Alternative Tax May Hit More

As many as 17 million Americans could face tax hikes next year as the result of the alternative minimum tax -- a little-understood tax once aimed at millionaires but now affecting the middle class.

Lawmakers in Washington are working furiously to pass a stopgap measure to keep the hikes from taking effect, but those efforts are complicated by the politics of the broader budget bill. “If Congress does not act, the percentage of taxpayers earning $75,000 to $100,000 subject to the AMT would rise next year to almost 30% from 1%,” said Rep. Steny H. Hoyer (D-Md.), the House Democratic whip.

The AMT is little known outside of tax and accounting circles, but every taxpayer should understand it. Here are some questions and answers to help clarify this obscure but important part of the U.S. tax code:

Question: What is the alternative minimum tax?

Answer: The AMT is a parallel tax system that was instituted in the 1970s by outraged legislators who had discovered that a few hundred millionaires had avoided paying federal income taxes by participating in tax shelters.

At the time, marginal income tax rates were as high as 90% and the law was rife with loopholes, allowing huge write-offs for those wealthy enough to take advantage.

The AMT was designed to ensure that everyone paid some tax by requiring that taxes be calculated twice: once under the traditional system that allows deductions and credits and once under the alternative system that eliminates deductions and credits but imposes income taxes at somewhat lower rates. The taxpayer pays the customary income tax or the AMT, whichever is higher.

Q: How is it calculated?

A: Under the ordinary tax system, you figure your taxable income by adding wages, interest and other income and then subtracting write-offs for personal exemptions, itemized deductions and tax credits.

The tax you pay is then based on graduated rates. You pay tax on a set amount of income (up to $7,300 if you are single and $14,600 for married couples) at a 10% rate. Income above those thresholds is taxed at a 15% marginal rate.

Once income exceeds the thresholds for the 15% bracket, it’s taxed at a 25% rate, then 33% and finally, 35%.

The actual tax you pay is a blended rate, encompassing all the applicable “marginal” tax brackets. If you paid $10,000 on taxable income of $50,000, for example, your blended tax rate would be 20%.

To figure the AMT, you start with the amount of taxable income reported on Form 1040 -- the figure after deductions -- and then you start adding certain write-offs back in. Personal exemption credits of $3,200 per person, medical and dental deductions, miscellaneous business expenses and write-offs for state income and property taxes, for example, all get added back to “alternative minimum taxable income.” Then, you subtract an “AMT exemption” amount and pay tax at just two rates -- 26% on AMT income under $175,000; 28% on income over $175,000.

The bottom line: If your blended tax rate is less than 26% and your income exceeds the AMT exemption threshold, you could owe AMT taxes.

Q: Are all itemized deductions added back to come up with AMT income?

A: No. Write-offs for home mortgage interest and charitable contributions are deductible under both the AMT and ordinary income tax systems.

Q: How are capital gains or dividend income affected?

A: Under the primary income tax system, capital gains and dividends are taxed at preferential rates -- a maximum of 15%. But under the AMT, there’s no preferential rate for capital gains or qualified dividends; all income is taxed at 26% or 28%.

Q: Why should I be concerned about a tax intended only for millionaires?

A: Because the law has not been significantly revised or adjusted for inflation since the 1970s, more middle-income people are getting hit by it. In fact, the IRS’ Taxpayer Advocate Service has estimated that about 60% of the AMT taxes paid in 2010 could be from individuals earning $100,000 or less.

Q: Is everyone at risk of incurring the AMT?

A: No, but anyone who earns more than the AMT exemptions of $58,000 for married couples and $40,250 for singles could be exposed to the AMT tax. (Those exemptions are set to drop at the end of the year to $45,000 for couples and $33,750 for singles, but Congress is trying to extend the higher limits for at least one year.) But most people earning less than $100,000 are not really exposed unless they have unusually large families, significant itemized deductions or income from capital gains and qualified dividends.

Q: What’s being done about the AMT?

A: Last week, the House of Representatives passed the so-called Stealth Tax Relief Act, which would stop the AMT exemption limits from dropping in 2006. A similar provision is now part of the budget reconciliation bill that’s being debated in the Senate. However, because the budget bill is controversial, it may be held up. Some legislators maintain that the AMT fix must be pulled out in order for the bill to be passed this year.

However, even the Stealth Tax Relief Act leaves many middle-income families exposed. That’s because claiming certain credits, such as the $1,000 child tax credit or the Lifetime Learning Credit, could also trigger the AMT. A fix for that also is in the budget bill.

Q: If the AMT isn’t doing what it was intended to do, why isn’t it just eliminated?

A: It’s a huge source of revenue. One tax policy group has estimated that, left unchecked, the AMT would generate more tax receipts than the ordinary income tax system within a few years.

Also, it’s so complicated and so few people are aware of it that it has not generated the hue and cry necessary to put it at the top of the legislative agenda.

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Kathy M. Kristof, author of “Investing 101” and “Taming the Tuition Tiger,” welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com. For previous columns, visit latimes.com/kristof.