AMT: Little Tax of Horrors

How did the alternative minimum tax grow to plague millions of American households?
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Editor's note: As a special feature for March,

TheStreet.com

offers an ongoing series on everything you need to know about taxes.Today is Part Four.

The alternative minimum tax is regarded by many experts as one of the most complex and confusing taxes on the books. But to understand its effect is simple: Simply think of the AMT as you would the main character of the 1980 horror film

Alligator

.

In that movie, the baby reptile was mindlessly flushed down a toilet and into the city's sewers. Forgotten but not gone, the little guy eventually grew into a 36-foot long man-eating monstrosity.

The AMT was once harmless, too. Introduced in 1969, the tax was created to prevent the wealthiest Americans from contributing virtually nothing in taxes.

But just like that baby alligator, the AMT was also forgotten about -- that is until it grew so large it started chomping at millions of Americans' assets.

A Growing Problem

"What's happening now is that if you don't adjust the threshold, a huge amount of people will be subject to the AMT," says Robert Bixby, executive director of the Concord Coalition, a nonpartisan group advocating fiscal responsibility. "More than 4 million people were subjected to the AMT last year. If the laws aren't changed, over 23 million will have to pay the AMT this year."

The Congressional Budget Office also estimates that if the current law isn't changed, 70% of all taxpayers in 2050 will be affected by the AMT, and the additional revenue from it will account for 20% of the personal income taxes collected by the government.

The most-likely candidates for the AMT are those with an adjusted gross income of $200,000 to $500,000 a year. Below is a table demonstrating the recent growth of the tax, which has increased almost tenfold in just 10 years.

Best Intentions Gone Awry

Although the tax has gotten out of hand, the original concept of the AMT was not a bad idea. It had been designed to prevent taxpayers from stiffing the IRS by using deductions and shelters to eliminate their burden.

In 1969, it had become a hot topic when then-Treasury Secretary Joseph Barr informed Congress that 155 families with incomes of more than $200,000 had managed to pay zero taxes.

The structure of the tax is rather complicated, but in a nutshell, the AMT works as a parallel tax that is imposed on top of the regular tax structure. If the AMT is higher than the regular tax liability for the year, the regular tax and the amount by which the AMT exceeds the regular tax are owed to the IRS.

"We think that the idea of a parallel tax calculation is preposterously complex," says Bill Ahern, a spokesman for the Tax Foundation, a nonpartisan group promoting tax education. "We feel the AMT problem would go away if even just the few unjustifiable exemptions on the regular side were repealed. That would be the clean way to dispense of the AMT problem."

So what went wrong? If this tax was supposed to hit only a small group of the richest families in the country, why is it now hitting millions of Americans? The main reason is that when the provision was created, it hadn't been indexed to inflation.

That means that as far as the tax is concerned, there is no such thing as inflation, and therefore the value of a dollar today is equal to the value of a dollar in 1969. But inflation does exist, and in today's world, $200,000 hardly qualifies one as a Rockefeller. Heck, the minimum annual salary for an NBA player is more than twice that.

Another reason the tax has hit so many people is because of President Bush's tax cuts. According to the CBO, the AMT affected less than 1% of taxpayers prior to 2000. Ironically, the 2003 tax cuts lowered ordinary taxes by so much that it forced a lot of people into having to account for the AMT.

Is the AMT still needed? The IRS' tax advocate doesn't seem to think so.

"Most of the significant tax loopholes that enabled taxpayers to escape tax at the time the AMT was written have long since been closed," Nina Olson, the Internal Revenue Service's national taxpayer advocate, said in her 2006 annual report to Congress.

"Today, the AMT is left to punish taxpayers for engaging in such classic tax-avoidance behavior as having children or living in a high-tax state," she adds, referring to the fact that the AMT disallows personal exemptions that parents are allowed to claim under the regular tax rules.

Slaying the AMT Beast

There are few issues on which Republicans and Democrats agree, and getting rid of the AMT appears to be one of them. So you would think that getting rid of the tax is a done deal, right?

Wrong. Congressional proposals to repeal the tax have been fruitless, and there was nothing in the recent Bush administration budget proposal that even addressed a long-term solution to the AMT.

If the AMT is so universally despised, then why is it still around? For the same reason so many people want to get rid of it: It's a monster. The tax has attacked and devoured so many assets that it has become a huge windfall for the government and getting rid of it will be expensive.

In fact, according to the CBO, the AMT is expected to contribute $95 billion by 2010, and the cost of getting rid of the AMT would surpass $1 trillion over the next 10 years. Between 2005 and 2015, the IRS will take in $645 billion in revenue from the AMT, or approximately 4% of personal income tax receipts.

It is for this reason that not everyone thinks the AMT should be completely repealed. "It's not that we're in favor of the AMT," says Bixby of the Concord Coalition. "But if they do repeal it, they should find some other source to pay for that income."

The government's current modus operandi concerning the AMT has been to slap on an emergency patch each year to prevent it from affecting millions of additional tax payers.

"Congress has been adjusting things one year at a time but not making it permanent," says Bixby. "The sane thing to do would be to negotiate some sort of reform instead of having to scramble every year to get a new bill. What we are doing now makes no sense at all. ... It's just a politically convenient thing to do."

In a February report to Congress, the CBO pointed out ways in which lawmakers could permanently lower the number of people subjected to the AMT. One way, it says, would be to make the exemption amounts as dictated by the Tax Increase Prevention and Reconciliation Act of 2005.

"Under that approach," the report says, "6.2 million taxpayers would be affected by the AMT in 2010 -- rather than the 30 million under current law."

Another option the report cited would be to allow people to take the standard deduction, personal exemptions and the deduction for state and local taxes when computing tax liability under the AMT. This would reduce the number of people affected by the AMT to 2.8 million in 2010.

Location, Location, Location

How much you earn and how many children you have are not the only factors affecting whether you owe the AMT. Where you live plays a big part as well. New Jersey, New York and Connecticut have the highest percentage of taxpayers who are required to pay the AMT. Below is a map showing each state's percentage of tax returns (in which there is a liability) that were affected by the AMT in 2003.

Percentage of Tax Returns With Positive Tax Liability Affected by the AMT (2003)

Source: The Tax Foundation

Next in the tax series: America Gives the IRS a $2.2 Billion Tip.TheStreet.com series previously featured

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  • How to Choose the Right Tax Software