Attack of the AMT
The Alternative Minimum Tax Has Morphed into a Beast; Is Legislative Relief Forthcoming?
The Alternative Minimum Tax, or AMT, as it’s called, was put in place to ensure that wealthy individuals pay a minimum amount of income tax. Over the years, though, the AMT has come to have a growing, often detrimental, impact on taxpayers in many different brackets. Lawmakers are talking about steps to reduce the pain, but when will they come?
The Alternative Minimum Tax (AMT) is a separate federal income tax system that runs parallel to the regular federal income tax system. Although the minimum tax provisions have been amended several times since the concept of a minimum tax was first introduced in the 1969 Tax Reform Act, the underlying purpose of the AMT provisions has always been to ensure that taxpayers with substantial economic income pay a minimum amount of federal income tax.
At the U.S. Senate Finance Committee’s hearings on the Alternative Minimum Tax (AMT), Senate Finance Committee Chair Max Baucus (D-Mont.) underscored the urgency of dealing with the AMT now, stating that “the AMT has morphed into a terrible beast.” He noted that more people making less than $100,000 pay the AMT than people making more than $1 million. In 2005, 3.6 million taxpayers paid the AMT, and 4.2 million are estimated to have paid it in 2006. “Without the patch, the number of Americans affected by the AMT for 2007 will explode from about four million to more than 23 million,” he said. He also noted that most of the 23 million would be middle-class taxpayers earning between $50,000 and $200,000.
AMT normally equals 26% of net alternative minimum taxable income (AMTI) up to $175,000 ($87,500 for married filing separately) and 28% of net AMTI above that amount. AMTI is computed on Form 6251 (Alternative Minimum Tax — Individuals) and is based on regular taxable income adjusted for specific adjustment and preference items and any AMT NOL. However, the regular tax capital gain rates also apply for AMT purposes. Each taxpayer is then allowed an exemption amount to arrive at the taxable amount of AMTI (net AMTI).
The exemption amount is intended to prevent AMT from applying to taxpayers in lower tax brackets or with few adjustments or preference items. The exemption amounts and phase-out ranges are not adjusted for inflation; thus, AMT may affect taxpayers who in the past have not had exposure to AMT if their income is steadily increasing each year (since the regular tax is adjusted for inflation each year). In addition, the exemption amount, combined with the mechanics of the AMT computation, may not prevent certain taxpayers who theoretically should not be subject to AMT from falling into an AMT situation. For example, taxpayers who claim a large number of personal exemptions may be subject to AMT even though they have no AMT preference items.
For tax years beginning after 2006, absent a law change, the AMT exemption amounts will drop from $62,550 to $45,000 for joint filers and surviving spouses, from $42,500 to $33,750 for unmarried individuals, and from $31,275 to $22,500 for married individuals filing separately. In addition, alternative minimum taxable income (AMTI) of married individuals filing separately for tax years beginning after 2006 will be increased by the lesser of $22,500 or 25% of the excess of AMTI (without regard to the exemption reduction) over $165,000; for 2006 it was increased by the lesser of $31,275 or 25% of the excess of AMTI (without regard to the exemption reduction) over $200,100.
While many of the adjustments in calculating AMT apply in only selected situations, certain adjustments and preferences affect most tax filers. For example, individuals are not allowed personal exemptions or the standard deduction. For individuals who itemize their deductions, taxes and most miscellaneous itemized deductions are not allowed. The exclusion of a deduction for taxes is a significant adjustment for residents of Massachusetts who pay state income taxes at a rate of 5.3% and local property taxes on real estate and vehicles. The non-deductibility of miscellaneous itemized deductions for AMT purposes can become a significant problem for taxpayers who have significant employee business expenses or investment-related expenses.
Regular Tax and AMT Computation
In August 2007, John and Sally sold a parcel of land they held for many years, realizing a long-term capital gain of $400,000. Their other sources of 2007 income and the computation of their regular tax and AMT are as follows:
For AMT purposes, medical expenses are allowable as a deduction only to the extent that the expenses exceed 10% of adjusted gross income as computed for regular tax purposes versus the 7.5% threshold used for regular tax purposes. Here’s an example: An individual taxpayer has adjusted gross income of $80,000 and incurs $7,000 in medical expenses. For regular tax purposes, $1,000 of the medical expenses is deductible as an itemized deduction ($7,000 — [$80,000 x 7.5%]). For AMT purposes, none of the expenses are deductible ($7,000 — [$80,000 x 10%]). Thus, the taxpayer must increase AMTI by $1,000.
Although the capital gains provisions are favorable to taxpayers, they complicate the AMT calculation. Further complications occur when calculating the capital gain if an asset’s basis is different for regular tax and AMT purposes. Also, even though net capital gains and qualified dividends are subject to the preferential capital gains tax rates for AMT purposes, they are fully included in AMTI. High AMTI can result in the phase-out, or complete loss, of the AMT exemption. That, coupled with the difference between the lowest tax rates of 10% for regular tax and 26% for AMT, makes it possible for a substantial capital gain to cause a taxpayer to be subject to AMT.
Despite having only one small AMT adjustment or preference item (i.e., the standard deduction), the Frosts are subject to AMT in 2006. Their total 2006 tax liability of $89,263 includes $11,135 of AMT.
The alternative minimum tax (AMT) can affect the year-end planning of taxpayers with large amounts of preference items. If the AMT applies, and the taxpayer’s regular taxable income is relatively small, year-end tax planning may have to be geared more to reducing the AMT than the regular tax.
On Oct. 30, House Ways and Means Chair Charlie Rangel (D-N.Y.) introduced H.R. 3996, the “Temporary Tax Relief Act of 2007.” The bill, which was slated to be taken up by the Ways & Means Committee on Nov. 1, would, among other changes:
• Allow taxpayers for 2007 to use non-refundable personal credits to offset both regular tax and AMT; and
• Increase the AMT exemption amount for 2007 to $66,250 for joint filers and to $44,350 for individuals.
In an Oct. 30 letter to Acting IRS Commissioner Linda Stiff, Rangel, Baucus, Ways & Means Committee ranking member Jim McCrery, and Senate Finance ranking member Charles Grassley committed themselves to enacting legislation that for 2007 would allow taxpayers to use non-refundable personal credits to offset both regular tax and AMT, and increase the AMT exemption amount to $66,250 for joint filers and to $44,350 for individuals. (As a corollary, the AMT exemption for married filing separately would increase to $33,125, half the joint filer amount.)
In effect, the letter urged the IRS to proceed with printing its 2007 tax forms as if these changes had already been enacted. However, the acting commissioner wrote back on Oct. 31, and said the IRS wouldn’t reprogram its systems for the 2007 tax year until the patch is passed and signed into law. In a covering E-mail, an IRS spokesman said the IRS wouldn’t reflect the AMT patch on its 2007 forms until then, either.
As released by Rangel, the bill and accompanying summary do not include provisions that would offset the cost of the AMT patch, the extenders, and the home mortgage debt provisions. Revenue-raising provisions that would offset the cost of the revenue losing provisions — required under the “pay-go” rules the Democratic leaders want to follow — will be added in the chairman’s mark for full committee consideration. Republican leaders are on record as strongly opposing the inclusion of revenue-raising provisions.
So stay tuned to see if the beast will soon be tamed.
Kristina Drzal Houghton, CPA, MST, is partner in charge of Taxation at Meyers Brothers Kalicka; (413) 536-8510.