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For Now, the Fix Is in on AMT

(RIVERWOODS, ILL., January 2005) – The alternative minimum tax – AMT – is the skeleton at the feast of tax reduction. Last year, Congress extended provisions that keep many taxpayers out of its clutches. But sooner or later, the AMT threatens to take some of the joy out of many people’s tax cuts, according to CCH INCORPORATED (CCH), a leading provider of tax and accounting information, software and services (tax.cchgroup.com). That’s because cuts in the regular income tax actually increase the exposure of middle- and upper-income taxpayers to the AMT.

Quite simply, the AMT is an alternate way of figuring your income tax. It’s the legacy of an era when tax rates went as high as 91 percent and the tax code was full of loopholes for the wealthy, according to Mark Luscombe, JD, CPA and principal federal tax analyst for CCH.

“At that time, every tax season brought news accounts of fabulously wealthy individuals who paid no tax whatsoever. The system that eventually was devised is basically a parallel tax universe. Things that are deducted in figuring regular tax are often added back in figuring AMT, and things that are added for regular tax purposes may be subtracted,” Luscombe said.

Doing Taxes Twice

For taxpayers, it means doing your taxes twice: You figure your regular federal tax, then calculate AMT and pay whichever is greater. Many items can trigger an AMT liability – and change character when you leave the “normal” 1040 world and enter the world of the Alternative Minimum Tax.

For example, the itemized deduction for state taxes isn’t subtracted from income in figuring AMT, so residents of high-tax states – such as New York or California – are more likely to find themselves subject to the tax.

“Miscellaneous” itemized deductions aren’t allowed in figuring the AMT, either. This can affect taxpayers with large amounts of unreimbursed business expenses.

Until 2004, it also meant that many people who successfully sued for employment discrimination ended up owing Uncle Sam for phantom “income.” If attorney’s fees were included in their damage awards, the fees were counted as their income. The fees could be subtracted as a “miscellaneous” itemized deduction, making the taxpayer more or less even as far as regular tax was concerned. But because they were not deductible in calculating AMT, the person who won in the courtroom often ended up losing at tax time.

Congress addressed this issue in last year’s American Jobs Creation Act by allowing attorney’s fees to be deducted from gross income. This shields them from both ordinary tax and AMT.

“The new law addresses one of the oddities of the AMT, but many others remain,” Luscombe observed.

Special rules apply to medical expenses, home mortgage interest and investment interest deductions in calculating AMT. For example, an itemized deduction for the interest on a mortgage that pays for your home or for home improvements is deducted for both regular tax purposes and AMT, but if you borrowed against your home to buy something else, the interest is not deductible on the AMT form.

In addition, personal exemptions are not allowed in figuring the AMT. In one noted case, David and Margaret Klaassen of Marquette, Kan., claimed 10 personal exemptions for their kids, plus one each for themselves in 1994. The IRS then figured their alternate tax, without the 12 personal exemptions, and sent them a bill for $1,085.

The Klaassens petitioned the Tax Court to declare that imposing the AMT on them was contrary to the congressional intent behind the alternative tax. They did not have a single “tax preference” item on their return. Nonetheless, the Tax Court ruled in 1998 that they owed the tax.

Stock Options Can Trigger AMT

During the stock market bubble years, the AMT brought extra anguish for those who saw their dot-com stock option fortunes disappear. When a company awards incentive stock options to employees, the recipients have to treat the value of the stock as income for AMT purposes as of the date they exercise the option. If the stock plunges in value before the holder can actually sell it and realize the hypothetical windfall, that’s too bad – the AMT bill still has to be paid.

“There undoubtedly have been people who escaped from the market owning just their home, only to find out that they had to sell it to pay the tax bill on ‘income’ they never actually saw,” Luscombe said.

About a dozen other items, mainly related to businesses, can change things enough to incur an AMT liability. For the AMT, depreciation is figured differently than for normal tax, and the difference becomes an “adjustment” to income – although the adjustment sometimes leads to a lower AMT liability. No single factor may be decisive. As they approach higher income levels, taxpayers must discover for themselves if the AMT applies.

Indexing and Nonindexing Increase AMT Exposure

The AMT has its own exemption amounts and tax brackets, but unlike their counterparts in the regular tax rules, numbers associated with the AMT have not been indexed for inflation. In fact, the indexing of various items for the purpose of regular tax – such as tax brackets, the standard deduction and personal exemptions – has a downright perverse effect on AMT liability, according to Luscombe.

“Indexing means that at any given level of income – say, $90,000 – you’ll owe less regular tax next year than you did this year,” he said. “But since AMT computations generally don’t use indexed figures, the AMT on that same level of income would stay the same. This means that the excess of your regular tax over AMT – the cushion that protects you from having to figure and pay the AMT – gets less and less at any given level of income, until you could find that you owe the AMT.”

Another Temporary Fix for the AMT

The series of tax reductions that started in 2001 will actually expose more people to the AMT, precisely because they lower regular taxes.

To delay the date when the AMT might start to eat away at the tax cuts for many people, Congress, in 2001, temporarily increased the exemption amounts used in figuring the AMT for the tax years 2001 through 2004, from $45,000 for joint filers to $49,000. It also allowed taxpayers to take the child credit and adoption credit against the AMT. Other nonrefundable personal tax credits, such as the Hope and lifetime learning credits, could be taken against AMT liability through the end of 2003.

When the tax cuts of the 2001 legislation were accelerated in the Jobs and Growth Tax Relief Reconciliation Act passed in 2003, Congress heaped on additional AMT relief. The exemption was boosted again, this time to $58,000, for the 2003 and 2004 tax years.

Last year, under the Working Families Tax Relief Act, the $58,000 exemption was further extended for the 2005 tax year, and the ability to take nonrefundable personal credits against the AMT was extended as well.

“The law gives some temporary protection from the AMT for a few years, but in the end, the alternative tax is likely to limit the tax reductions that many people can expect,” Luscombe noted. “As regular tax rates fall, more taxpayers will find themselves stranded on the AMT.”

Numbers Tell the Story

For the last several years, the temporary fixes have indeed kept the AMT at bay. In 2002, just a bit more than 1.9 million returns showed any AMT liability out of 130.2 million total returns. But when the AMT exemption amounts go back to their pre-tax cut levels, the alternate tax is expected to widen its reach: 14.9 million in 2006, soaring up to 30 million in 2010.

The Joint Committee on Taxation forecasts that in 2011, the number affected by the AMT will be roughly cut in half – because the tax cuts begun in 2001 are scheduled to come to an end. If those provisions live on beyond their current expiration date, the Congressional Research Service estimates that 41 million taxpayers – 37 percent of all the returns filed – would be affected by the AMT in 2012.

Abolish the AMT?

One obvious way to end the perceived inequities of the alternative tax – and to deliver the full benefits envisioned by the recent tax cuts – would be to eliminate the AMT once and for all. Abolishing the personal AMT itself is a relatively cheap step to take right now – the AMT brought in only about $6.1 billion for the tax year 2002 compared to total individual income tax receipts of $834 billion.

But its contribution to the nation’s finances will grow over time, and it poses a dilemma – can we afford to live with it, and, if we can’t, can we afford to live without it?

In fact, the single tax year of AMT relief in the Working Families Tax Relief Act will cost the Treasury $22.6 billion in fiscal 2005 and 2006 – more than any other single provision in the legislation, which also lowered regular tax rates over several years, maintained the child credit at $1,000 and offered special tax relief for married couples filing jointly.

“But by limiting AMT relief to a few years, Congress has lowered the long-term cost of the 2001 and 2003 tax cuts,” Luscombe said. “If there were no AMT, budget deficits in future years would be larger than they’re currently projected to be and would extend further into the future.”

AMT for Everyone?

President Bush has said that he will propose a simplification of the entire income tax system and address the problems of the AMT in his second term. Oddly enough, one possible solution would be to junk what is now the normal income tax and keep the AMT.

The AMT has many of the characteristics of a so-called “flat tax,” favored by some who criticize the current system. The AMT has a large personal exemption that would eliminate income tax for most families of low or moderate income, if it were the only tax in town. It has a simple rate structure, with only two rates – eliminate one of them and it would truly be a “flat tax” system. It does not have a complicated “phase-out” of itemized deductions. Since it does not allow deductions for state taxes, it does not discriminate between residents of high-tax and low-tax states. By some estimates, the AMT will someday produce more income than the regular tax system anyway.

“The problem is, you’d have to broaden the reach of the AMT, or raise the rates, to replace the revenues generated by the current system,” Luscombe observed. “But if you eliminated the AMT, you’d have to do something with the regular tax to make up for the shortfall, or face some pretty staggering deficits for a long time to come.”

About CCH INCORPORATED

CCH INCORPORATED (tax.cchgroup.com), based in Riverwoods, Ill., is a leading provider of tax and accounting information, software and services. CCH has served tax, accounting and business professionals and their clients since 1913, providing them with the most authoritative, timely and comprehensive tax resources. CCH is a Wolters Kluwer company (www.wolterskluwer.com).

Wolters Kluwer is a leading multinational publisher and information services company. The company’s core markets are spread across the health, tax, accounting, corporate, financial services, legal and regulatory, and education sectors. Wolters Kluwer has annual revenues (2003) of €3.4 billion, employs approximately 18,750 people worldwide and maintains operations across Europe, North America and Asia Pacific. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. Its depositary receipts of shares are quoted on the Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices .

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nb-05-06