Understanding the Alternative Minimum Tax (AMT)

Learn if it affects you – and how to plan accordingly

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The Alternative Minimum Tax (AMT) has been around since 1986, but many Canadians may be unfamiliar with it. That’s about to change. Starting in 2024, the AMT’s scope has significantly expanded — that means it’s affecting more individuals than ever before.

What is the AMT?

The AMT is essentially an alternate method for calculating income tax, running alongside the regular tax system. It was created to ensure that every individual pays a minimum amount of tax each year, regardless of the deductions, exemptions and credits they claim.

Under the AMT system, individuals pay the greater of:

• The regular income tax calculated under the regular rules
• The minimum tax calculated using the AMT rules

If the AMT results in additional tax payable, that extra amount becomes a “minimum tax carryover” which can be carried forward for up to seven years. This carryover can be used to offset future regular income tax if it exceeds the AMT in any of those years. If the carryover can’t be fully used within the seven-year period, the additional AMT tax becomes a permanent cost.

How does the AMT work?

The main difference between the regular income tax calculation and the AMT calculation is that the AMT reduces the impact of preferential forms of income and allows fewer deductions and exemptions. It also applies a flat tax rate to what’s called “adjusted taxable income,” rather than the graduated rates used in regular tax calculations. This means that the AMT often hits individuals who benefit from certain tax preferences, such as capital gains, employee stock options, or charitable donations.

In practice, the AMT targets individuals who have a high amount of income from tax-preferred sources and relatively lower regular income. However, if your income mostly comes from regular sources, such as employment or business income, the AMT might not affect you.

AMT in action

Understanding the AMT’s impact is easier when we look at some real-life scenarios:

Angela: Sale of a business
Angela is selling her business shares and expects to make a capital gain of $5 million. She can claim a $1 million lifetime capital gains exemption (LCGE). Here’s how the AMT affects her federal tax:

• Regular tax: Angela would pay $632,900 in taxes after applying her LCGE.
• AMT: However, the AMT calculation would result in $843,900 in taxes.

This means Angela would have to pay an additional $211,000 in taxes due to the AMT. If she can’t use the carryover of this additional tax in future years, it becomes a permanent cost.

Angela: Charitable donation
Let’s say that in the same year as the business sale, Angela also donates $1 million worth of publicly listed securities to charity, which have an accrued gain of $500,000. While this donation would normally reduce her federal tax, the AMT rules make things more complicated:

• Regular tax: Angela would pay $302,900 after the donation tax credit.
• AMT: Under AMT, she ends up paying $610,700, an additional $307,800 in tax.

This demonstrates how AMT can increase the tax burden on donations, particularly in scenarios where it makes economic sense to do so, like in years where there is a large liquidity and tax event.

Harper: Capital gains and losses
Harper sold investments and realized a $500,000 capital loss last year. This year, she sells other investments and realizes a $500,000 capital gain. Under the regular tax system, she can offset the gain with last year’s loss, but under AMT, she can only claim 50% of the capital loss carryover. The result? An additional federal tax payment of $13,700 due to AMT.

David: Family trusts
Several years ago, David established a family trust for his grandchildren and loaned $5,000,000 to the trust. The loan carries interest at 1%, which was the prescribed rate at the time it was made. The proceeds of the loan were invested, earning an annual rate of return of 5%. The trust distributes all of its income to the grandchildren each year. What is the trust’s estimated federal tax liability?

• Regular Tax: The trust pays no tax because all income is distributed.
• AMT: The trust faces $5,100 in additional tax due to the AMT.

Although the trust distributes all of its income, the AMT limits the deductions, such as interest expense, that it can claim. As a result, the trust faces an ongoing AMT burden. If you’re a trustee of a family trust, be sure to regularly evaluate potential AMT implications for the arrangements you oversee.

What does this mean for you?

If you’re a high-income individual with tax-preferred income, deductions and credits, the AMT can have a significant impact. It can even affect family trusts, where deductions like interest expenses are limited under the AMT system.

How can you plan for AMT?

To minimize the impact of the AMT, strategic planning is crucial. Some general strategies include:

• Use minimum tax carryovers: If you pay AMT, try to generate sufficient regular income tax in the following 7 years to offset the carryover.
• Adjust income sources: If possible, adjust your income sources, such as withdrawing from RRSPs or changing the salary/dividend mix if you’re a business owner. Also look to match the recognition of capital gains and losses in the same year.
• Donate strategically: If you plan to make large charitable donations, consider how the AMT will affect your tax situation and consult with your tax advisor before acting.
• Use a corporation: Corporations are not subject to the AMT. If you have significant tax preferences personally that create AMT issues, ask your tax advisors whether the use of a corporation could be a good planning strategy.

Work with your tax advisor to help you understand the AMT and manage its impact on your taxes.

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