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.
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.
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.
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