses from passive activities.
Adjustments passed through to the beneficiary of an estate or trust (i.e., the difference between amounts included in income for regular tax purposes and the AMT income shown on Schedule K-1, Beneficiary’s Share of Income, Deductions, Credits, etc.) must be taken into account in the calculation of AMT.
For property disposed of during the year, the gain or loss is refigured to take into consideration the impact that AMT adjustments, such as depreciation, have on the taxpayer’s basis in the property.
For partners in partnerships and shareholders in S corporations, the income or loss is refigured to take into account AMT adjustments.
In exercising an incentive stock option (ISO), the taxpayer needs to adjust for the difference between the option price and the fair market value at the time the option is exercised. In calculating the AMT gain or loss on the subsequent sale of the ISO stock, the AMT basis in the stock is the sum of the option price paid and the AMT adjustment included in alternative minimum taxable income when the ISO was exercised.

TAXALERT

Adjustment for medical expenses. Beginning in 2013, taxpayers under age 65 are only allowed to deduct medical and dental expenses in calculating taxable income for both regular tax and AMT purposes that are more than 10% of their adjusted gross income (AGI). Before 2013, these expenses were deductible for regular tax purposes to the extent that they exceeded 7.5% of AGI.

Through the 2016 tax year, the 7.5% limit for regular tax purposes continues to apply if you or your spouse are age 65 and over by the end of the year. On the other hand, for alternative minimum tax (AMT) purposes, medical expenses are deductible only to the extent that they exceed 10% of AGI, regardless of your age. Accordingly, taxpayers who were eligible for the 7.5%-of-AGI threshold for regular tax will need to adjust their taxable income subject to AMT for the higher 10%-of-AGI threshold that applies for AMT. In other words, the AMT preference is the lesser of (a) the amount of deductible medical expenses in excess of the 7.5% limit, or (b) 2.5% of your AGI.

Beginning in 2017, the medical and dental expenses threshold for all taxpayers is scheduled to be increased to a 10% limit. When this occurs, there will no longer be an adjustment for AMT.

TAXALERT

Incentive stock options present a unique AMT trap. While the “spread”—the difference between the fair market value of the stock at the time the option is exercised and the exercise price—is not taxable for regular tax purposes, it is taxable for the AMT. The larger the spread, the more likely you will be liable for AMT.

In addition, you compute your “basis” (generally the amount you paid) for stock bought with incentive stock options one way for regular tax purposes and another way for figuring your AMT. Your basis for regular tax purposes will generally be the exercise price of the options. The basis for AMT will usually be the fair market value of the shares when exercised, assuming you held the shares more than 1 year from the date you exercised your option. Figuring your basis is more complicated if you sell the shares within a year of exercising your options. You should consult your tax advisor.

If matters weren’t complicated enough, the amount of AMT attributable to an incentive stock option can be credited against your regular tax liability in a future year. So, should your regular tax liability exceed your AMT tax calculation in a subsequent year, you can apply the credit against the difference between the two.

Example

In 2017, Martin and Fern Burns have $125,000 of ordinary income and $18,000 of itemized deductions—$1,500 of state income taxes, $1,500 of real estate taxes, and $15,000 of mortgage interest. They have no dependents. Their regular tax would be $16,203. They would not be subject to the AMT since that amount ($6,630) would be less than their regular tax.

Now suppose that in 2017 Fern exercised 5,000 incentive stock options (ISOs) that had an exercise price of $10 a share and that the stock was worth $45 a share at the time of exercise. That results in a total spread of $175,000 (5,000 × $35) that has to be added back in calculating AMT. The Burnses’ gross AMT for 2017 would be $58,109, an additional tax of $41,906. But all is not lost. Since the additional $41,906 in AMT liability was a result of the ISO exercise, that amount can be carried forward to a future year and credited against their tax to the extent their regular tax exceeds their AMT in that future year.

Let’s say that in 2019 Fern sells the stock she got from the ISO exercise for $50 a share. The basis of the stock for regular tax purposes is $10 a share, so she has a regular long-term capital gain of $200,000 (5,000 × $40). But her basis for AMT purposes is $45 a share—the value of the stock on the date of exercise—for an AMT long-term capital gain of $25,000 (5,000 × $5). So in calculating her AMT in 2019 she would reflect a negative adjustment on Form 6251, Alternative Minimum Tax—Individuals, of $175,000.

Explanation

The law provides a credit against the regular tax for all or a portion of the AMT you paid in previous years. The credit is the AMT attributable to deferral, rather than exclusion, items. Deferral items, such as accelerated depreciation or the spread on incentive stock option (ISO), are those that have the effect of reducing your regular taxable income relative to alternative minimum taxable income in early years, but the situation reverses over time. Thus, the same total of deductions is eventually allowed under both tax systems.

When you pay AMT as a result of deferral preferences or adjustments, the law gives you a credit that can be used to reduce your regular tax liability in the future. This avoids double taxation on the same income. Exclusion preferences, such as certain private-activity bond tax-exempt interest income, reduce your regular taxable income permanently. Because exclusion preferences never reverse in the future, you are not given a credit for AMT paid. The AMT credit is carried forward indefinitely from the year of payment and cannot be carried back.

In Fern’s case above, assuming the same amount of income and deductions in 2019 as 2017 (with the exception of the stock sale), her AMT liability would be significantly less than her regular tax liability. As a result, the AMT credit generated in 2017 when Fern exercised the ISO can be applied to reduce her regular tax down to the amount of the AMT.

The AMT credit can be applied in any future year where your AMT liability is less than your regular tax liability. The availability of the AMT credit in a future year is not tied to the reversal of the same item (in Fern’s case, the sale of the stock) that originally caused the credit to have been generated.

TAXALERT

If you plan to make a substantial gift of appreciated property (e.g., stock) to a charity, there is no adjustment to consider for the AMT. You are able to recognize a charitable contribution deduction for the full fair market value of appreciated long-term capital gain property for both regular and AMT purposes (subject to adjusted gross income limitations).

If the Burnses in the earlier example made a charitable contribution of the ISO stock in a future year, Martin and Fern would get a charitable deduction based on the fair market value of the stock without recognizing any gain for both regular tax and AMT purposes. However, the basis difference in the ISO stock would not cause their AMT to be decreased in the year of the contribution. In that case, they would not be able to claim their AMT credit that was created in 2017 when Fern exercised the option. Instead, the credit will continue to be carried forward and used over time. If Martin and Fern do not expect to have an AMT liability less than regular tax in the future, the donation of the stock has significantly limited their ability to use the AMT credit. Therefore, Martin and Fern may be better off donating appreciated property other than the ISO stock to preserve their ability to benefit from the AMT credit.

Example

The following example demonstrates how you would calculate your regular tax and your AMT for calendar year 2017, assuming your filing status is married filing jointly.

	Regular Tax	Alternative Minimum Tax
Salary	$150,000	$150,000
Interest	11,000	11,000
Long-term capital gains (15%)	80,000	80,000
Net passive losses	(25,000)	(25,000)
Passive losses disallowed by Tax Reform Act of 1986	25,000	25,000
Adjusted gross income	$241,000	$241,000
State taxes	(30,000)	n/a
Charitable contributions	(50,000)	(50,000)
Interest expense—principal residence	(27,000)	(27,000)
Exemptions (4)	(16,200)	n/a
Tax adjustment items:
Incentive stock options	n/a	25,000
Alternative taxable income before exemption	n/a	$191,000
Exemption ($84,500 less 25% of alternative taxable income in excess of $160,900)	n/a	($76,975)
Taxable income	$117,800	$114,025
Tax	$20,928	$29,647

^* n/a means “not applicable.”

Because your regular tax is less than your AMT, you must pay the AMT of $29,647.

The $30,000 you paid in state income tax was not allowed as a deduction in arriving at alternative minimum taxable income. Because deductions are based on actual payments made during the calendar year, good planning would require minimizing your state income taxes and your miscellaneous deductions to the extent that you are able in a year when it is possible you will be subject to the AMT.

TAXPLANNER

Even if you have benefited from the tax preference items that generally subject you to the AMT, you may avoid the AMT by controlling the timing of certain transactions. The trick is not to exceed the amount exempt from the AMT for a given year. If you know that you will be subject to the AMT this year, and provided your current AMT situation is due to exclusion items, you should consider realizing income this year that otherwise would be realized next year so that it is taxed at 26% or 28% rather than at a higher rate next year. Likewise, consider deferring deductions, especially those that are not deductible for AMT purposes.

The $84,500 exemption for joint returns is phased out beginning at $160,900 of alternative minimum taxable income. For unmarried taxpayers, the exemption amount is $54,300, and it is phased out beginning at $120,700. You lose $1 of exemption for every $4 over the base amount. Consequently, the exemption amount is completely phased out at $498,900 for joint returns and $337,900 for unmarried taxpayers.

More information. For more information about the AMT, see the Instructions for Form 6251.

Additional Medicare Tax

TAXALERT

Additional Medicare Tax

Under the Affordable Care Act, higher income individuals are subject to an additional 0.9% Medicare hospital insurance tax on wages and self-employment income received in excess of specified threshold amounts ($250,000 for joint filers, $125,000 for a married individual filing a separate return, and $200,000 for all other taxpayers) starting in 2013. This tax is assessed in addition to the basic 1.45% Medicare tax employees already pay. There is no corresponding employer portion of the additional Medicare tax. As a result, the Medicare tax remains at 2.9% on all wages (with the worker and the employer each paying 1.45%) and self-employment income for income levels at or below these thresholds. However, beginning in 2013, the Medicare tax rate rose to 3.8% for wages and/or self-employment income over the applicable threshold levels.

Employers are required to withhold the 0.9% Additional Medicare Tax on wages paid to an employee in excess of $200,000 regardless of the tax filing status (married or single) indicated on the employee’s Form W-4, Employee’s Withholding Allowance Certificate, and without regard to other earned income on which the 0.9% Additional Medicare Tax may be owed. So, an employee may see this additional tax being withheld even though he or she may not even be liable for it because, for example, the employee’s wages or other compensation together with that of his or her spouse (when filing a joint return) does not exceed the $250,000 liability threshold. In this case, however, any Additional Medicare Tax withheld can be credited against the total tax liability—including income taxes—shown on the couple’s income tax return (Form 1040).

On the other hand, since an employer is only allowed to withhold the 0.9% Additional Medicare Tax on wages paid in excess of $200,000, married employees who file separately may have too little of this additional tax withheld since the threshold at which the 0.9% tax kicks in is only $125,000 for married taxpayers filing separately. To make up the difference, you can (1) increase your federal income tax withholding by submitting a new Form W-4 to your employer, or (2) make quarterly estimated tax payments in order to avoid a tax underpayment penalty.

If you are subject to the Additional Medicare Tax, you will report and pay this tax with your Form 1040. Use Form 8959, Additional Medicare Tax, to report your additional tax.

For more information on the Additional Medicare Tax, the IRS has a Questions & Answers webpage dedicated to the Additional Medicare Tax. Go to www.IRS.gov and search for “Additional Medicare Tax.”

Net Investment Income Tax (NIIT)

TAXPLANNER

Net Investment Income Tax

Under the Affordable Care Act (ACA), starting in 2013, the 3.8% Net Investment Income Tax (NIIT) on certain unearned net investment income (NII) took effect for tax years beginning in 2013 and thereafter. For individuals, the tax is 3.8% of the lesser of: (1) “net investment income” or (2) the excess of modified adjusted gross income (MAGI) over $200,000 ($250,000 if married filing jointly or a surviving spouse with a dependent child; $125,000 if married filing separately). These threshold dollar amounts will not be indexed each year for inflation.

The NIIT is a surtax that is payable regardless of whether you otherwise pay any regular income tax or are subject to alternative minimum tax.

Net investment income is defined as investment income reduced by deductions that are properly allocable to such income. Investment income includes the following:

Income not derived in the ordinary course of a trade or business, including interest, dividends, rents, royalties, and income from nonqualified annuities
Trade or business income from passive activities or from trading in financial instruments or commodities
Net capital and ordinary income gains from the disposition of property not used in a trade or business, such as
- Gains from the sale of stocks, bonds, and mutual funds.
- Capital gain distributions from mutual funds.
- Gain from the sale of investment real estate (including gain from the sale of a second home that is not a primary residence).
- Gains from the sale of interests in partnerships and S corporations (to the extent you were a passive owner).

Investment income does not include social security benefits, operating income and gains attributable to an active trade or business conducted by a sole proprietor, partnership, or S corporation, distributions from an IRA or qualified retirement plan, alimony, or Alaska Permanent Fund dividends. Nor does it include any wages, other compensation, and self-employment income.

Items that are otherwise excluded from your gross income for income tax purposes are also excluded from investment income subject to the 3.8% tax. Excluded items include: interest on tax-exempt bonds; income from tax-exempt trusts; life insurance proceeds paid out on death; inside build-up in life insurance and annuity contracts; and the portion of capital gains from the sale of a principal residence that is excluded from income tax.

Deductions that are properly allocable to reduce investment income for purposes of calculating NII include, but are not limited to, investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes related to specific investment income.

Example. Abner is a single filer with wages of $175,000 and NII of $16,000. His MAGI is $191,000, which is less than the $200,000 NIIT threshold that applies to single filers. Therefore, Abner is not subject to the NIIT.

Example. Juanita is a single filer. She was paid $180,000 in wages and also received NII of $90,000. Her MAGI is $270,000, and she exceeds the $200,000 NIIT threshold for single taxpayers by $70,000. Since the NIIT is applied to the lesser of $70,000 (the amount by which Juanita’s MAGI exceeds the applicable $200,000 threshold) or $90,000 (her NII), her NIIT is calculated to be $2,660 ($70,000 × 3.8%).

Example. Ali’s only income for 2017 is a pension of $500,000 and $30,000 of tax-exempt income. The NIIT surtax does not apply because Ali has no investment income.

Example. Fred, a retired engineer, turned 70 years old in March 2016. He received investment income from commercial annuities, and interest and dividends from his taxable brokerage account of $170,000, in addition to taxable social security income of $15,000. Fred’s MAGI is $185,000 in 2016. Fred is not subject to the NIIT in 2015.

Beginning in 2017, Fred began taking required minimum distributions from his IRA of $30,000. Assuming his annuity, interest, dividend, and social security income is the same, Fred’s MAGI is $215,000 for 2017. He will be liable for $570 of NIIT in 2016 ($15,000 × 3.8%). Although the IRA distribution is not included in Fred’s NII, it caused his MAGI to exceed the threshold for the tax.

Finally, nonresident aliens (NRAs) are not subject to the NIIT. But, special rules apply if the NRA is married to a U.S. citizen or resident and has made, or is planning to make, an election to file a joint return with his or her spouse. See your tax advisor for assistance.

If you are subject to the NIIT, you will report and pay this tax with your Form 1040. Use Form 8960, Net Investment Income Tax—Individuals, Estates, and Trusts, to report NII and to calculate your NIIT. For more information on the Net Investment Income Tax, see chapter 49, Net Investment Income Tax. In addition, the IRS has a Questions & Answers webpage dedicated to the NIIT. Go to www.IRS.gov and search for “Net Investment Income Tax.”

Tax Figured by IRS

If you file by the due date of your return (not counting extensions)—April 18, 2017, for most people—you can have the IRS figure your tax for you on Form 1040EZ, Form 1040A, or Form 1040.

If the IRS figures your tax and you paid too much, you will receive a refund. If you did not pay enough, you will receive a bill for the balance. To avoid interest or the penalty for late payment, you must pay the bill within 30 days of the date of the bill or by the due date for your return, whichever is later.

The IRS can also figure the credit for the elderly or the disabled and the earned income credit for you.

When the IRS cannot figure your tax. The IRS cannot figure your tax for you if any of the following apply.

You want your refund directly deposited into your checking or savings account.
You want any part of your refund applied to your 2018 estimated tax.
You had income for the year from sources other than wages, salaries, tips, interest, dividends, taxable social security benefits, unemployment compensation, IRA distributions, pensions, and annuities.
Your taxable income is $100,000 or more.
You itemize deductions.
You file any of the following forms.
1. Form 2555, Foreign Earned Income.
2. Form 2555-EZ, Foreign Earned Income Exclusion.
3. Form 4137, Social Security and Medicare Tax on Unreported Tip Income.
4. Form 4970, Tax on Accumulation Distribution of Trusts.
5. Form 4972, Tax on Lump-Sum Distributions.
6. Form 6198, At-Risk Limitations.
7. Form 6251, Alternative Minimum Tax—Individuals.
8. Form 8606, Nondeductible IRAs.
9. Form 8615, Tax for Certain Children Who Have Unearned Income.
10. Form 8814, Parents’ Election To Report Child’s Interest and Dividends.
11. Form 8839, Qualified Adoption Expenses.
12. Form 8853, Archer MSAs and Long-Term Care Insurance Contracts.
13. Form 8889, Health Savings Accounts (HSAs).
14. Form 8919, Uncollected Social Security and Medicare Tax on Wages.
You must make a shared responsibility payment.

Shared responsibility payment. You must make a shared responsibility payment with your tax return unless you and your spouse (if filing jointly), and anyone else you do or can claim as a dependent, had minimum essential coverage or a coverage exemption for each month during 2017. Use the Shared Responsibility Payment Worksheet in the Instructions for Form 8965 to figure your shared responsibility payment.

Filing the Return

After you complete the line entries for the tax form you are filing, fill in your name and address. Enter your social security number in the space provided. If you are married, enter the social security numbers of you and your spouse even if you file separately. Sign and date your return and enter your occupation(s). If you are filing a joint return, both you and your spouse must sign it. Enter your daytime phone number in the space provided. This may help speed the processing of your return if the IRS has a question that can be answered over the phone. If you are filing a joint return, you may enter either your or your spouse’s daytime phone number.

If you want to allow a friend, family member, or any other person you choose to discuss your 2017 tax return with the IRS, check the “Yes” box in the “Third party designee” area on your return. Also enter the designee’s name, phone number, and any five digits the designee chooses as his or her personal identification number (PIN). If you check the “Yes” box, you, and your spouse if filing a joint return, are authorizing the IRS to call the designee to answer any questions that may arise during the processing of your return.

Fill in and attach any schedules and forms asked for on the lines you completed to your paper return. Attach a copy of each of your Forms W-2 to your paper return. Also attach to your paper return any Form 1099-R you received that has withholding tax in box 4.

Mail your return to the Internal Revenue Service Center for the area where you live. A list of Service Center addresses is in the Instructions for your tax return.

Form 1040EZ Line Entries

Read lines 1 through 8b and fill in the lines that apply to you. Do not complete lines 9 and 10. Complete line 11. Do not complete lines 12 through 14. If you are filing a joint return, use the space to the left of line 6 to separately show your taxable income and your spouse’s taxable income.

Payments. Enter any federal income tax withheld on line 7. Federal income tax withheld is shown on Form W-2, box 2, or Form 1099, box 4.

Earned income credit. If you can take this credit, as discussed in chapter 38, the IRS can figure it for you. Enter “EIC” in the space to the left of line 8a. Enter the nontaxable combat pay you elect to include in earned income on line 8b.

If your credit for any year after 1996 was reduced or disallowed by the IRS, you may also have to file Form 8862, Information To Claim Earned Income Credit After Disallowance, with your return. For details, see the Form 1040EZ Instructions.

Form 1040A Line Entries

Read lines 1 through 27 and fill in the lines that apply to you. If you are filing a joint return, use the space to the left of the entry space for line 27 to separately show your taxable income and your spouse’s taxable income. Skip lines 28 and 30, but complete lines 29, 31 through 35, 38, and 40 through 45 only if they apply to you. However, do not complete lines 32 and 42a if you want the IRS to figure the credits shown on those lines. Also, enter any write-in information that applies to you in the space to the left of line 46. Do not complete lines 36, 37, 39, or 47 through 51.

Payments. Enter any federal income tax withheld that is shown on Form W-2, box 2, or Form 1099, box 4, on line 40. Enter any estimated tax payments you made on line 41.

Credit for child and dependent care expenses. If you can take this credit, as discussed in chapter 33, complete Form 2441, Child and Dependent Care Expenses, and attach it to your return. Enter the amount of the credit on line 31. The IRS will not figure this credit.

Net premium tax credit. If you can take this credit, as discussed in chapter 37, complete Form 8962, Premium Tax Credit, and attach it to your return. Enter the amount of the credit on line 45. The IRS will not figure this credit.

Credit for the elderly or the disabled. If you can take this credit, as discussed in chapter 34, the IRS can figure it for you. Enter “CFE” in the space to the left of line 30 and attach Schedule R (Form 1040A or 1040), Credit for the Elderly or the Disabled, to your paper return. On Schedule R (Form 1040A or 1040), check the box in Part I for your filing status and age. Complete Part II and Part III, lines 11 and 13, if they apply.

Earned income credit. If you can take this credit, as discussed in chapter 38, the IRS can figure it for you. Enter “EIC” to the left of the entry space for line 42a. Enter the nontaxable combat pay you elect to include in earned income on line 42b.

If you have a qualifying child, you must fill in Schedule EIC (Form 1040A or 1040), Earned Income Credit, and attach it to your paper return. If you do not provide the child’s social security number on Schedule EIC, line 2, the credit will be reduced or disallowed unless the child was born and died in 2017.

If your credit for any year after 1996 was reduced or disallowed by the IRS, you may also have to file Form 8862 with your return. For details, see the Form 1040A Instructions.

Form 1040 Line Entries

Read lines 1 through 43 and fill in the lines that apply to you. Do not complete line 44.

If you are filing a joint return, use the space under the words “Adjusted Gross Income” on the front of your return to separately show your taxable income and your spouse’s taxable income.

Read lines 45 through 73. Fill in the lines that apply to you, but do not fill in lines 55, 63, and 74. Also, do not complete line 56 and lines 75 through 79. Do not fill in line 54, box “c,” if you are completing Schedule R (Form 1040A or 1040), or line 66a if you want the IRS to figure the credits shown on those lines.

Payments. Enter any federal income tax withheld that is shown on Form W-2, box 2, or Form 1099, box 4, on line 64. Enter any estimated tax payments you made on line 65.

Credit for child and dependent care expenses. If you can take this credit, as discussed in chapter 34, complete Form 2441 and attach it to your paper return. Enter the amount of the credit on line 49. The IRS will not figure this credit.

Net premium tax credit. If you take this credit, as discussed in chapter 37, complete Form 8962 and attach it to your return. Enter the amount of the credit on line 69. The IRS will not figure this credit.

Credit for the elderly or the disabled. If you can take this credit, as discussed in chapter 35, the IRS can figure it for you. Enter “CFE” on the line next to line 54, check box “c,” and attach Schedule R (Form 1040A or 1040) to your paper return. On Schedule R (Form 1040A or 1040), check the box in Part I for your filing status and age. Complete Part II and Part III, lines 11 and 13, if they apply.

Earned income credit. If you can take this credit, as discussed in chapter 38, the IRS can figure it for you. Enter “EIC” on the dotted line next to Form 1040, line 66a. Enter the nontaxable combat pay you elect to include in earned income on line 66b.

If your credit for any year after 1996 was reduced or disallowed by the IRS, you may also have to file Form 8862 with your return. For details, see the Form 1040 Instructions.

TAXORGANIZER

Records you should keep:

Form W-2 Wages, salaries, tips; allocated tips; advance EIC payments; dependent care benefits; adoption benefits; employer contributions to a medical savings account
Form W-2G Gambling winnings
Schedule K-1 Partner’s share of income, deductions, credits, etc.
Form 1098 Mortgage interest; points; refund of overpaid interest
Form 1098-E Student loan interest
Form 1099-A Acquisition or abandonment of secured property
Form 1099-B Stocks and bonds; bartering; futures contracts
Form 1099-C Canceled debt
Form 1099-DIV Ordinary dividends; total capital gains distributions; nontaxable distributions; investment expenses; foreign tax paid
Form 1099-G Unemployment compensation; state or local income tax refund; taxable grants; agriculture payments
Form 1099-INT Interest income; early withdrawal penalty; interest on U.S. savings bonds and Treasury obligations
Form 1099-LTC Long-term care and accelerated death benefits
Form 1099-MISC Rents; royalties; other income (prizes, awards); nonemployee compensation
Form 1099-MSA, 1099-HSA Distributions from medical savings accounts and health savings accounts
Form 1099-OID Original issue discount; other periodic interest; early withdrawal penalty
Form 1099-PATR Patronage dividends and other distributions from a cooperative; credits; patron’s AMT adjustment
Form 1099-R Distributions from IRAs; distributions from pensions, annuities; capital gain
Form 1099-S Gross proceeds from real estate transactions; buyer’s part of real estate tax

In addition to the items listed above, you should retain any item that may be needed in a future year to calculate your tax. For example, you should retain in your permanent records items such as:

HUD-1 from the purchase of real estate and invoices pertaining to significant improvements (such as a new roof or a kitchen remodel) to support your tax basis for a subsequent sale or for depreciation (if applicable)
Confirmation of purchases of investments (stocks and bonds) or commercial annuities
Records pertaining to nondeductible contributions to IRAs (generally, reported when made on Form 8606, Nondeductible IRAs)

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Table of Contents for Chapter 31: How to figure your tax

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What’s New

Figuring Your Tax

Alternative Minimum Tax

Additional Medicare Tax

Net Investment Income Tax (NIIT)

Tax Figured by IRS

Filing the Return

Form 1040EZ Line Entries

Form 1040A Line Entries

Form 1040 Line Entries

Table of Contents for
Chapter 31: How to figure your tax