Jeff Schnepper

The Basics

A big, ugly tax surprise is looming

The alternative minimum tax is snaring more Americans every year, and unless Congress fixes it, tens of millions will pay higher income taxes in the next few years -- maybe even you.

By Jeff Schnepper

If you haven't been hit by the alternative minimum tax, this is no time to relax. It's getting closer and closer to you. And you might get hit by the tax sooner than you think -- unless Congress fixes it.

The AMT victimized about 3.5 million households for the 2006 tax year, 57% of which had incomes of $200,000 to $500,000. The Tax Policy Center estimates the result was an average increase in taxes for each household of $4,599.

For the 2007 tax year, the increase is expected to grow to $6,782, with about 19 million families getting drawn in. About 64% of those taxpayers will have earnings of $100,000 to $200,000.

Without a long-term fix, the AMT likely will reach nearly 30 million more taxpayers and grow from $28 billion in fiscal 2008 to $140 billion in 2012. By 2010, the AMT is projected to hit half of taxpayers earning between $75,000 and $100,000.

And all those people weren't even supposed to pay it.

The AMT is a tax computation different from your normal tax puzzle. It was designed in the late 1960s and enacted in 1970 to ensure all taxpayers paid something. The problem is that the tax is not indexed to inflation, and, as a result, growing numbers of middle-income taxpayers have been finding themselves subject to this higher tax.

This alternative enigma disallows your personal exemptions (subjecting those with lots of kids to increased exposure), adds back your itemized deductions for taxes and miscellaneous deductions (making residents of high-tax states such as California, Massachusetts and New York prime targets), and then adds certain items that the tax pros call "preferences."

That sum is reduced by an exemption amount, which itself is wiped out if your new AMT income is too high. That new total is subject to a flat tax of 26% or 28%, unless you had qualified dividends or capital gains. You then compare your tax computed this way with the normal computation and pay the higher amount.

If that's clear, you should run for Congress and explain it to the ding-a-lings (that's a technical tax term) who have let this get out of hand. Lawmakers have been talking about killing or fixing the AMT for years. Each year they duck the issue by a last-minute adjustment of the exemption amount -- just as they did in December 2007.

The problem for the government is that the AMT brings in a whole lot of money that would have to be replaced if it was ended. In other words, to replace the AMT means somebody else is going to pay more taxes. That's where things get complicated.

How to fix it

Here's a look at some of the proposed solutions:

  • Raise taxes on Big Oil and the very affluent. Sen. Charles Schumer, D-N.Y., wants higher taxes on oil companies and people making more than $400,000 a year. He also wants to increase Internal Revenue Service enforcement to close the almost $400 billion "tax gap." That's the difference between what's actually collected and what would be collected if everybody followed the rules. "Increased enforcement" is congressional gobbledygook for more audits.
  • Exempt all taxpayers whose incomes are $250,000 or less. The shortfall would be made up with increased taxes on people making more than $500,000. Taxing the "rich" always plays well in Washington, D.C.
  • Eliminate the 15% tax rate on capital gains and dividends. This idea comes from the Citizens for Tax Justice. The group suggests taxing those dollars at 26% and 29% rates. It also would extend the recently increased exemption amount through 2010. According to its numbers, the combined changes would make the plan "virtually revenue-neutral for the rest of the decade." But what happens after that?
  • Cut tax rates and cut exemptions and itemized deductions. This is an interesting idea from the Joint Committee on Taxation. It would reduce the current income-tax rates from 10%, 15%, 25%, 33% and 35% to 7.55%, 11.55%, 19.1%, 21.4%, 25.2% and 26.8%. The proposal would eliminate all personal exemptions and itemized deductions, including those for home-mortgage interest, state and local taxes, and charitable contributions. It would also scrap the exclusion for employer-provided health care and life insurance. And the proposal would repeal the AMT entirely. The lobbyists would go crazy. I don't know anybody in Congress who's pushing hard on this one. Maybe that's a good reason to give it some consideration.
  • Repeal the AMT and raise all income-tax rates by 6 percentage points. The Tax Policy Center suggests this. As an alternative plan, the center would increase the top three tax rates by 15 points. So under 2007 rates, if you were single, you'd pay a 43% rate on income exceeding $77,100.

What will Congress do?

My guess is that Congress will do absolutely nothing. Congress, Republicans and Democrats alike, will punt until after the 2008 elections.

At best, they'll continue to fiddle with the exemption amount.

What would I do?

The idea behind the AMT is to get the rich to pay more -- or at least some -- tax. I'd scrap the whole system and put a 20% surcharge on all income of more than$1 million.

It wouldn't take any food from anybody's mouth, and the marginal rate would then be 55%, still a whole lot better than the 94% marginal rate we had in 1944 or even the 70% marginal rate we had as recently as 1970.

What should you do now?

Start planning.

If you think you're going to be hit with the AMT, you reverse normal tax-planning strategy and techniques. Accelerate income and defer expenses not allowable under the AMT.

Instead of accelerating deductible state and local income tax payments, or tax payments on real estate, defer them to the next year. You get no benefit from those tax payments under the AMT. In fact, the more you pay, the higher the AMT hit is going to be.

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Woman & finances  © Stockbyte/Getty Images
Watch out for the AMT
Intended to ensure the rich pay their share, this tax hits more Americans each year. Are you one?

Capitalize rather than expense those "preference," or deductible items, that aren't allowed under the AMT, such as research and experimental expenditures, mining exploration and development costs, and intangible drilling expenses.

Don't exercise incentive stock options.

Employee business expenses aren't allowed under the AMT, either. They are added back to your AMT income. So the more employee business expenses you have, the greater your AMT exposure.

See if you can get your employer to cover those expenses for you under an "accountable plan." Such plans are used extensively with outside salespeople, but they can be used with any employee. That's where you turn over all of your employee business receipts to your employer. That way, none of the reimbursements is includable in your income. The employer gets the deduction.

Published Dec. 27, 2007

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