CCH Scenarios Show that Congress Giveth, but the AMT Taketh Away

(RIVERWOODS, ILL., September 22, 2005) – When Congress passed the Economic Growth and Tax Relief Reconciliation Act back in 2001, many high-income taxpayers began to look forward to 2006 as the year in which they could begin to receive relief from special tax provisions that limited the value of their itemized deductions and personal exemptions.  But according to CCH, a leading provider of tax and accounting information and software, what the regular tax code gives with one hand, the alternative minimum tax (AMT) may take away with the other (tax.cchgroup.com). 

“Many people may find that the hefty tax reductions they expected next year are completely negated by the AMT – or even that they will face higher tax bills on the same amount of income, despite the ‘relief’ promised in the legislation,” observed Mark Luscombe, J.D., principal federal tax analyst with CCH.

“Stealth” Taxation

Currently, taxpayers begin to lose the full value of many itemized deductions and personal exemptions when their income exceeds certain thresholds.

 “Some observers have called this ‘stealth’ taxation, because taxes as a percentage of income go up without any visible increase in the tax rates.  Instead, due to the loss of deductions and exemptions, taxable income increases faster than gross income,” Luscombe noted.

Once adjusted gross incomes go over the itemized deduction threshold, taxpayers must reduce the itemized deductions they otherwise could take by three percent of the excess.  The reduction is capped at 80 percent of their itemized deductions. 

Personal exemptions are reduced by 2 percent for every $2,500 in excess of the personal exemption threshold.  (For married persons filing separately, the reduction is 2 percent for every $1,250 over the threshold.)  There is no cap on the phaseout, so high-income taxpayers can completely lose the value of their personal exemptions.

The thresholds are indexed for inflation based on statistics released every September, and are usually officially announced by the IRS every December.  Based on the September inflation numbers, CCH is able to project the 2006 itemized deduction threshold for joint filers at $150,500 and the personal exemption threshold for joint filers at $225,750.

Raising the thresholds each year provides some inflation protection for high-income taxpayers, but in 2006 the phaseouts themselves begin to be phased out.  Taxpayers will compute their phaseouts as usual in 2006, but then any reduction will be reduced by one-third.  Taxpayers will apply only two-thirds of the normal reduction against their itemized deductions and personal exemptions.  The same rule will hold true for 2007.  In 2008 and 2009 the phaseouts will be further reduced, so that only one-third of the normal reduction will apply.  In 2010, the phaseouts will be completely repealed.  Under current law, however, in 2011 the phaseouts, like many other items in the Code, will go back to their status as of 2001.

Scenarios Show AMT, Phaseout Interaction

Two scenarios calculated by CCH illustrate the interplay of the AMT and the phaseout reductions next year.

Consider a family of five with $500,000 in adjusted gross income and itemized deductions – before phaseout – of $75,000, with $35,000 of that total coming from deductible state taxes.  In 2005, they can claim only $64,378 of the itemized deductions, and they cannot subtract any personal exemptions from their taxable income of $435,622.  They owe regular tax of $126,530 and are not subject to AMT.  

If there were no “relief” from the phaseouts in 2006, the inflation adjustment in the itemized deduction phaseout would shave $137 from their taxable income.  Other inflation adjustments would put more of their taxable income into lower brackets, also, dropping their tax to $125,670.

So how much “relief” will they experience in 2006?  They can take an additional $3,632 in itemized deductions, for total allowable itemized deductions of $68,010 and also subtract $5,500 in personal exemptions.  Their taxable income drops by more than $9,000 to $426,490 and their regular tax goes down by about $4,000 to $122,522.

But then the AMT comes into play. Their state taxes are added back into their income in figuring AMT; and so are their personal exemptions. AMT increases their tax bill by $2,778, to $125,300. Their tax is $125,300 – just $370 less than it would be without any “relief” from the phaseouts in their itemized deductions and personal exemptions.

More Relief Needed?

A family of four with an adjusted gross income of $300,000 and itemized deductions of $50,000, including $22,000 in state taxes, would already owe AMT of $1,989 in 2005, with a total tax bill of $65,170.  In 2006, their tax bill will jump to $68,810, due to a scheduled decrease in the exemption used in figuring AMT.  This is the same tax that they would owe without any “relief” from phaseouts.

“In many cases, it looks as though relief from phaseouts won’t produce significant bottom-line results on April 15,” Luscombe observed.

One problem facing taxpayers is that the exemption used in figuring AMT is scheduled to decrease next year – from $58,000 to $45,000 for joint filers.  This exposes an additional $13,000 to the effects of the alternative tax.  When the exemption was slated to decrease in the past, Congress acted to keep it at its current level.  But even if they pass an extension of AMT “relief” again, some taxpayers may not be better off in 2006 than in 2005, despite the double helping of “relief” from both the AMT and the phaseouts.  And even that assumes that Congress will make AMT relief a priority in a time of growing deficits.

“We’ve known for some time that AMT could negate some of the ‘tax relief’ promised in the 2001 legislation, but what we see in the scenarios we’ve run comes as a surprise even to tax professionals.  And ‘surprise’ may be too mild a word to describe what some high-income taxpayers feel when their accountants run the numbers on their 2006 taxes,” Luscombe said.

AMT Audio Seminar