Tax Preference Item

A tax preference item refers to a specific item of income, tax deduction, or tax credit that is considered to provide an extra benefit under federal tax law. These items are identified as potentially leading to excessively low tax liability for some taxpayers, which is why the Alternative Minimum Tax (AMT) is imposed to ensure a minimum tax is paid.
On this page

What is a Tax Preference Item?

A tax preference item is an element of income, deduction, or credit that the federal tax law designates as providing an advantageous tax benefit. The rationale behind designating these items is to identify sources of preferred tax treatment that could significantly lower a taxpayer’s overall tax liability, potentially leading to an unjustly reduced tax payment. To remedy this, tax preference items are added back to income to determine the necessity for the Alternative Minimum Tax (AMT), which ensures that a minimum level of tax is paid by taxpayers who might otherwise exploit these benefits to significantly lower their taxes.

Examples of Tax Preference Items

  1. Accelerated Depreciation: Using accelerated depreciation methods on property acquired before January 1, 1987, can create a tax preference item.
  2. Tax-Exempt Interest: Interest on certain private activity bonds issued after August 7, 1986, is considered a tax preference item.
  3. Percentage Depletion: The excess of the percentage depletion deduction over the adjusted basis of the property to which it relates.

Frequently Asked Questions

Q1: Why are tax preference items significant in taxation? A1: Tax preference items are significant because they are used to ensure taxpayers don’t disproportionately reduce their tax liability through preferential treatments. These items inform the calculation of the Alternative Minimum Tax (AMT), ensuring that all taxpayers contribute a minimum amount of tax.

Q2: How does the Alternative Minimum Tax (AMT) interact with tax preference items? A2: The AMT recalculates income by adding tax preference items back into taxable income to determine whether a taxpayer should pay the regular tax amount or the AMT, which is designed to ensure a minimum tax payment by higher-income individuals.

Q3: Can tax preference items affect both individuals and corporations? A3: Yes, tax preference items can affect both individual taxpayers and corporate entities, necessitating the calculation of AMT for both to ensure fair taxation.

  1. Alternative Minimum Tax (AMT): A parallel tax system designed to ensure that taxpayers who benefit from certain exemptions, deductions, or credits still pay a minimum amount of tax.
  2. Accelerated Depreciation: Depreciation methods that allow higher deductions in the early years of an asset’s life.
  3. Private Activity Bonds: Bonds issued by or on behalf of local or state government for the purpose of funding projects that include private investments, partially exempt from federal taxes.
  4. Percentage Depletion: A method allowed for calculating depletion (using up of a natural resource) that is based on a fixed percentage of gross income from the resource.

Online References

Suggested Books for Further Studies

  1. “Taxation of Individuals and Business Entities” by Benjamin C. Ayers, John R. Barrick, and Troy Lewis
  2. “Federal Income Taxation” by Joel S. Newman
  3. “Understanding the AMT: Why Tax Reform Must Deal with the Alternative Minimum Tax” by Peggy A. Hedges and Neil Bruce

Fundamentals of Tax Preference Items: Taxation Basics Quiz

Loading quiz…

Thank you for exploring the concept of tax preference items and testing your understanding. Keep practicing as you enhance your knowledge in the field of taxation!

Tax Rate
Tax Point