In January 1969, the U.S. Congress received shocking news from then Treasury Secretary Joseph W. Barr that 155 taxpayers with incomes of more than $200,000 had managed to escape paying federal income tax in 1966. When this became public, it generated more mail to Congress in 1969 than the divisive Vietnam War.
As a solution, Congress created the alternative minimum tax (AMT) to ensure that wealthy individuals and corporate taxpayers pay their fair share of federal income taxes. Nearly 40 years later, Congress is bracing itself for another firestorm around the same issue. This time, it's not taxes for the super-wealthy that are raising taxpayers' hackles. Instead, it's the fact that millions of middle- and upper-middle-class taxpayers are falling into the clenches of a tax system that was designed to apply only to the wealthiest Americans.
Unless changes are made to the AMT calculation, 2005 may become known as the year of the "AMT Perfect Storm." According to the Urban-Brookings Tax Policy Center, that's when the number of taxpayers subject to the AMT is projected to skyrocket to 12 million from 2.9 million in 2003. By 2010, 99% of American families with two or more children and incomes between $75,000 and $500,000 will be subject to the AMT.
How did we get here?
Originally, Congress enacted the AMT to reduce the number of high-income households that paid zero federal income tax and to address tax-shelter abuses among the wealthiest of Americans. Prior to the AMT, many of these taxpayers had been using tax shelters, deductions, and other benefits to pay minimal, if any, federal income tax. To fight shelter-abusers, the AMT disallows many deductions allowed under the regular tax system, including those for state and local income taxes, and denies the favorable tax treatment otherwise afforded certain items.
There are two key reasons why the AMT is touching so many more Americans, and will likely continue to do so. First, unlike personal tax exemptions and standard deductions, the AMT exemption amount was never indexed for inflation.
"Certainly, what's subject to the AMT has been tinkered with since 1969, but by and large the reason its grasp has been expanding each year is because the AMT exemption amount was not, until recently, adjusted for inflation, while a lot of other provisions in the Code, including the ordinary income rate brackets, have been adjusted," says Mark Luscombe, principal tax analyst at CCH Inc., a Riverwoods, Ill.-based provider of tax and business law information and software. "Over time, that's had the effect of gradually taking people to a level where they're subject to the AMT."
Another major factor that's increasing the AMT's reach is recent ordinary income tax cuts, as well as reductions in the tax rates on qualified dividends and long-term capital gains.
"If you have reductions in the regular rates but not AMT, when you calculate your taxes under both systems, that will tend to cause the AMT to be a higher amount of tax for a greater number of people, which will therefore subject them to the AMT," Luscombe says.
While the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JAGTRRA) lowered income tax rates, it increased AMT exemption amounts, but only for 2003 and 2004.
Determining AMT liability
As Luscombe suggests, the AMT is actually a second tax system that is applicable only if the "tentative minimum tax" exceeds the taxpayer's "regular tax." Essentially, determining AMT liability requires that taxes be calculated first using standard tax rules and then by using the AMT rules incorporated within IRS Form 6251. If the regular tax liability is larger than the AMT tax, the AMT does not apply; if the regular tax liability is less than the AMT amount, then the AMT applies.
"The AMT is basically a separate tax system where you go through the same list of deductions, income exclusions, and credits allowed for regular tax purposes and see which are allowed or not allowed for AMT purposes," Luscombe says. "If they are not allowed, you add them back and instead of calculating regular taxable income, you're calculating the alternative minimum taxable income (AMTI)."
Certain triggering items that may have been considered "shelters" in the past, and as such are disallowed under AMT rules, are now common to more Americans than ever. These include exercises of employee incentive stock options where the spread (the difference between the value of the stock received and the exercise price) is not taxable at the exercise date for regular tax purposes but is for AMT purposes.
Should you worry?
Knowing what to look for can help taxpayers avoid an AMT surprise. Unfortunately, there is no one factor that can predict whether someone will be exposed to the AMT.
"There's no specific level of income where AMT kicks in," says Ed Mann, of E.L.Mann, PC Certified Public Accountants. "It's a function of items reported on your tax return and what you claim for deductions, so income alone is not the issue. Rather, the issue is the relationship of deductions to that income."
That said, there are some factors that typically increase a taxpayer's likelihood of being subject to the AMT. These include having a large number of personal exemptions (i.e., children) or living in a state with a high income tax rate, such as California, New York, or Massachusetts. Other potential triggers include taking an interest deduction on a second mortgage or exercising employee incentive stock options.
As for specific tax rates, AMT rates are 26% on the first $175,000 of AMTI and 28% on income above that level. Regular federal income tax rates start at 10% and 15%, and range as high as 35%.
Taxpayers in the 10% and 15% brackets are pretty well protected by the AMT exemption amount. Those in the highest income brackets are often exempt from the AMT as well, as they pay enough in regular taxes to avoid the AMT. However, these taxpayers can be subject to the AMT if they have enough AMT preferences and adjustments.
Figures from the Tax Policy Center offer some perspective on those wage earners who can expect to be subject to the AMT. By 2005, it's projected that about 27% of those earning between $75,000 and $100,000 will be subject to the AMT; 54% of those earning between $100,000 and $200,000; 83% of taxpayers earning between $200,000 and $500,000; and 19% of those earning more than $1 million.
AMT warning signs
As the AMT is calculated, specific deductions and income exclusions that can be used for regular taxes must be added back to taxable income to compute alternative minimum taxable income. Significant levels of some deductions that may increase a taxpayer's odds of becoming subject to the AMT include:
- deductible personal exemption amounts
- itemized deductions for state and local income taxes and real estate taxes
- itemized deductions for home equity loan interest, not including interest on a loan to buy, build, or improve a home
- itemized deductions for any portion of medical expenses that exceed 7.5% of adjusted gross income but not 10% of AGI
- addition of certain income from incentive stock options
- changes in certain passive activity loss deductions
- deductions relating to oil and gas investments or drilling or mining operations
- interest on certain private activity bonds that would otherwise be tax-exempt
Taxpayers who have large amounts of any items on this list, with alternative minimum taxable income that exceeds current exemption amounts, may be at risk of exposure to the AMT.
Hedging against AMT
While it's difficult to avoid the AMT, taxpayers can take steps to minimize its effects.
"Those who have the ability to control income flow or deductions can help ease AMT concerns," Mann says. "If taxpayers own their own businesses, they may be able to accelerate or delay payments from customers to help limit AMT exposure. Taxpayers should consider the timing effects of receipts and evaluate the benefits of delaying or accelerating the receipt of income. Similar consideration should be given to deductions, particularly tax and medical payments."
Taxpayers may also want to take these factors into consideration when looking for ways to help reduce AMT exposure:
AMT-exempt interest. "For taxpayers looking to generate income, AMT-free municipal bond and money market funds (those that don't invest in private activity issues) may offer one way to earn income that is truly AMT-free," says Bruce Cummings, a certified financial planner and director of product development in Fidelity Investments' municipal bond group.
Capital gains. Although the top federal long-term capital gains tax rate has fallen to 15% for purposes of both the regular tax and the AMT, investors with significant, highly appreciated securities should think twice about the AMT ramifications of selling those holdings. Harvesting a large capital gain may accelerate the phase-out of the AMT "exemption amount" (designed to ensure that the AMT doesn't apply to lower levels of income).
For example, a single taxpayer with income below $112,500 doesn't have to include the first $40,250 of income when calculating federal alternative minimum taxable income. But a big capital gain might kick income above the $112,500 mark. From there, the exemption amount gradually starts to phase out as AMTI increases. What can taxpayers do about that? It might be advantageous to delay a sale into a new year, assuming AMT exposure may be lower in the future. This may make it possible to preserve a larger portion of the federal AMT exemption amount.
Additional income. "Generating additional taxable income may be a good thing for someone currently subject to the AMT," Cummings says. "If you're in the 30% or 35% federal ordinary income tax bracket but nonetheless subject to AMT, taking an IRA distribution (over age 59 1/2) may allow you to pay taxes at the lower marginal AMT rate of 28%."
He adds, "The AMT acts like a flat tax: once it's triggered, it overrides marginal ordinary income tax rates, for better or worse. Since each customer's AMT and tax situation is highly unique, it's important to work with a knowledgeable tax adviser to discuss the particulars of your situation."
The future of AMT
Recent legislation has offered temporary relief from the AMT. Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the joint filer exemption was raised from $45,000 to $49,000. JAGTRRA increased that exemption to $58,000. However, this benefit will be shortlived. In 2005, the exemption reverts back to the 2001 level of $45,000. According to CCH's Luscombe, the current exemptions under EGTRRA and JAGTRRA were implemented to give Congress time to makes changes to the AMT system.
"Although it's being discussed, until some sort of groundswell emerges to get Congress excited about it, it won't get done. Other interests always seem to come ahead of it," he says. "If you get into a situation where the average middle-class taxpayer is paying AMT, you'll get the attention of Congress at some point."
According to the Urban-Brookings Tax Policy Center, if nothing is changed by 2008, it will be more expensive to get rid of the AMT than regular taxes.
"Short of elimination, one possible change Congress might makeand it's what some people think they should have done a long time agois to make the increase in the exemption amount permanent and add an inflation adjuster so that the AMT will keep up with inflation. But even that has a significant cost that will have to be paid for somehow," Luscombe says.
The Tax Policy Center estimates that eliminating the AMT would cost the federal government more than $1 trillion over the next 10 years. So for taxpayers, the best approach may be to bone up on AMT rules and work closely with a tax adviser.
(Jon Feld is a freelance writer from Newton, Mass. E-mail any questions or comments to Investor's Weekly at Investors.Weekly@fmr.com.)
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