Downturn, deficit, audits, tax increases: the pattern is fairly reliable. An economic downturn causes a federal deficit which in turn sends Washington on a hunt for money (thus, the audits). Next, to narrow those deficits, come the tax increases. Right now we are seemingly in the audit stage. The Internal Revenue Service has been after entrepreneurs who had the temerity to use an obscure tax shelter known as "Son of BOSS".

But there is another and more mundane form of audit to which higher earners are subjected. It is an automatic audit: the AMT audit. And it brings with it its own troubles and penalties.

The Alternative Minimum Tax, as most readers will know, is not a true audit. It is rather an alternate tax regime, a sort of penalty box into which taxpayers are cast when their tax bill gets "too low" by IRS formulas. Even if a big deduction takes you only $1 below the cutoff, that deduction can still send you into the AMT regime. And there you will find the entire deduction can no longer be taken - along with the few others.

Among the deductions the AMT does not allow are state and local income tax deductions, property tax deductions and investment management fees - in short, the deductions most taxpayers count on.

But there is more bad news: when you are in AMT-land, certain events - exercising qualified options - trigger unique tax liabilities.

All this hardly mattered for a long time because the AMT hit relatively few households. That, however, is changing, with many millions of households scheduled to be subject to the AMT over the next 10 years.

Who will be especially vulnerable this year? Qualified option holders, for one. Employees granted qualified options, also known as incentive stock options, typically pay no tax when they exercise. They only owe taxes when they sell their option stock and the applicable tax rate can be as low as 15 per cent, the rate on long-term capital gains.

Next to "Mr Qualified", the executive who holds non-qualified options tends to feel sorry for himself. For the exercise of his options do create a tax event: the difference between the strike price and the market price at the time of the exercise counts as ordinary income and is subject to up to the 35 per cent rate.

But to get back to the qualified option holder: his advantage disappears in the alternate universe of the AMT. Here the difference between strike price and market price is subject to AMT tax - up to 28 per cent - for the year of the exercise.

Four years ago, when so many options were under water, the AMT's effect on qualified options hardly mattered. Now, however, your company's successes may force your acquaintance with the AMT.

Next there is what we shall call the "quality of life" trap: the exposure of families who live in pleasant, high-cost places such as California, Massachusetts or New York. These households frequently find themselves in the AMT box because high-cost states also have high income and real estate taxes, the deductions for which are AMT triggers.

One way to avoid AMT trouble, suggests Gerald DesRoches, a managing director at HSBC's Wealth and Tax Advisory Services, is to think about paying state income tax a year early or a year late. By pre-paying in a high income year - when you are going to be paying a lot of tax anyway - you may spare yourself an extra-large tax bill in a low income year. Low income years are also years when deductions loom large.

A disappointing bonus may also make you an AMT subject. As Mr DesRoches points out, another typical executive habit also sets off the AMT-deferring income. Never think about deferring income because of tax savings without taking AMT into account. "You cannot look at any year in isolation," he says.

Finally, there is the real estate problem. Everyone knows the euphoria that comes with the news that a neighbour sold for a record price. Record prices are being set all around the country. In the Park Slope district of Brooklyn, New York, houses that used to list for $1m began listing for $3m or $4m recently.

And California is more extreme. Coldwell Banker, one of the larger real estate businesses, recently reported Los Angeles luxury home values were up 28 per cent in 2004 over the year earlier.

Taxpayers tend to be aware of the fact that "good news for the neighbourhood" will cost them in increased property taxes. What they forget is that property tax increases, normally deductible, can trigger the AMT. Moving house can likewise send you, willy-nilly, into AMT-land. Even if the purchase of your new home is the same as the sale price of your old one, check the property tax. It may be higher than the tax on your old house and just high enough to prevent your taking the deduction at all.

But what about the fourth stage in the cycle - tax increases? This, after the AMT, will be a big worry in Tax Season 2005. With the top income tax rate at 35 per cent and a dividend tax rate of 15 per cent, tax rates are at a historic low. Now, even some Republicans are talking tax increases.

The headline that Mr DesRoches of HSBC puts on this story is: rethink deferring compensation. "Conventional wisdom says that deferring compensation is good. But nowadays conventional wisdom does not hold for many folks," he says.

Beyond the prospect of tax increases there is the fact that the new tax law of last autumn created an entire new section in the tax code governing deferred com-pensation. The changes reduce flexibility.

Formerly, it was often possible for executives to alter their deferral schedule, postponing compensation far longer than the original plan. This made a lot of sense in recent years, when the top income tax rate dropped every 12 months. Now the new law makes it much more difficult to extend the period of payment. In other words, when taxes do go up you will have a harder time planning to avoid them. For some the prospect of tax increases is more about estate planning than compensation. The estate tax is fading and is scheduled to disappear in 2010. Still, the phase-out may not hold, especially as news of deficits mounts.

If you want to get macabre, you may want to ask yourself whether 2006 is the optimal time to die: that year, the current exemption for the tax rises to $2m from $1.5m. But you have to hope that even the gloom of the tax cycle will not force us to think in those terms.

© Copyright 2005 Financial Times