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Meet the Unintended Consequence of the Tax Cut: the AMT

The alternative minimum tax isn't just for the super-rich anymore, and Congress just made it worse.

Amid all the crowing about how the new tax law will help Americans, and complaining that it doesn't go far enough, one crucial issue has been left out of the discussion altogether: the increasingly problematic alternative minimum tax.

The AMT, as you've probably heard, is an alternate tax calculation designed to make sure the super-wealthy don't shelter or deduct away all of their tax liability. But the AMT calculation hasn't been materially adjusted since its inception in 1969 -- and what was super-wealthy over 30 years ago is considered, well, just very wealthy today. (Roughly 1 million taxpayers owe the AMT today, according to the Congressional Joint Committee on Taxation.)

But the problem is set to get exponentially worse. Rather than helping the taxpayers who are the targeted beneficiaries of many of the new provisions, the new law will likely exacerbate the problem. If Congress continues to ignore the problem, by 2017 more than 17 million taxpayers will be subject to the AMT, according to the Joint Committee on Taxation. But fixing the AMT is a messy and costly process, and lawmakers would prefer issuing more high-profile tax cuts -- even if they make a bad situation worse for taxpayers.

To stave off the worst-case scenarios under the new tax law, Congress fudged standard tax calculations and made exceptions to the AMT rules. Typically, if a taxpayer's effective (overall average) tax rate dips too low, the AMT could kick in. That means that a high proportion of capital gains could trigger the AMT. Because capital gains are taxed at a much lower rate, taxpayers with a high percentage of their overall income coming from capital gains could find themselves ensnared by the AMT. With the capital gains rate even lower under the new tax law, plus the reduced dividend tax rate, investors with big chunks of their annual income attributable to capital gains or dividends risked the AMT.

Congress countered that possibility by making a huge exception to the AMT calculation. Typically, large deductions (or so-called preference items such as state and local taxes) are disallowed under the AMT calculation. Instead of various write-offs and exemptions, though, the AMT grants one big income exemption: $58,000 for married couples and $40,250 for individuals. The remainder is taxed at 26% or 28%.

But the 2003 act specifically allows the reduced rate of tax on capital gains and dividends for AMT purposes -- that means that rather than lumping all types of income together the way it used to, the AMT calculation will differentiate between earned income and capital gains and dividend income. The latter two will be taxed at the new 15% rate, even if the taxpayer owes AMT on his or her earned income.

This may sound like good news, but there are some serious drawbacks to this solution -- actually, so many drawbacks that nobody is even calling it a solution.

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First of all, it undermines the integrity of the AMT -- that the wealthy, who have more tax-avoidance options and more tax breaks available to them, should not pay an average tax rate that's lower than the vast majority of working Americans.

Politically speaking, all of the conservative arguments for tax simplification and/or a flat tax are being eviscerated by the conservatives looking to add exemptions and loopholes to the AMT calculation.

"The AMT is the closest to a flat tax we're ever going to get," says Tom Oschenschlager, tax partner with Grant Thornton in Washington, D.C. "But now, with two regular rates and three capital gains rates, they're junking up the AMT rates like the regular income tax code."

In addition, the new provisions will only apply for the length of time the new tax rates apply -- that is, only for five years. And the minor adjustments made to the calculations to account for the drop in income tax rates will expire in 2005.

But the really bad news is that even though the new capital gains and dividend rates are allowed for AMT purposes, taxpayers who see an increase in income because of capital gains and dividends might still be more likely to incur the AMT. There are two ways this can happen, according to Martin Nissenbaum, national director of personal income tax planning at Ernst & Young.

First, the exemption amount under the AMT calculation is subject to a phasing out if overall AMT income is too high. So, including the larger gains and dividends in income could reduce the available AMT exemption. Second, state and local taxes on capital gains will reduce the spread between ordinary tax and AMT. And that means a higher AMT.

Unless some further action is taken, the reach of the AMT will start its rapid rise in 2005. But Congress isn't in any rush to tackle this problem.

Indeed, many observers agree that something of a de facto plan may already be in place: Once the problem reaches truly egregious proportions, Congress can just eliminate the AMT altogether.