Making sense of the alternative minimum tax issue

Congress is trying to amend the tax code to keep millions of Americans from having to pay the alternative minimum tax, which the Internal Revenue Service and the taxpayer advocate say is one of the most complicated provisions for taxpayers.

What is the alternative minimum tax?

The AMT is a tax on income calculated by an alternative method than that used to calculate the standard income tax.

Unlike the standard income tax calculation, which allows multiple deductions, the AMT calculation is designed to limit deductions.

There are no deductions for children, so families with many lose a substantial tax break.

The AMT also disallows deductions for state and local taxes, which play an important role in reducing taxes for residents in states, including California, that have income taxes.

How does it work?

Taxpayers who meet certain income or deduction criteria must calculate how much income tax they owe under the standard method and also how much they would owe under the AMT method. Then they compare the two results and must pay whichever is greater.

To determine what they would owe under the AMT, taxpayers recalculate their taxable income using a different series of steps. Then taxpayers subtract a single exemption from that income and calculate their tax liability on the difference -- 26% on the first $175,000 and 28% on the rest.

Why was it created?

Congress created the AMT in 1969 in response to concerns that 155 very wealthy families were avoiding income taxes by claiming extensive deductions. Lawmakers hoped that the alternative minimum tax would guarantee that high-income Americans would pay at least a minimum amount of taxes each year.

What is the problem?

The tax was not indexed for inflation, so as incomes have increased over the years, more Americans have become eligible to pay the tax. Last year, about 4 million taxpayers paid the tax, compared with about 20,000 in 1970.

Congress has enacted several temporary fixes to the AMT since 1969 to spare middle-income taxpayers. The most recent fix has expired. If a new one is not enacted, the AMT could hit as many as 23 million taxpayers next year, some with incomes as low as $75,000.

What are lawmakers proposing to do about it?

Democrats in the House of Representatives last month passed what they call a “patch” to prevent the AMT from catching more taxpayers. Under the plan, most of the roughly 4 million taxpayers who paid the AMT last year would probably have to pay it this tax season.

What is the patch?

It simply amends the tax code to increase the AMT exemption for single taxpayers to $44,350 from $33,750, and for married couples filing jointly to $66,250 from $45,000.

Why hasn’t that happened yet?

Democrats and Republicans are hung up in a debate about whether to replace the $50 billion the federal government would not collect from the AMT next year if the law is changed.

The House Democratic plan offsets the $50-billion cost by raising the tax rate on some investment fund managers and partners in private equity firms, many of whom make millions of dollars but pay only a 15% tax rate on much of their income, which they classify as capital gains. If they were subject to the standard income tax, they would pay a 35% rate, like other high-income Americans.

But Republicans have fiercely resisted raising taxes on anyone to recoup the cost of shielding taxpayers from the AMT. And facing a filibuster from Senate Republicans, Senate Democrats agreed Thursday to patch the AMT without raising revenue elsewhere.

What happens next?

The bill returns to the House, where Democratic leaders are considering other ways to raise at least some revenue to offset the lost $50 billion. If they do that, the bill will have to return to the Senate, where it is expected to face GOP opposition.

The White House, which once said an AMT fix should be paid for, has also indicated that President Bush will not support any measure that includes a tax increase.

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noam.levey@latimes.com