The problem that I believe requires the most immediate and thorough response is the growing reach of the individual Alternative Minimum Tax. This problem is looming over all of us–taxpayers, Congress, the IRS. In the years to come, the IRS will be faced with applying resources to make adjustments to the returns of increasing numbers of taxpayers who were unaware that they, too, “won” the AMT lottery. For that is how the AMT appears to function: randomly, no longer with any logical basis in sound tax administration or any connection with its original purpose of taxing the very wealthy who escape taxation. Congress must address the AMT before it bogs down tax administration and increases taxpayers’ cynicism to such a level that overall compliance declines.

Nina E. Olson

National Taxpayer Advocate

2003 Annual Report to Congress

The individual alternative minimum tax (AMT) has become the poster child for everything that’s wrong with our current system of taxation. Originally implemented over 30 years ago to prevent a few hundred high-income individuals from completely escaping federal income taxation, the AMT has evolved into a somewhat ominous, definitely complicated, and poorly understood shadow tax that is projected to impact about 3.3 million individuals this year, according to an April 2004 Treasury Department fact sheet on the issue. It’s become the equivalent of using drift nets to catch a rare species of fish–you may get the fish you’re looking for, but you wreak havoc on the entire marine environment in doing so, and you catch a whole lot of fish you didn’t want in the process.

Because its key figures aren’t indexed for inflation, the AMT reaches further into the ranks of middle-income Americans every year. Ironically, the lower regular marginal income tax rates imposed by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and accelerated by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) have actually increased exposure to the AMT. Temporary increases in AMT exemption amounts have so far prevented an immediate and dramatic rise in the number of individuals impacted, but these increases are set to expire at the end of this year.

(Congress passed the working Families Tax Relief Act of 2004 (H.R. 1308) late in September after Investment Advisor went to press; President Bush says he will sign the bill, which extends the higher JGTRRA AMT exemption amounts through 2005 (a one-year extension) and allows nonrefundable personal tax credits to be applied against AMT for 2004 and 2005, extending a provision that expired at the end of 2003.–Ed.).

Fixing the situation is easier said than done, though. Projected to account for $28 billion in 2005, according to that same Treasury report, the AMT brings in more federal tax dollars every year. That means repealing or even significantly curtailing the AMT will leave a substantial revenue hole, making additional temporary fixes more likely than any attempt at true reform, at least in the short term. One thing is certain: If you haven’t been struggling with the AMT on behalf of your clients already–and many advisors have reported doing just that–then you’re bound to get questions about the AMT from clients over the next few months.

Despite this gloomy situation, it’s important that you understand how the AMT was born, how it works now, and how it may change in the near term so you can help your clients lessen the pain of paying the tax, if not avoid it.

AMT Basics

The AMT is essentially a separate federal income tax system with its own tax rates, and its own set of rules governing the recognition and timing of income and expenses. An individual who is subject to the AMT has to calculate his or her taxes twice–once under the regular tax system and again under the AMT system. If an individual’s income tax liability under the AMT is greater than his or her liability under the regular tax system, the difference is reported as an additional tax on the individual’s federal income tax return. If an individual’s liability under AMT is less than his or her regular tax, the individual is not subject to AMT. The AMT effectively establishes a tax “floor.” Individuals who are subject to AMT in one year may be entitled to a credit that can be applied against regular tax liability in future years.

Calculating AMT tax liability involves four general steps:

o Individuals must make specific adjustments to their taxable income as calculated under the regular income tax system. These AMT adjustments can be positive or negative.

o Individuals must also add in certain AMT preference items to determine alternative minimum taxable income (AMTI).

o Individuals subtract their AMT exemption amount from AMTI, and the result is multiplied by the appropriate AMT tax rate(s) to determine the “tentative minimum tax.”

o This amount is compared with an individual’s regular tax liability to determine if AMT must be paid in addition to regular tax.

Part of the problem with AMT is that without doing some calculations there’s no easy way to determine whether or not an individual is subject to the tax. Key AMT “triggers” include the number of personal exemptions, miscellaneous itemized deductions, and state and local tax deductions. IRS Form 1040 instructions include a worksheet that accounts for these items in determining whether or not AMT applies. Other individuals will need to complete IRS Form 6251 to determine whether or not they’re liable. Clients are certain to look to you for guidance, so take some time to review the AMT rules, and stay on top of any legislative changes that may occur affecting AMT over the last few months of the 108th Congress.

Common AMT Adjustments

The complexity of the AMT calculation is reflected in the number of common AMT adjustments, including these:

Standard deduction and personal exemptions

The federal standard deduction, generally available under the regular tax system to individuals who don’t itemize their deductions, is not allowed for purposes of calculating AMT. Nor can individuals take a deduction for personal exemptions. These items alone can draw many higher-middle-income families with children within the grasp of the AMT. The larger the family, the more likely AMT will apply. For example, if there are no legislative changes, in 2005 married couples with four children who don’t itemize could be subject to AMT when their income exceeds approximately $58,500.

Itemized deductions

AMT adjustments include certain itemized deductions:

o Medical expenses. While medical expenses are deductible for regular income tax purposes to the extent they exceed 7.5% of adjusted gross income (AGI), for AMT purposes they’re deductible only to the extent that they exceed 10% of AGI.

o State and local taxes paid. State and local taxes are deductible for regular tax purposes, but not for AMT purposes. They need to be added back when calculating AMTI.

o Miscellaneous itemized deductions subject to the 2% AGI limitation. Miscellaneous itemized deductions that are subject to the 2% AGI limitation (e.g., unreimbursed employee business expenses and certain investment expenses) must also be added back when calculating AMTI.

o Qualified housing interest. Qualified residence interest, deductible for regular income tax purposes, is not deductible for AMT purposes unless loan proceeds are used to purchase, construct, or improve a principal residence or a qualified dwelling. This means clients who do a cash-out refinance or take out a home equity loan but then don’t put the cash back into their homes generally can’t deduct some or all of the interest on the loan for AMT purposes.

Where clients are subject to AMT in some years but not others, it may be possible to “bunch” some of these deductions (for example, some miscellaneous itemized deductions and medical expenses) in non-AMT years, since they won’t be of benefit in years in which AMT applies. Consider, however, that the general phase-out of itemized deductions that applies to taxpayers with high incomes under the regular income tax system doesn’t apply when calculating AMTI. So a client’s itemized deductions need to be looked at closely–it may actually make sense for clients subject to these phase-out rules to “bunch” itemized deductions into AMT years.

Incentive Stock Options

While under the regular tax system there’s generally no tax consequence when ISOs are exercised–since tax is generally deferred until the acquired stock is eventually sold–AMT rules are different. For AMT tax purposes, when an ISO is exercised, income is generally recognized to the extent that the fair market value of the acquired shares exceeds the option price. That means a significant ISO exercise in a year can trigger AMT liability. That also means that the stock acquired will carry one basis for AMT purposes (basis would be increased by the amount of the income reported for AMT purposes) and another basis for regular tax purposes going forward. If ISOs are exercised and sold in the same year, no AMT adjustment is needed, since any income would be recognized for regular tax purposes as well.

Depreciation

Depreciation may be calculated differently for AMT purposes than for regular income tax. AMT rules have the general effect of limiting the benefits of accelerated depreciation allowed under the regular income tax system. Basically, this means individuals have to calculate depreciation twice: once under regular income tax rules and once under AMT rules. In the early years of an asset’s depreciation, taxpayers generally get a smaller depreciation deduction under AMT rules, but in later years, the AMT depreciation deduction will actually be greater. This adjustment means that, as with shares acquired through an ISO, the basis of depreciated assets can be different for AMT and regular income tax purposes.

AMT Preferences

AMT preference items that must be added back into income when calculating AMTI relate to:

o Depletion deductions

o Intangible drilling costs

o Tax-exempt interest on certain private activity bonds

o Depreciation on certain property placed in service before 1987

o Exclusion of gains on the sale of small business stock.

AMT Exemption Amounts

AMT exemption amounts are not adjusted for inflation–they only change through legislation. This is one of the principal reasons that more people are subject to the AMT each year.

The Economic Growth and Tax Relief Reconciliation Act of 2001(EGTRRA) reduced marginal income tax rates. Without a corresponding AMT adjustment, the lower rates would have had the effect of exposing a large number of new higher-middle-income individuals to the AMT tax “floor.” To prevent this, EGTRRA temporarily bumped up AMT exemption amounts, the first such change since 1993 (see Table 2: Rising Exemptions, on page 64). Yet despite the fact that EGTRRA tax rate reductions are effective through 2010, the increased AMT exemption amounts were made effective for tax years 2001 through 2004 only. (Coincidentally, this had the effect of reducing the projected costs of the tax legislation.)

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), which accelerated marginal income tax reduction, took the same approach (for the same reasons) and further increased the AMT exemption amounts for tax years 2003 and 2004. As a result, for 2004 married individuals who file jointly are entitled to a $58,000 AMT exemption and single individuals are entitled to an AMT exemption amount of $40,250. AMT exemptions are phased out, however, for higher incomes.

Absent further legislative action, AMT exemptions will return to their pre-2001 levels in 2005, causing a significant increase in the number of individuals subject to the AMT. This expected “spike” is reflected in the “More and More ‘Winners’” graph above. At press time, Congress was considering legislation to extend the JGTRRA AMT exemption levels through 2005. If passed, this would postpone the sharp increase illustrated here for at least one year.

AMT Tax Rates

Once an individual’s AMT exemption amount is subtracted from his or her AMTI, the result is multiplied by the appropriate AMT rate(s) to determine tentative minimum tax. An AMT tax rate of 26% applies to the first $175,000 ($87,500 for married individuals filing separately), and a rate of 28% applies to anything beyond this amount.

If the result is greater than an individual’s regular income tax, the difference is added to the individual’s regular income tax. If the result is less than an individual’s regular income tax, the individual’s tax is his or her regular income tax liability. The AMT may, however, still serve as an income tax “floor” in determining the allowable amount of some tax credits.

The lower maximum tax rates that apply to long-term capital gain and qualifying dividends under JGTRRA apply to the AMT calculation as well. So even under AMT rules, a maximum rate of 15% (5% for individuals in the lower two tax brackets) applies. However, long-term gain and qualifying dividends are included in determining AMTI. That means large capital gains and qualifying dividends can push clients into the phase-out range for AMT exemptions, and indirectly increase AMT exposure.

Tax Credits

Even clients who aren’t actually subject to the AMT may be impacted in the form of limited tax credits. That’s because nonrefundable personal tax credits (e.g., the credit for child and dependent care expenses, the credit for the elderly or the permanently and totally disabled, the Hope credit, the Lifetime Learning credit) as well as the electric vehicle credit and the general business credit are allowed only to the extent that regular income tax exceeds tentative minimum tax. (Note: nonrefundable personal credits could offset AMT in tax years 2000 through 2003. Congress is considering legislation to extend this provision.) So if a client’s regular income tax is $40,000, and his or her tentative minimum tax is $39,000, there’s no AMT due (since regular tax exceeds tentative minimum tax), but affected tax credits will be limited to a total of $1,000.

Tax credits currently allowed against the AMT include the child tax credit, the adoption credit, and the retirement savings contributions credit (the “savers” credit). The foreign tax credit (with modification) is allowed against the AMT as well.

What Does the Future Hold?

The last sustained attempt to address the AMT head-on occurred in 1999. Legislation repealing the AMT–the Financial Freedom Act of 1999, H.R. 2488–was passed by Congress, but vetoed by President Clinton.

At least 15 bills introduced in the 108th Congress have contained provisions that would modify or repeal the AMT. As this article was being written, two specific pieces of legislation awaited action by Congress. H.R. 4227 (“Middle-Class Alternative Minimum Tax Relief Act of 2004″) proposes to extend the increased AMT exemption amounts under JGTRRA to 2005, and to index those amounts for inflation. Additionally, a miscellaneous provision in the Jumpstart Our Business Strength (JOBS) Act (S. 1637) would allow nonrefundable personal credits to be applied against AMT liability for the 2004 tax year. The 2004 Republican Party platform references the growing AMT problem, but offers only a nonspecific call to action: “…we call upon Congress to address this increasingly unfair second tax system on hardworking Americans.” The 2004 Democratic Party platform does not address AMT specifically.

The biggest problem with addressing the AMT is the revenue impact. Each year, as more people become subject to the AMT, the revenue dollars attributable to the AMT increase as well. Repeal the AMT, and those revenue dollars disappear. The AMT is currently projected to account for $28 billion in 2005, and assuming EGTRRA and JGTRRA tax cuts aren’t allowed to expire at the end of 2010, that amount will rise to $177.2 billion in 2014, according to the Treasury Department. Moreover, Treasury Department projections (see “A Sacred Cow?” graph on previous page) indicate that by 2013, the AMT could generate more tax revenue than the regular income tax system.

Even steps far short of full repeal will have a serious revenue impact. For example, according to a recent Congressional Research Service Report (RS21817), simply extending JGTRRA’s increased AMT exemption amounts and allowing personal tax credits against AMT liability would cost $204 billion between 2004 and 2010.

What should you expect? Pay attention over the next few months, but it seems likely that Congress will buy time by extending the increased AMT exemptions and allow personal tax credits to offset AMT, postponing any larger discussion of the AMT problem until after this election year.

James Walsh, JD, is VP, content, and editor-in-chief at Forefield Inc. (www.forefield.com) in Marlborough, Massachusetts, which provides Web-based sales, education, and presentation solutions for institutions and advisors. He can be reached at jwalsh@forefield.com.