Whole Ball of Tax 2003

MORE TAXPAYERS ON COLLISION COURSE WITH THE AMT

(RIVERWOODS, ILL., January 2003) – Like a skeleton at a feast, the little-understood alternative minimum tax, or AMT, threatens to take some of the joy out of scheduled and proposed cuts in the federal income tax, according CCH INCORPORATED (CCH), a leading provider of tax law information and software. Because tax cuts scheduled for future years — or effective in 2003, if President Bush’s tax plan becomes law — will lower the regular tax of many people, they will actually increase the exposure of middle- and upper-income taxpayers to the alternative tax even further.

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, CPA, attorney 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.

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. 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 or who deduct the attorney’s fees they pay out of damage awards they receive. Special rules apply to medical expenses, home mortgage interest and investment interest deductions. For example, an itemized deduction for the interest on a mortgage that pays for your home is not affected, but if you borrowed against your home to buy something else, beware.

In addition, personal exemptions are not allowed in figuring the AMT. David and Margaret Klaassen of Marquette, Kan., found this out when they 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.

During the stock market bubble years, the AMT brought an extra measure of 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. 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’ve escaped from the market owning just their home, only to find out that they will have 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 AMT purposes, 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 whether AMT applies.

The AMT has its own exemption amounts and tax brackets, but unlike their counterparts in the regular tax rules, numbers associated with the AMT are not 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."

A major tax law enacted in 2001 will actually expose more people to the AMT in the future, precisely because it lowers regular taxes over a number of years. To delay the date when AMT might cancel out the tax cuts for many people, the law temporarily increased the exemption amounts used in figuring AMT for the tax years 2001 through 2004. Congress has also enacted legislation that allows taxpayers to take the child credit, adoption credit and college tuition credit against the AMT, and apply other nonrefundable personal tax credits, such as the Hope and lifetime learning credits, against their AMT liability through the end of 2003.

But when these temporary "fixes" begin to expire at the end of this year and next, many taxpayers will find that their taxes will go down, but only as far as the AMT will allow.

As part of his economic stimulus plan, which fast-forwards many of the tax-cutting provisions of the 2001 law, President Bush is proposing a further temporary "fix" – an additional increase in the AMT exemption through the 2005 tax year.

"The law gives some temporary protection from the AMT for the next 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."

To see what lies ahead, it may pay to look at the recent past, before the 2001 tax law and the accompanying AMT "fixes." Preliminary figures for 2000, the last year for which statistics are available, show a 30-percent jump in the number of returns with an AMT liability over comparable numbers from 1999. In the 2000 tax year, 1,295,393 individuals were subject to the alternate tax. What’s more, over 60 percent of the returns showing AMT were for adjusted gross incomes of less than $200,000. Twenty-seven percent were for adjusted gross incomes of less than $100,000.

The 2000 figures available show more than 1 percent of all tax returns with adjusted gross incomes between $50,000 and $100,000 paid AMT. Roughly 5.4 percent of all taxpayers in the $100,000 to $200,000 range and 18.4 percent of those with adjusted gross incomes above $200,000 were subject to the alternate levy in that year.

The Congressional Research Service reports that by 2010, with inflation and reductions in regular tax, the number of taxpayers affected by the AMT will grow to an estimated 35 million – 33 percent of all taxpayers. In 2011, the provisions of the 2001 law are set to expire, but the Bush administration and its allies in Congress are seeking to make them permanent. Assuming they are successful, 41 million taxpayers would be affected by the AMT in 2012 – 37 percent of the total.

One obvious way to end the perceived inequities of the alternative tax – and to deliver the full benefits envisioned by the 2001 tax legislation – 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 tax amounted to only about $8.8 billion for the tax year 2000 compared to total individual income tax receipts of $976 billion.

But its direct contribution to the nation’s finances will grow over time, and its indirect contribution – by limiting the availability of personal tax credits – will increase as well. The Congressional Research Service estimates that the cost of total repeal could be as much as $840 billion for the period 2003 to 2012, while simply indexing the AMT for inflation would cost at least $400 billion.

In fact, the AMT makes the 2001 tax cuts much more "affordable" than they would be otherwise.

At the time the 2001 tax law was passed, Sen. John Kerry (D-Mass.) proposed exempting taxpayers with incomes under $100,000 from the AMT, and making up the lost revenue by giving less tax relief to the top tax brackets and phasing the relief in over a longer period.

Such a proposal may surface again as others seek to accelerate the reductions called for in the law and add to them to stimulate the economy.

"The AMT is sure to be a part of any debate about lowering taxes," Luscombe observed. "People don’t like high taxes, but they also don’t like tax complexity and uncertainty. If tens of millions of ordinary families start grappling with the AMT, there’s likely to be a groundswell of sentiment to do something about it."

CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served four generations of business professionals and their clients. The company produces more than 700 electronic and print products for the tax, legal, securities, insurance, human resources, health care and small business markets. CCH is a wholly owned subsidiary of Wolters Kluwer North America. The CCH web site can be accessed at cch.com. The CCH tax and accounting destination site can be accessed at tax.cchgroup.com

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