Middle class vulnerable to minimum-tax trap

Congress needs to act to corral a good idea now gone out of control

On the Money

Your Money

March 07, 2004|By Lorene Yue

From reformers to politicians, everybody's talking about the alternative minimum tax, but nobody seems to be doing anything about it.

The AMT, enacted in 1969 to reduce the use by the super-rich of special deductions to avoid paying their share of income tax, has spiraled out of control. This year you have a one in 10 chance of getting walloped with a higher-than-expected tax bill thanks to the AMT, and by 2010 one out of every three households is expected to fall into the AMT trap.

Without sweeping reform, a married couple with two kids and an income of $75,000 to $100,000 has a 97 percent chance of paying AMT in 2010, according to the Tax Policy Center, a joint venture of the Urban Institute and Brookings Institution.

The private sector agrees.

"It is not going to get better," said John Battaglia, a director at Deloitte & Touche's New York office. "It is going to get worse."

The Taxpayer Advocate's office, an independent organization within the Internal Revenue Service, called AMT the most serious problem facing taxpayers in 2003.

"Congress must address the AMT before it bogs down tax administration and increases taxpayers' cynicism to such a level that overall compliance declines," wrote national taxpayer advocate Nina Olson in her 2003 annual report.

How did we get into this fix? Critics say it's the confluence of tax cuts throughout the decades and the lack of adjusting AMT exemptions for inflation. That combination has created a troublesome mix as incomes creep up and AMT exemptions remain the same, making more taxpayers susceptible to AMT.

"It's gone way beyond affecting the number of taxpayers it was intended to affect," said Francis Romano, taxpayer advocate in Hartford, Conn. "First of all, many people are not aware of it, and that in and of itself is a problem. People don't know to look for it."

Congress has put a Band-Aid on the growing wound by bumping up the AMT exemption in 2003 and 2004. But those exemptions are scheduled to revert to lower levels in 2005, which traps more middle-class taxpayers.

There is no litmus test to determine whether you'll be socked with AMT, which makes it tough to predict when it will come knocking on your door.

Tax experts advise most filers to work through a 12-line questionnaire in the IRS instruction booklet to see if they are subject to AMT. If you are, you will have another 65-line form to wade through if you do a paper return. Tax software should automatically alert users to any AMT liability, but it won't explain why you'll have to pay more in taxes.

Some taxpayers may be more susceptible than others. A few possible triggers:

High state income taxes. If you live in California, Connecticut, New Jersey or New York, you have a strong chance of getting caught, said John Nersesian, managing director for Nuveen Investments in Chicago. Paying lofty property taxes can also snare you.

Heavy miscellaneous deductions. You could be setting yourself up for a higher AMT bill if you rack up a significant amount of assorted deductions. Money spent on items such as medical procedures, your job, investment advisers - typically subtracted from gross income - gets added back when figuring out AMT, and that can jack up your tax liability.

Incentive stock options. Tax experts warn that when cashing in stock options, make sure you are not bumping yourself into AMT or pumping up your AMT bill. Under the regular system, you would not pay taxes if you buy stock at the option price but then do not sell it at the market price, but under AMT rules, you pay taxes when options are exercised.

Tax experts do not expect immediate solutions, thanks to the complexity of AMT and how tightly it has become woven into the income tax system.

The Taxpayer Advocate's office suggests Congress might try such alternatives as setting a gross income bar for AMT so taxpayers know immediately if they are subject to the higher tax, adjusting the exemption amounts for inflation and allowing filers to claim personal exemptions, state and local taxes, standard deductions and miscellaneous items.

Why don't the politicians act? Anita Williams, a vice president at J.P. Morgan Private Bank in Chicago, said, "Maybe they are counting on the revenue that is being generated from it to offset the tax cuts."

Williams added, "For a lot of people, there is nothing they can do to avoid it. No planning is going to get you out."

Lorene Yue is a Your Money staff writer.

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