I just finished my 2020 US taxes, and while reviewing them noticed that I had a chunk of Alternative Minimum Tax, over $600! Fortunately, it was offset by my child tax credits (thanks girls!), so I didn’t actually owe any tax, but it got me to thinking. My kids are growing up fast, and there will come a time when I won’t have child tax credits – will I actually wind up paying AMT to the US government, despite my UK foreign tax credits?
This post explores what the AMT is and how it applies to Americans living outside the US – the example uses UK numbers for the amount of foreign tax paid, but the concept applies anywhere that has generally higher tax rates than the US.
Caveat up front: the Alternative Minimum Tax and the Foreign Tax Credit are both very complicated bits of the US tax system – mash them together, and my head starts to hurt quickly. I am not a tax professional, and I’m not going to try to explain AMT or FTC in any detail; this is not a guide on how to file your taxes. What I want to explore is why AMT is showing up on my 1040 and how it might apply to you, at a conceptual level.
Personally, I think FTC + AMT is right about the limit of what a non-specialist person is reasonably capable of doing for their taxes – typical tax software doesn’t help much in guiding you, and if you aren’t eager to read a lot of IRS instructions, it might be time to get help.
As I wrote this post, I realized that I was making a sub-optimal decision around the “simplified limitation election” – this fairly arcane term could end up costing you money if you aren’t careful. I’ve learned my lesson, and it’s not the end of the world to fix (I think), but I wanted to share my missteps with you. This stuff is complicated, and the more we can share our learnings, the better prepared we all are.
Bottom line up front: If you have a moderately high income (about $113k+ for MFJ) and are having to do AMT calculations, you probably do not want to elect to use the “simplified limitation election”, or at the least you want to calculate it out both ways the first time you do. Otherwise, you could wind up actually paying AMT.
I’m going to try to keep this discussion reasonably high level, but a certain amount of discussion of forms and schedules and the like is unavoidable in trying to make sense of this subject – it really is the details that matter. Sorry!
It might help to open the relevant forms and follow along:
Quick Background on the AMT & FTC
The AMT is designed to “catch” US taxpayers who have lots of credits, deductions, exemptions, etc. and make them pay their “fair share.” It was originally designed for very high income people, but has drifted down to more average taxpayers over the years.
If you claim the FTC (like most people should, in countries with generally higher tax rates than the US), the form 1040 instructions require you to fill in Form 6251, “Alternative Minimum Tax – Individuals”. That doesn’t necessarily mean you owe AMT, but you need to calculate it to see.
The AMT form 6251 is basically an abbreviated version of your whole tax return, adding back in a bunch of deductions that are included in your “regular” tax calculations but excluded from AMT calculations. This includes recalculating your foreign tax credits, using the AMT numbers. These calculations result in an “alternative minimum taxable income” (AMTI) which is subject to AMT tax rates. If this AMTI is greater than the AMT exemption (for 2020, $113,400 for married filing jointly, $72,900 for single), then AMT tax gets imposed at a 26% rate (28% for AMTI over $98,950 above the exemption).
Following that? Me neither – let’s work through an example, that helps it make a lot more sense.
Meet Prosperous Polly (again)
You remember Polly from my post on US vs US taxes, right?
- Polly earns £100,000 from her wages, and contributes 5% to her UK pension which is matched at 5% from her employer
- She’s married to Pat – we’ll assume that Pat doesn’t have any income for this example (we previously assumed some self-employment, but that just muddies the conceptual waters for AMT & FTC)
- Polly and Pat don’t have any other income – no interest, dividends, capital gains, etc. I know most people will have some of this, but it doesn’t make a material difference here and simplifies the story, so go with it
- Polly and Pat are US citizens living in the UK
- Assume a pound buys $1.40
Let’s walk through calculating Polly & Pat’s taxes – not line by line, but at least in conceptual chunks. I’m using the 2020 versions of all the forms; line numbers might change a bit from year to year.
Form 1040 – Income & “Regular” Tax
- Line 1 – Wages – $147,000 (£100,000 + £5,000 converted to dollars, and assuming that Polly is not taking the treaty position to exclude her or her employer’s pension contributions)
- Line 12 – Standard Deduction – $24,800 (Polly & Pat don’t have any deductions worth itemizing, like most of us these days)
- Line 15 – Taxable Income – $122,200 (just $147,000 wages minus the $24,800 standard deduction)
- Line 16 – “Regular” Tax – $18,464 (there’s a simple formula to get here, taking account for the progressive tax system – Polly & Pat are in the 22% bracket, so pay 22% on their last dollar)
So far, so simple – a basic, boring 1040 tax return for just wage income. But then we get to line 17: “Amount from Schedule 2, line 3”.
Schedule 2, line 3 is the sum of two other taxes: alternative minimum tax and “excess advance premium tax credit repayment.” Polly & Pat don’t have any of the latter, it’s to do with health insurance purchased on the US insurance marketplace, but they do need to calculate the AMT.
Form 6251 Part 1 – Alternative Minimum Taxable Income
- Line 1 – Taxable Income – $122,200, just copied from form 1040 line 15
- Line 2a – Standard Deduction – $24,800
- Lines 2b through 2t and 3 are all kinds of other deductions and adjustments that get added back in. Polly & Pat don’t have any investment interest expense, mining costs, intangible drilling costs, or any of the other stuff on this list.
- Line 4 – Alternative minimum taxable income (AMTI) – $147,000 (just Polly’s wages & employer pension match, right back where we started)
AMTI is the income that the AMT will be based on. In Polly’s simple case, it’s just her income, without subtracting off the standard deduction.
Form 6251 Part 2 – Alternative Minimum Tax
- Line 5 – Exemption – $113,400 (this is the exemption for married filing jointly, unless AMTI is over $1,036,800 – it takes the place of the standard deduction for AMT purposes, only income over this exemption amount is subject to AMT)
- Line 6 – Alternative minimum taxable income over the exemption – $33,600 (just AMTI minus the exemption)
- Line 7 – Alternative minimum tax before the AMT FTC – $8,736 (in Polly’s simple case, this is simply 26% of the income over the exemption. With capital gains, dividends, or the Foreign Earned Income Exclusion, this gets more complicated. The rate goes up to 28% above $197,900 of taxable income over the exemption)
- Line 8 – Alternative minimum foreign tax credit
This is just a single line, but now it pushes us into a whole new form, Form 1116, “Foreign Tax Credit.” We’ll wind up doing this form twice, once for “regular” taxes and again for the AMT; let’s start with the regular version and then we can see how it’s different for AMT, because that’s where the real impact can be for Americans abroad.
Form 1116 Part 1 – Taxable Income from Outside the US
Form 1116 is set up so that you must do one form for each “category” of income, including up to three countries per form. In Polly’s case, she only has one category (General) and one country (the UK).
Many Americans overseas will also have Passive category income (interest, dividends, capital gains, etc.), the others are less typical. For the AMT, you have to do each category twice, so a typical tax return for an American overseas could have four copies of the form 1116.
One twist is the “simplified limitation election” – that allows you to use the Part 1 numbers for your AMT version without calculating them again. If you’re using tax software like me, there wasn’t much background on this – I just kind of figured “simple is good” and went for it. Bad move, it turns out, but we’ll see why in a bit. The fun of this is whether you pick simple or non-simple, you’re stuck with that forever, unless you ask the IRS’s consent to change.
- Line 1a – Gross income from the UK – $147,000 (Polly’s is simple – all her General category income is from the UK, and she only has General category income)
- Line 3a – Standard Deduction – $24,800
- Line 6 – Total deductions & losses $24,800 (there are some calculations to get here, basically apportioning your deductions and losses to the category and to the country. Polly’s case makes this simple – she only has the standard deduction, only has one country, and only has General category income).
- Line 7 – Taxable income from sources outside the US for this category – $122,200 (just Polly’s gross income minus the standard deduction)
Form 1116 – Part II – Foreign Taxes Paid or Accrued
- Boxes (j) and (k) – Paid or Accrued? Polly has to option to select that she has either paid or accrued her UK taxes. She’s had UK tax taken out of her paychecks throughout the year, so she’s paid HMRC with every paycheck. She’s kept all her paystubs, so can do some quick math to add it all up. You can’t rely on the UK’s end of year tax documentation, like a P60, because the US and UK use different tax years (the US uses 01 Jan to 31 Dec, the UK uses 06 Apr to 05 Apr).
- Polly selects “Paid”
- This is another long-lasting selection – if you pick “Accrued”, you have to stay with it forever. If you pick “Paid”, you can later change to “Accrued”. I won’t go into the pros and cons today – at least for the UK, it typically doesn’t make much difference in the end, and Paid is easier to keep track of.
- Line 8 – Foreign taxes paid/accrued for this category – $38,360 (Polly’s £27,400 UK taxes converted to dollars)
Form 1116 – Part III – Figuring the “Regular” Credit
Here’s where the Regular and AMT calculations diverge, under the simplified limitation. It’s the same form, but using slightly different numbers. Let’s do the regular FTC first.
- Line 9 – Foreign taxes paid/accrued for this category – $38,360 (copy from line 8)
- Line 10 – Carryback or Carryover – $0 (we’ll assume Polly doesn’t have any carryover from previous years – it doesn’t make a difference here anyway, she’ll have more than enough foreign taxes paid that she can’t use them all)
- Line 14 – Foreign taxes available for credit – $38,360 (total of lines 9, 10, 12, and 13; we skipped lines 12 and 13, they don’t apply to Polly)
- Line 15 – Taxable income from sources outside the US for this category – $122,200 (copy from line 7 – copy this down to line 17, because line 16 doesn’t apply to Polly)
- Line 18 – Taxable income – $122,200 (copy from form 1040 line 15, this is just Polly’s income minus the standard deduction)
- Line 19 – Divide line 17 by line 18 – 1.0000 (this is calculating what percentage of your taxable income came from this foreign category – for Polly, it’s 100%. If you have any income in another category or from the US, this number will be less than 1).
- Line 20 – Regular Tax – $18,464 (copied from form 1040 line 16, this is Polly’s “normal” tax without considering the AMT).
- Line 21 – Maximum FTC for this category – $18,464 (line 19 times line 20; conceptually, you can only take a credit up to the percentage of the tax you owe that is coming from this foreign category. For example, if 80% of your income is foreign general category income and 20% is US general category income, you can only take a FTC to offset 80% of your tax, the IRS wants to get paid for the 20% that came from the US. We’ll skip line 22 and also use this for line 23).
- Line 24 – Foreign tax credit for this category – $18,464 (the smaller of line 23, the maximum FTC for this category, and line 14, the actual foreign taxes paid for this category. You can’t take a credit for more taxes than you paid! In Polly’s case, and for most UK residents, you’ll have paid more tax to HMRC than you’re allowed to claim, because the UK income tax rate is higher than US federal income tax rates).
At the end of all that, what we’ve calculated is that Polly can take a “regular” foreign tax credit for $18,464 – exactly the amount of “regular” tax that she would have owed the IRS without the credit, reducing her tax to zero.
There is a Part IV that totals together different categories of FTC – this won’t make any difference to Polly, since she has only one category of FTC. If you have more than one category, the note here is that you can still only take a credit up to the amount of your “regular” tax – if your general and passive FTCs add up to more than your regular tax, you’re capped at taking the regular tax to zero. The FTC isn’t refundable, the IRS will not pay you back for what you’ve paid to HMRC 😦
Form 1116 – Part III – Figuring the AMT Credit using the Simplified Limitation Election
- Line 14 – Foreign taxes available for credit – $38,360 (same as the regular FTC)
- Line 17 – Net foreign source taxable income – $122,200 (for the simplified limitation, you just copy this from line 17 of the regular form 1116)
- Line 18 – Taxable income – $147,000 (this is the big difference from the regular FTC, where it was $122,200. There’s a “worksheet for line 18” to get to this number, but for Polly’s simple situation without qualified dividends or capital gains, this number is her total income, before taking off the standard deduction. For the regular FTC, it’s after taking off the standard deduction)
- Line 19 – Divide line 17 by line 18 – 0.8313 (the difference carries on – because line 17 is net foreign source taxable income after taking off the standard deduction, but line 18 is taxable income before taking off the standard deduction, line 17 will always be less than line 18, limiting the credit)
- Line 20 – Alternative Minimum Tax before the AMT FTC – $8,736 (copy from way back, form 6251 line 7. This is different from the regular FTC, because we’re going to figure out how much of the AMT we can apply the credit against, not how much regular tax we can offset).
- Line 21 – Maximum AMT FTC for this category – $7,262 (line 19 times line 20. Because line 19 is always less than 1.0, this amount will always be less than the AMT before the FTC – Polly will owe AMT. Copy this down to line 23, because line 22 doesn’t apply to Polly)
- Line 24 – AMT Foreign tax credit for this category – $7,262 (the lesser of the maximum AMT FTC or the actual foreign taxes paid. For the UK, this will almost always be the maximum AMT FTC).
Now we finally have our AMT FTC, we can go back to the AMT calculations and apply it. If Polly had more than one category of FTC to calculate, we’d do that in Part IV, but since she only has general category foreign taxes, it’s the same value as line 24.
Form 6251 – Part II – Alternative Minimum Tax (continued)
- Line 8 – Alternative minimum tax foreign tax credit – $7,262 (from line 24 on form 1116)
- Line 9 – Tentative minimum tax – $1,474 (line 7, the AMT before the FTC, minus line 8)
- Line 10 – Regular Tax minus regular foreign tax credit – $0 – (this makes sense – under the regular tax system, Polly’s foreign tax credit completely offsets her regular taxes)
- Line 11 – Alternative minimum tax – $1,474 (line 9 minus line 10)
This $1,474 is what Polly & Pat will actually owe in Alternative Minimum Tax. This shows up back on form 1040 on line 17 as an additional amount of tax, above their “normal” tax. There’s only a handful of lines after this before you get to what you actually owe: child tax credit is probably the most common. If Polly & Pat have kids, they can wipe out the AMT amount and they wind up owing nothing (or even get paid by the IRS). But without kids or a few other credits, Polly & Pat could actually pay the IRS, despite all their foreign tax credits!
Obviously, Polly & Pat don’t want to do this, and neither do I. So, let’s go back a bit and revisit that “simplified limitation election” – we’ll recalculate Polly & Pat’s AMT FTC using the non-simplified method.
Form 1116 – Part I & II – Taxable Income from Outside the US & Foreign Taxes (AMT non-simplified limitation)
Basically, the non-simplified method requires you to redo the whole foreign tax credit form 1116, but only using income and deductions that are both allowed for the AMT and attributable to sources outside the US. This can get complicated, but it’s not too bad for Polly & Pat:
- Line 1a – Gross Income from the UK – $147,000 (still the same, this hasn’t changed)
- Line 3a – Standard Deduction – $0 (this is the key change! instead of reducing Pat’s foreign taxable income by the standard deduction, it stays the same, because the standard deduction isn’t allowed by the AMT)
- Line 7 – Taxable income from sources outside the US for this category – $147,000 (just Pat’s taxable income, no deductions)
- Line 8 – Total foreign taxes paid/accrued for this category – $38,360 (no change from the regular calculation
Form 1116 – Part III – Figuring the AMT FTC (non-simplified limitation)
Let’s do this calculation for the third time – now we’re using the data from the AMT Part I & II, following the instructions for form 6251 that tell us how to do the calculations for AMT.
- Line 9 -Total foreign taxes paid/accrued for this category – $38,360 (copy from line 8)
- Line 10 – Carryback or Carryover – $0 (still assuming zero, still doesn’t make a difference)
- Line 14 – Foreign taxes available for credit – $38,360 (total of lines 9, 10, 12, and 13; we skipped lines 12 and 13 again)
- Line 15 – Taxable income from sources outside the US for this category – $147,000 (here’s where the non-simplified method makes a difference – this value was $122,200 for the simplified method. Just copy from line 7, then we copy this down to line 17, because line 16 doesn’t apply to Polly)
- Line 18 – Taxable income – $147,000 (this is the same number as using the simplified method, but now lines 17 and 18 are the same number)
- Line 19 – Divide line 17 by line 18 – 1.000 (because of the non-simplified method, we’re now able to take a credit against 100% of the AMT, not just the 83% we could with the simplified method)
- Line 20 – Alternative Minimum Tax before the AMT FTC – $8,736 (copy from form 6251 line 7, same as the simplified method. ).
- Line 21 – Maximum AMT FTC for this category – $8,736 (line 19 times line 20 – copy this down to line 23, because line 22 doesn’t apply to Polly)
- Line 24 – AMT Foreign tax credit for this category – $8,736 (the lesser of the maximum AMT FTC or the actual foreign taxes paid. For the UK, this will almost always be the maximum AMT FTC).
Now we’ve got an AMT FTC that is equal to the preliminary AMT amount – you can see where this is going now.
Form 6251 – Part II – Alternative Minimum Tax (non-simplified AMT FTC)
- Line 8 – Alternative minimum tax foreign tax credit – $8,736 (from line 24 on form 1116)
- Line 9 – Tentative minimum tax – $0 (line 7, the AMT before the FTC, minus line 8)
- Line 10 – Regular Tax minus regular foreign tax credit – $0 – (this makes sense – under the regular tax system, Polly’s foreign tax credit completely offsets her regular taxes)
- Line 11 – Alternative minimum tax – $0 (line 9 minus line 10)
Now we carry this back to form 1040 line 17, via schedule 2 lines 1 and 3. But since the value is zero, it’s easy to see that there’s no AMT payable. And since the “regular” FTC is equal to the “regular” tax, the tax owed is reduced to zero. If there are any refundable tax credits, like part of the child tax credit, Polly & Pat get paid to file their taxes. Even without the refundable part, they owe nothing! Much better result than the simplified limitation.
That was a really, really long winded way of saying that you should definitely do some calculations before you decide whether or not to use the “simplified limitation election” – if your situation is similar to Polly & Pat, it could cost you!
For me, understanding this much better now, I need to switch to the non-simplified method moving forward. I’m lucky to have only filed two years with the simplified method, and in both of those I had enough child tax credit that the AMT didn’t make any difference at all (the non-refundable part of the child tax credit was more than my AMT, so I still got the full amount of the refundable portion).
So I’ll write the IRS a letter, requesting consent to switch to the non-simplified method for 2021 onwards and explaining the situation (in a LOT less detail). Given how backed up they are these days, I may not even hear back before I file my 2021 taxes, but I’ll plan on using the non-simplified method – even if it takes them a year+ to respond, it won’t change the bottom line on my taxes until the kids grow out of the child tax credit.
If I hear back anything other than “that’s fine, go ahead”, I’ll provide an update so we can all learn together.
IRS Training on calculating AMT FTC – this was helpful in understanding the calculations more conceptually than just using the form instructions