The Alternative Minimum Tax--It’s Not Just for the Wealthy Anymore
Tax accountants may not be known for literary allusions, but when you talk to Mark Luscombe about the alternative minimum tax, he’s likely to quote Lewis Carroll.
When it comes to the AMT, the already curious U.S. tax code just gets “curiouser and curiouser,” says Luscombe, principal tax analyst at CCH Inc., a Riverwoods, Ill.-based publisher of tax information.
The alternative minimum tax was instituted in the 1970s, when top tax rates hit 70% and the country was rife with tax shelters that offered huge write-offs for those wealthy enough to make smart investments. The idea behind this parallel tax system was to ensure that wealthy people paid tax regardless of how cleverly they sheltered their income.
But today, an increasing number of U.S. taxpayers--and not just the very wealthy--are becoming subject to the complex and topsy-turvy world of the AMT.
Just 414,000 Americans were subject to AMT taxes in 1995--the most recent year for which statistics are available--but the number appears to be rising sharply. According to a recent congressional study, about 856,000 individuals are expected to pay the AMT this year. By 2008, a staggering 8.8 million Americans--about 6.5% of the taxpaying public--will be required to pay it, according to the Joint Committee on Taxation.
This tax once hit only people with exceptionally high incomes and unusually big deductions, but in the future it is far more likely to apply to the middle class. By 2008, more than 85% of the individuals who owe AMT taxes will earn $200,000 or less, the congressional study found.
Theoretically, every taxpayer who earns more than $45,000 if married, filing jointly (or more than $33,750 if single or $22,500 if married, filing separately) is potentially subject to this tax.
Most tax preparers and tax software programs will alert you if you owe the AMT. However, many people find out only after the Internal Revenue Service sends them a notice saying they haven’t paid enough.
Practically speaking, though, the AMT is not likely to be an issue for most people. What triggers it are so-called preference items--high state income taxes; substantial miscellaneous itemized deductions; a home equity loan that was used to pay for things not related to the home (such as a car or a boat); interest from private activity bonds; depreciation from business assets or rental properties; stock options exercised during the tax year.
When it created the AMT, Congress took the U.S. tax code and turned it on its head. It said that all taxpayers who claimed itemized deductions and earned more than set amounts--about $45,000 for a married couple--needed to figure their tax using the ordinary method: filling out Form 1040 and Schedule A. In addition, they had to figure their taxes a second time by filling out Form 6251, which starts with taxable income from Form 1040 and works backward by making the taxpayer add back certain things that might have been claimed as itemized deductions.
For example, on a 1040, you deduct state income tax from your income, but you add that amount back on the AMT form; on the 1040, you subtract unreimbursed business expenses but add them when figuring the AMT.
In addition, if you exercise a stock option--that usually means you get to buy your employer’s stock at a discounted price--you don’t have to claim the discount (the difference between your price and the current market price of the stock) on your 1040. Instead, you claim a profit only if and when you later sell the shares, presumably at a profit. (When you exercise a stock option, you are buying shares, not selling. Although the price you pay is generally lower than the going market price for the same shares, there’s no guarantee that will still be true when you seek to sell the shares later.)
But when figuring the AMT, you have to claim income on your paper profit--the difference between your price and the market price for the shares you purchased.
The bottom line: Your AMT income can be dramatically different from your “taxable” income under the ordinary income tax system. So, too, are income tax rates. Whereas there are five marginal tax rates, ranging from 15% to 39.6%, under the ordinary income tax system, there are just two AMT rates, 26% and 28%.
The final step in determining how much tax you owe is to look at what you’d owe under the ordinary system and compare that with what you would owe under the AMT. You pay whichever is higher.
To illustrate, consider a hypothetical couple, Mark and Pam Spam, who have two children and $150,000 in income. They claim $25,000 in itemized deductions, including $10,000 in state taxes, and they deduct $4,000 in interest on a home equity loan, the proceeds of which went to finance a boat and pay off credit card debt. Also during 1997, Pam took advantage of a stock option program that allowed her to buy her company’s shares at $10 apiece. The stock was worth $30 a share at the time, and Pam bought 1,000 shares.
Under the ordinary income tax system, Pam’s stock purchase doesn’t count as income and won’t until she sells those shares, presumably at a profit. Under the AMT, however, the $20,000--based on the $20 difference between the current market price and the price Pam paid for her 1,000 shares--is a taxable profit. In addition, the $10,000 in state income tax and $4,000 in interest the Spams claimed as itemized deductions don’t count.
Under the ordinary system, the Spams would have paid $27,544 in income taxes, but under the AMT, they owe $30,225. They’re required to pay the higher amount--a difference of $2,681.
As the Queen says in “Alice in Wonderland,” when Alice complains that she’s confused: “That’s the effect of living backwards. It always makes one a little giddy at first.”
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
A Growing Alternative
The alternative minimum tax was created in the late 1970s to ensure that wealthy people paid taxes, regardless of how cleverly they sheltered their income. The AMT eliminates the benefit of most itemized deductions, but assesses tax at a somewhat lower marginal rate. Today, a growing number of middle-class U.S. taxpayers are subject to the AMT.
Projected Income Distribution of AMT Taxpayers, 1998 and 2008
*
Number of U.S. taxpayers subject to AMT, in millions
2008: 8.83 million
*--*
Income category Number of AMT returns Projected Number of AMT returns (in thousands) 1998 (in thousands) 2008 Less than $10,000 * * $10,000-$19,999 1 * $20,000-$29,999 * 9 $30,000-$39,999 9 157 $40,000-$49,999 14 248 $50,000-$74,999 68 1,356 $75,000-$99,999 97 2,700 $100,000-$199,999 270 3,043 $200,000 and over 388 1,310
*--*
*Category includes fewer than 500 taxpayers.
Source: Joint Committee on Taxation
