If you ve been socked with a big alternative minimum tax (AMT) bill, the most likely cause was exercising some lucrative incentive stock options (ISOs). This is because the AMT rules tax you on the so-called bargain element (the difference between the fair market value of the ISO shares on the date you exercise and the exercise price) when you exercise an ISO. In contrast, the regular tax rules don t tax you on the bargain element until you actually sell the ISO shares. So your AMT bill may be bigger (perhaps much bigger) than your regular tax bill in a year when you exercise in-the-money ISOs. Naturally, the IRS insists that you pay the larger AMT amount for that year.

AMT Credit May Help

Thankfully, the amount of AMT triggered by exercising ISOs generally results in an AMT credit. When you generate an AMT credit in one year, you can use it to lower your tax bills in future years. You can carry forward any unused AMT credit indefinitely.

Unfortunately, for pre-2007 tax years, you were only allowed to use the AMT credit to reduce your regular tax liability (after reduction by certain other credits such as the child tax credit and the education tax credits) to the point where your regular tax equaled the AMT.

For instance, say your regular tax bill for a pre-2007 year was $35,000, and your AMT bill was $33,000. Say you also had a whopping $50,000 AMT credit from exercising lucrative ISOs in earlier years. You could use $2,000 worth of AMT credit to reduce your regular tax bill to $33,000. You had to carry forward the remaining $48,000 and hope you could use it in later years. In other words, your whopping AMT credit did you absolutely no good in years when you owed the AMT, and it only did a modest amount of good in years when your regular tax bill was only slightly larger than your AMT bill. As you can see, it could take many years to use up a big AMT credit generated from exercising ISOs.

Little-Known Refundable AMT Credit May Help More

In 2006, Congress decided to give some help to folks with big unused AMT credits by making them refundable in certain circumstances. Refundable means you can use them to reduce both your regular federal income tax bill and your AMT bill. In fact, you can even collect a refundable AMT credit for a year when you owe no federal income tax at all. This favorable change (which comes with several strings attached that I ll explain) is available for tax years 2007 through 2012.

Key Point: If you ve not yet filed your 2007 Form 1040, the little-known refundable AMT credit could get you some cash back right now. If you ve already filed your 2007 return but were unaware of the refundable AMT credit, you can file an amended 2007 return (using Form 1040X) to get cash back. In any case, the refundable AMT credit may help slash your 2008 tax bill. However, there are some strings. So please keep reading.

Only Unused AMT Credits Over Three Years Old Are Refundable

The refundable AMT credit amount that you can collect in a particular tax year doesn t include any unused AMT credits that were generated in the preceding three years. Only older unused credits can be refundable.

Example 1: For the 2008 tax year, the refundable AMT credit amount doesn t include any unused AMT credits that were generated in the three prior years (2005-2007). It only includes unused AMT credits that were generated in 2004 and earlier. For the 2007 tax year, it only includes unused AMT credits that were generated in 2003 and earlier.

Refundable Credit Is Limited

If the amount of the refundable AMT credit available to you for a particular tax year is less than $5,000, you can collect the whole amount by filing Form 1040 for that year (assuming the phase-out rule explained later doesn t affect you). If the amount of the refundable AMT credit available for a year exceeds $5,000, the amount you can actually collect for that year is limited to the greater of: (1) 20% of the refundable amount, or (2) $5,000. The following example illustrates how this dollar-value limitation works.

Example 2: Say the amount of the refundable AMT credit available for your 2008 tax year is $4,000. You can collect the full $4,000 by filing your 2008 Form 1040. If the refundable credit amount for 2008 is between $5,000 and $25,000, you can collect exactly $5,000 (because $5,000 exceeds 20% of the total refundable amount). If the refundable credit amount is $50,000, you can collect $10,000 by filing your 2008 return (20% x $50,000 = $10,000, which exceeds $5,000). However, the amount you can collect can be reduced or even completely eliminated if the phase-out rule explained immediately below applies to you.

Refundable Credit Is Phased Out for Higher-Income Individuals

The refundable AMT credit amount for a tax year (after the dollar-value limitation explained above) is phased out over the same AGI range that applies to the phase-out of personal exemption deductions for that year.

* For 2008, the phase-out range for a married joint filer is between AGI of $239,951 and $362,450.

* The range for a single filer is $159,951-$282,450.

* The range for a head of household is $199,951-$322,450.

(If you ve not yet filed last year s Form 1040, the phase-out ranges for 2007 are slightly lower.)

Fill Out Form 8801 to Collect Your Rightful Credit

Use Form 8801 (Credit for Prior Year Minimum Tax) to calculate your total AMT credit and the refundable amount (if you qualify). Last but not least, be aware that Congress might liberalize the refundable AMT credit rules for 2008 and beyond. I will keep you posted.