Alternative Tax Can Be a Big Blow to Many

Ron Speltz, a phone repairman in Cedar Rapids, Iowa, is finding out that you don’t have to be a rich person to pay taxes like one.

Speltz, a 35-year-old father of three, is facing bankruptcy because of taxes he owes on unrealized gains from stock options. The culprit? The alternative minimum tax, an obscure federal levy originally intended to ensure that rich people paid at least some income tax, but which is increasingly ensnaring middle-income Americans.

“Here I stand with this huge debt that is financially destroying our family and I have absolutely nothing to show for it,” Speltz said.

He’s not alone. By 2010, the AMT is expected to affect 35 million Americans--including an increasing number of Californians--unless the tax code is changed, according to a study released last month by the Tax Policy Center. That’s up from an estimated 1.8 million last year.

Although Speltz’s problem with the AMT is more dramatic than most, experts agree that it can increase a tax bill in ways that are difficult to explain or justify.

“The AMT operates unfairly on most of the people who get pulled into it today,” said National Taxpayer Advocate Nina Olson, the government official who represents taxpayers’ interests in Washington. “It may have made sense when it was designed in 1969, but it doesn’t make any sense today,” Olson said.

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Budget Deficit Woes

This year, lawmakers appeared ready to revamp the AMT, which brought in $8.9 billion in 2000. But the burgeoning federal budget deficit is making it difficult to fix or eliminate the AMT without replacing the revenue that would be lost.

The AMT is the product of Vietnam War-era outrage over a report that 155 high-income Americans--they each earned the equivalent of about $1.1 million in today’s dollars--didn’t pay income tax. To prevent the wealthy from sheltering all of their income from taxation, Congress created the AMT--a parallel tax system that operates side-by-side with the ordinary federal income tax.

Under the AMT, marginal tax rates are lower, but fewer deductions are allowed. For instance, deductions for state income taxes, medical expenses and personal exemptions--the tax deductions you get for yourself and other dependents--are eliminated under the AMT.

In the last several years, a number of factors have conspired to turn the alternative tax into a nightmare for many in the middle class.

Among other things, the AMT exemption amount--the equivalent of the normal tax code’s standard deduction--isn’t indexed for inflation. At its current level of $49,000 for married filers and $33,750 for single filers--including single parents--it’s not much higher than it was 30 years ago. As a result, the alternative tax can hit a single mom earning $45,000 a year, Olson said.

Even the meager boost in the AMT exemption included in the 2001 tax-cut legislation expires in 2004. That legislation also contributed to the problem by cutting ordinary tax rates while leaving AMT rates unchanged, and is a major reason the number of Americans paying the alternative tax is expected to soar.

To make matters worse, the alternative minimum tax doesn’t even fulfill its original mission. The IRS estimates that thousands of wealthy Americans still manage to pay no income tax, for reasons ranging from sheltering money in offshore accounts to reporting large amounts of tax-free income from municipal bonds.

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AMT Triggers

What triggers the AMT? Individuals who cut their tax bill too much can be dragged in--for instance, when certain deductions and tax credits reduce an individual’s tax bill below about 24% of income. Deducting state taxes can trigger the AMT for people living in high-tax states such as California. Claiming deductions for high medical expenses or having a large number of children also can put a taxpayer at risk. People with substantial capital gains income can get hit, too, because capital gains are taxed at a lower rate.

Stock options also are a big problem. Roughly 15 million Americans receive incentive stock options--rights to buy a company’s shares at a set price in the future--as part of their pay packages. If a worker exercises stock options--buys his or her company’s stock--and doesn’t sell the shares, no income tax is due even if the shares rise in value, giving the worker a paper profit.

But if the paper profit is big enough, the worker may be subject to the alternative tax, which is levied on the difference between the exercise price of the options--what the worker actually paid for the stock when exercising the options--and what the stock was selling for in the open market on the day the options were exercised.

Stock options were a part of Ron Speltz’s annual pay. Hoping to build a home in 1999, Speltz exercised his options. But he says he held on to the shares on the advice of a tax expert, who said Speltz would save money by holding the shares for a year so his profit on the options would be taxed at lower long-term capital gains rates.

A year later, the stock market tanked and his company’s stock was worth a fraction of what it was worth when he exercised his options. And Speltz was shocked to learn that, thanks to the AMT, he owes $262,000 in tax on shares that are now worth $1,120.

Efforts to pay the tax bill have been fruitless, and Speltz has been unable to reach a compromise with the IRS to pay less than what he owes. In the meantime, his wife has gone back to work and they’re struggling to keep their home.

“I have no problem paying taxes on gains I actually made,” he said. “But I have received nothing.”

Brian Morin of Crown Point, Ind., is in similar straits. The former tech company executive held on to his company’s stock after exercising options, saying he never knew about the AMT. He was able to realize an $80,000 profit when he finally sold the stock, but his tax hit was nearly four times higher--roughly $300,000.

“We had no way to fathom how it was possible that we could be taxed $300,000 on $80,000 in gains,” said Morin. “I don’t have any other capital assets. I don’t even have a car. We just have no hope of ever being able to pay this.”

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Hoping for Reform

Morin and Speltz said they are hopeful that the AMT will be reformed. Half a dozen bills were introduced in Congress last summer as lawmakers tried to come up with a more lasting solution. But none is making progress, in part because of the growth of the federal deficit.

Reforming the AMT is difficult for another reason: Lawmakers want to preserve the intent of the law--to ensure that the wealthy don’t escape the income tax entirely. In her annual report to Congress, Taxpayer Advocate Olson provided suggestions for AMT reform, including outright repeal and indexing the AMT exemption thresholds for inflation--a move that would cut in half the number of people subject to the tax.

She admits that fixing the AMT won’t be easy.

“The current system not only pulls in unintended targets, it doesn’t capture all the intended taxpayers,” Olson said. “I have been trying to think about how you would structure a replacement system, and I have to admit I haven’t gotten very far. It is a very difficult issue.”

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Potential AMT Triggers

The alternative minimum tax is figured using slightly lower rates than the federal income tax that most Americans are familiar with. But it takes away deductions and credits that taxpayers might otherwise claim. Theoretically, every taxpayer is supposed to figure their tax twice--once under the ordinary system, once using the AMT--and pay whichever is higher.

Here are some of the deductions and sources of income that can trigger the AMT:

* Long-term capital gains

* Paper profits from incentive stock options

* State income tax and property tax deductions

* Home equity interest deductions

* Unreimbursed business expenses

* Accelerated depreciation write-offs

* High medical and dental deductions

* Tax-exempt income from private activity bonds

* A large number of personal exemption credits--in other words, having a big family

In general, taxpayers who have such deductions amounting to more than $49,000 for married filers or $35,750 for singles--regardless of income--may risk triggering the AMT. Also, income from capital gains or paper profits from stock options can trigger the tax. If possible, postponing deductions for a year or accelerating income can help, but anyone faced with the AMT should seek advice from a tax professional.

Source: Times research

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Times staff writer Kathy M. Kristof, author of “Investing 101” (Bloomberg Press, 2000), 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 past Personal Finance columns visit The Times’ Web site at www.latimes.com/perfin.