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New Congress, Old Dilemma: What to Do About the AMT?(RIVERWOODS, ILL., January 2007) – The new Congress will be facing a familiar tax dilemma this year, according to CCH, a Wolters Kluwer business and a leading provider of tax and accounting law information, software and services (CCHGroup.com). What will they do about the alternative minimum tax (AMT)? Will legislators abolish or make fundamental changes to this funhouse-mirror section of the tax laws, or will they settle for a temporary “fix” that will keep most middle-class taxpayers free of the AMT’s clutches? The AMT is the one part of the tax system that everyone loves to hate. Democrats and Republicans, the President and the Commissioner of the IRS all say that the AMT has got to go. However, getting rid of the AMT will not be easy. 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. “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 the AMT, and things that are added for regular tax purposes may be subtracted,” said Mark Luscombe, JD, LLM, CPA and CCH Principal Federal Tax Analyst. Doing Taxes TwiceFor taxpayers, it means doing your taxes twice: You figure your regular federal tax, then calculate the 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. Special rules apply to medical expenses, home mortgage interest and investment interest deductions in calculating the 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 the 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. Stock Options Can Trigger AMTDuring 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. To somewhat ease that burden, the IRS has placed an “AMT Assistant” on their web site – an electronic version of a worksheet that tells taxpayers whether they might be subject to the alternative tax. Indexing, Nonindexing Increase AMT ExposureThe 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,” Luscombe 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.” AMT Exemption an IssueThe 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 for the 2003 and 2004 tax years, then extended for the 2005 tax year, and the ability to take nonrefundable personal credits against the AMT was extended as well. In 2006, Congress upped the exemption once again, to $62,550 for joint filers and $42,250 for single taxpayers. But as things stand today, the exemptions for 2007 have fallen back to the levels of seven years ago: $45,000 for joint filers and surviving spouses; $33,750 for single taxpayers; $22,500 for married taxpayers filing separately. “It’s possible that Congress will eventually agree on another temporary fix for 2007, but unless the AMT is permanently indexed or abolished, the underlying problem will remain,” Luscombe noted. “As regular tax rates fall, more taxpayers will find themselves stranded on the AMT.” Numbers Tell the StoryFor the last several years, the temporary fixes have indeed kept the AMT at
bay. In 2003, about 2.6 million returns showed AMT liability out of 130.4 million
total returns. But when the AMT exemption amounts go back to their pre-tax
cut levels, returns with an AMT liability will be soaring up to 30 million
in 2010. A Skeleton at the FeastThe AMT is also the skeleton at the feast of tax reduction. For example, some higher-income taxpayers may be subject to the AMT for the first time on their 2006 returns precisely because a pair of tax breaks – a reduction in the phaseouts for both itemized deductions and personal exemptions. These phaseouts limit the ability to subtract the full amount of your itemized deductions and personal exemptions on your return, but they are reduced by one-third for 2006 and 2007, another third in 2008 and 2009 and will be completely eliminated for 2010. Consider a married couple with three children and $500,000 in adjusted gross income and $75,000 in itemized deductions before phaseouts in both 2005 and 2006. Of their total itemized deductions, assume that $35,000 are taxes that are not deductible in figuring AMT. In 2005, their personal exemptions were completely phased out, their itemized deductions were reduced to $64,378 and as a result they owed $126,530 in ordinary tax, but no AMT. In 2006, they can take more itemized deductions – $68,010 – and they can claim personal exemptions of $5,500, lowering their regular tax to $122,522. But now they owe AMT, which raises their tax burden back up to $125,300. So their taxes fall as a result of reduced phaseouts, but only by $1,230, not the $4,008 they would have seen absent the AMT. And, in their case, increasing the AMT exemption amount has made no difference. At their income level, the AMT exemption itself is completely phased out, and Congress did nothing in the latest law to ease the AMT phaseout. “As long as the AMT exists in anything like its present form, we’re likely to continue to see this kind of effect,” Luscombe noted. 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. Based on preliminary IRS figures, the AMT brought in only about $12 billion for the tax year 2004 compared to total individual income tax receipts of over $830 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 last year’s tax bill is estimated to cost the Treasury nearly $34 billion. “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?Representative Charles Rangel, the incoming chairman of the House Ways and Means Committee, where tax legislation originates, has indicated that he wants some long-term solution to the AMT, but has warned that a true solution may require a wide-ranging overhaul of the tax system to close loopholes and generate replacement revenue. Interestingly enough, in 2005, President Bush appointed a commission to propose a simplification of the entire income tax system and address the problems of the AMT. One possible solution the commission considered was 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. It 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. 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 commission rejected this approach, but its recommendations did not win any ringing endorsements from either Congress or the administration. Whether the new Congress can come up with anything better – or will settle in the end for another short-term “fix” will occupy the attention of taxpayers and tax practitioners once again this year. “The AMT may be a pain, but it’s unlikely that Congress will embrace even greater pain just to get rid of it,” Luscombe observed. “On the other hand, doing nothing will expand the breadth and deepen the bite of the AMT, and that’s not an enticing option, either.” About CCH, a Wolters Kluwer businessCCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax and accounting law information, software and services. It has served tax, accounting and business professionals and their clients since 1913. Among its market-leading products are The ProSystem fx® Office, CCH® Tax Research Network™, Accounting Research Manager® and the U.S. Master Tax Guide®. CCH is based in Riverwoods, Ill. Wolters Kluwer is a leading global information services and publishing company. The company provides products and services for professionals in the health, tax, accounting, corporate, financial services, legal and regulatory, and education sectors. Wolters Kluwer has annual revenues (2005) of €3.4 billion, employs approximately 18,400 people worldwide and maintains operations across Europe, North America, and Asia Pacific. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. Its shares are quoted on the Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices. For more information, visit www.wolterskluwer.com. -- ### -- nb-07-08
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