DEFINITION of Tax Preference Item
Tax preference item is a type of income, normally tax-free, that may trigger the alternative minimum tax (AMT) for taxpayers. Tax preference items include interest on private activity municipal-bond, qualifying exclusion for small business stock, and excess intangible drilling costs for oil and gas, if this amount exceeds 40% of AMT income. Tax preference items are added to the amount of AMT income in the tax formula.
BREAKING DOWN Tax Preference Item
Alternative minimum tax (AMT) is the least tax that an individual or corporation must pay after all eligible exclusions, credits, and deductions have been taken. AMT is a mandatary supplement tax alternative to the standard income tax. It uses many common itemized deductions and, therefore, impacts high income earners mostly because it eliminates many of those deductions. A taxpayer that makes more than the AMT exemption amount and uses the deductions must calculate his taxes twice – one calculation for the regular income tax, and another for the AMT. Individuals that have an adjusted gross income higher than the exemption ($70,300 for single/head of households and $109,400 for married filing jointly, as of 2018) must calculate the AMT, and pay the higher of both taxes calculated.
Items that must be included when calculating the alternative minimum tax are called tax preference items. The tax preference item is income that subjects an individual to the AMT, and is treated differently for regular tax and AMT purposes – it is excluded when calculating one's ordinary tax liability but is included when calculating one's liability for the alternative minimum tax. Thus, a tax preference item would be tax deductible under normal circumstances but is not for purposes of the alternative minimum tax. If the amount of tax preference items exceeds a certain percentage of the taxpayer's income, the taxpayer must add these items back to his or her taxable income to compute the amount of tax owed, thus, creating a higher tax bill. To calculate the AMT, then, calculate the taxable income the usual way and then add back preference items for minimum tax purposes. Tax preference items include:
- Deductions for accelerated depreciation/depletion
- Net income from oil and gas properties
- Excess intangible drilling costs
- Interest on special private activity bonds reduced by any deduction (not allowable in computing the regular tax) which would have been allowable if such interest were included in gross income
- Qualifying exclusion for small business stock
- Capital gains from exercise of stock options
- Investment tax credits
Like the AMT itself, tax preference items are designed to prevent high-income taxpayers from avoiding too much income tax through participating in certain activities. For example, investors who own private-activity bonds (PAB) issued after August or September of 1986 must declare all income received from these bonds, minus investment expenses. This rule, thereby, prevents taxpayers from shielding all of their investment income in this type of bond issue.