Just as tax cuts given to some taxpayers must be made up by increased levies on others, Congress' vaunted "simplification" of the tax law has resulted in the state of utter confusion imposed on at least one class of citizen: the taxpayer subject to the alternative minimum tax.
The AMT (for short) was created in 1978 in the wake of an uproar over the maneuvers used by wealthy taxpayers to avoid paying any income tax. Congress tried to close the zero bracket to the rich by imposing an inescapable tax on those with heavy tax-shelter losses and other "preference items" (those that were taxed at a preferentially low rate) such as long-term capital gains.
Under the AMT rules, a taxpayer was required to recalculate his or her tax bill by adding such preference items back onto income and computing a new tax--albeit one lower than the then-current 70% top bracket--on the new total. Of the regular tax and the AMT, the taxpayer had to pay whichever was higher.
Congress' revision of the tax law has retained that fundamental procedure but radically changed the AMT in other ways. Under the new rules taking effect this year, the AMT will strike not only rich people with tax shelters but even some upper-middle-income taxpayers with more conventional deductions. People who once only dreamed about living like the Rockefellers will now share not only their tax bracket but the unique stress of planning for and computing the AMT.
Congress has provided an exemption designed to relieve most middle-class taxpayers from paying the AMT. Once preference items have been added and income recalculated under AMT, most married couples can deduct $40,000 and singles can deduct $30,000; the rule ensures that those taxpayers' regular tax will remain higher than their AMT. But many taxpayers will still have to undertake for the first time the wildly complex calculations necessary to determine if they must pay the alternative minimum tax.
The implications of the AMT now reach further across the tax-planning spectrum than ever before. In previous years, tax professionals say, the AMT was triggered for most affected taxpayers by one preference item in particular: long-term capital gains. Under the old tax law, long-term gains were 60% exempt from tax, meaning that in 1986 the top tax rate for them was 20% rather than 50%.
Until Dec. 31, 1986, "this was the one item most common to AMT taxpayers," said Michael Wolff, the AMT expert in the New York office of Alexander Grant & Co., the big accounting firm. The exempt 60% of capital gains income had to be added back to taxable income and the AMT calculated on the new sum.
Because the preferential tax rate on capital gains is being phased out under tax reform, they will not play as important a role in pushing taxpayers from the regular tax system into the AMT. But several other items will more than take their place.
Starting this year, the AMT could be triggered even for relatively modest-income taxpayers who itemize deductions and have large state income tax, property tax and consumer interest totals.
The AMT may also pose one argument for avoiding home equity loans, which have lately been getting a marketing push as the only kind of credit for which interest payments remain tax-deductible. Under the new rules, any portion of the loan used for a purpose other than buying or improving a home is subject to the AMT, as is any portion of the loan that exceeds the home's original cost plus improvements. That means that families taking out a second mortgage to send a child to college may find themselves in the AMT category and stuck with a higher tax bill.
Owners should be aware that the deduction rules are much more stringent under the AMT than under the regular tax. For example, if a home is refinanced for more than the original mortgage's principal, the interest on the excess is subject to the AMT. Also, while interest on second mortgages used to pay for medical or educational expenses is deductible under regular tax rules, it is not deductible under the AMT.
Finally, and perhaps most important, the compression of tax brackets itself will force more taxpayers into the AMT.
Last year, the top regular tax bracket was 50% and the top AMT bracket was 20%, a gap that served to ensure that only the wealthiest taxpayers would be subject to the AMT.
For example (and assuming for simplicity that all income is taxed at the maximum tax bracket), a taxpayer with $100,000 in taxable income, after deductions, would pay $50,000 in regular tax. To become subject to the AMT, his deductions, assuming they were all preference items, would have had to be at least $150,000. That's because, at the 20% AMT rate, only a gross income of $250,000 would produce the same $50,000 tax bill or more.
This year, the top regular bracket has come down to 28% and the top AMT bracket has inched up to 21%. Now $100,000 in taxable income generates $28,000 in tax--a threshold that can be reached with only $33,333 in deductions subject to the AMT--meaning the AMT kicks in for this taxpayer at a gross income of $133,333. (Of course, the AMT exemption means this taxpayer would still escape the AMT. The threshold would be reached with $63,333 in deductions subject to the AMT for single taxpayers or $73,333 for most couples.)
Accountants say the new AMT is so extensive that they have scarcely begun to understand all of its ramifications.
"When Congress first started the AMT, it was a huge source of confusion," said Janice M. Johnson, senior manager in the New York City office of Seidman & Seidman/BDO, an international accounting firm. "I'm sure that as we work with it, now we'll find new impacts we just didn't expect."
Chief among the AMT triggers are these items:
Tax Shelter Losses: "Tax shelters are the national enemy, as far as Congress is concerned," Johnson remarked. "One way they've chosen to hit at them is with the AMT."
The key rule here is the disallowance of deductions for most "passive activity" losses. Most tax shelters have been marketed as allowing taxpayers a loss deduction in excess of their actual investment. These losses were used to reduce a taxpayer's regular taxable income. No longer: Under both regular tax and AMT rules, passive income losses can only be used to offset passive income gains. The remainder is a disallowed deduction, although a disallowed passive activity loss can be carried forward indefinitely until the taxpayer does have passive income to offset.
The good news there is that it means the tax shelter deduction is only deferred, not lost altogether. The bad news is that it requires taxpayers to keep detailed records, possibly for years, showing their accumulated losses. "That's certainly not tax simplification," Johnson remarked.
The rules are particularly stringent as they apply to farming tax shelters, those investment vehicles that led to the phenomenon of urban professionals owning interests in cattle herds and vineyards that they had never seen. Farm losses claimed by anyone not engaged in farming as an active trade or business are disallowed. Although most tax shelter losses can be used to offset other tax shelter gains, the farm losses can only be applied to farm shelter gains.
In all, Johnson said, the evolution of the tax shelter rules means that taxpayers who invested in shelters early on--mostly the very wealthiest people--have been rewarded and those who jumped in more recently, when shelters became available for the less well-heeled, have been hurt. An investor who joined a limited partnership in 1981, when Ronald Reagan was inaugurated and the top tax bracket was 70%, got a huge tax benefit then. Now, when many of those shelters are finally beginning to generate real income, the income is taxable at a top rate of only 28%.
Anyone who invested later got a smaller tax benefit, for the top rate was reduced to 50% shortly after Reagan's inauguration. Today, while such shelters are still generating losses, they are scarcely deductible.
Itemized Deductions: Many accountants say this category will be the most bothersome for taxpayers. The AMT disallows most deductions permitted under the regular tax. Only those for charitable contributions, permissible home mortgage interest, medical expenses, casualty and theft losses, gambling losses and certain estate taxes are allowed.
That leaves several items that for many taxpayers are the most significant itemized deductions: state and local taxes and consumer interest. For consumer interest, AMT rules are more strict than the regular tax. For while the interest deduction is being phased out under the regular tax (only 65% is deductible this year), it is fully disallowed under the AMT. As the accounting firm of Arthur Andersen & Co. notes, for a taxpayer with $3,000 in credit card and other consumer interest in 1987, 65%, or $1,950, is still deductible under the regular tax. But none is deductible under the AMT.
Under the new rules taking effect this year, the AMT will strike not only rich people with tax shelters but even some upper-
middle-income taxpayers with more conventional deductions. People who once only dreamed about living like the Rockefellers will now share not only their tax bracket but the unique stress of planning for and computing the AMT.