Legal Definitions - tax-preference items

Tax-preference items are specific types of income or deductions that are allowed to reduce a taxpayer's liability for regular income tax but are treated differently when calculating the Alternative Minimum Tax (AMT). While these items are perfectly legitimate for standard tax calculations, they are added back or adjusted for AMT purposes. The goal of the AMT is to ensure that individuals and corporations with significant tax benefits still pay a minimum level of tax, preventing them from reducing their tax liability to zero or near-zero through various deductions and exclusions.

Here are some examples to illustrate how tax-preference items work:

• Example 1: Accelerated Depreciation for a Business

  Imagine a manufacturing company that purchases new machinery. For regular tax purposes, they might use an accelerated depreciation method, which allows them to deduct a larger portion of the machinery's cost in the early years of its life. This significantly reduces their taxable income.

  How it illustrates the term: While this accelerated deduction is perfectly legal for regular tax, for AMT purposes, the tax rules might require the company to use a slower, "straight-line" depreciation method for that same machinery. The difference between the accelerated depreciation taken for regular tax and the slower depreciation allowed for AMT is considered a "tax-preference item." This difference is added back to their income when calculating their AMT, potentially increasing their overall tax obligation.

• Example 2: Incentive Stock Options (ISOs) for an Individual

  Consider an executive at a technology company who exercises 10,000 incentive stock options (ISOs). The market price of the company's stock on the exercise date is $70 per share, but the executive's exercise price was only $20 per share.

  How it illustrates the term: For regular income tax purposes, the $50 difference per share ($70 market price - $20 exercise price) is generally not taxed at the time of exercise; it's only taxed when the shares are later sold. However, for AMT purposes, this $50 "bargain element" per share (totaling $500,000) is considered income in the year the options were exercised. This amount is a "tax-preference item" that increases their income for AMT calculation, even though it's not taxable for regular income tax until a future sale.

• Example 3: Tax-Exempt Interest from Private Activity Bonds

  An individual invests in municipal bonds issued by a local government to finance the construction of a new private hospital, which is operated by a for-profit healthcare corporation.

  How it illustrates the term: Interest earned from most municipal bonds is typically exempt from federal income tax (and often state and local taxes) for regular tax purposes. However, because these specific bonds finance a "private activity" (the for-profit hospital), the interest income from them is classified as a "tax-preference item" for AMT. This means that while the interest is tax-free for their regular tax calculation, it must be included as income when calculating their Alternative Minimum Tax, potentially leading to an AMT liability.