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Everyone hates the AMT, but fix will be costly

Everyone agrees that something needs to be done to “fix” the alternative minimum tax. But there’s little agreement on how to go about it.  By's John W. Schoen.
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Everyone agrees that something needs to be done to “fix” the alternative minimum tax. But there’s little agreement on how to go about it.

This year, some 3.7 million Americans this year learned the hard way that they are subject to the AMT, a stealth tax increase that forces many to prepare their returns twice and pay the rate that hits them hardest. And unless the tax law is changed, some 23 million — 17 percent of all filers — will be subject to the AMT when they file in 2008. Many taxpayers are in for a nasty surprise.

Established in 1969 by Congress to tax millionaires who used loopholes to reduce or eliminate their obligations, the alternative minimum tax system does away with a variety of exemptions and deductions, boosting the amount AMT filers owe. But Congress made a critical error: By not indexing the income threshold used to calculate the AMT, this higher tax is now hitting more and more people further down the income ladder.

“The majority of middle-class taxpayers have never heard of the AMT and are unaware that it may apply to them,” Joseph Walloch, an accountant with the American Institute of Certified Public Accountants, told a Congressional panel in March.

Worse, there’s no simple formula for determining whether the tax applies to you, because eligibility depends heavily on how many exemptions, credits or deductions you claim under the regular system. The only way to know for sure is to complete a 16-line worksheet, read 10 pages of instructions and fill in a 55-line form. If you don’t check, and it turns out you owe the tax, you can expect a bill for the difference — plus a penalty for not paying up. Last year, the average AMT filer owed $6,800 in extra taxes.

So it’s no wonder that politicians of all stripes are vowing to provide AMT relief. But fixing the problem turns out to be much more difficult that just eliminating it. That's because scrapping AMT also means eliminating a “stealth tax” windfall that Congress and the White House have already factored into their budget forecasts.

“We’ve already spent the money,” said Brian Phillips of the non-partisan Tax Foundation who has written about the AMT. “If you look at these ridiculous five-year projections — both on the president's side and on the Democratic Congress’ side — they assume we’re going to take in all that money.”

$1 trillion price tag
By some estimates, eliminating the AMT would cost the government some $1 trillion over 10 years — money that would have to made up with further spending cuts or tax increases.

Debate over the AMT is also snarled in the wider discussion of the Bush administration’s tax cuts, which are set to expire in 2010. Ironically, those cuts had the effect of accelerating the problem. Because rates under the AMT system were not cut, lowering taxes under the regular tax system pushed more people into the higher AMT rates.

Now, with Congress scrambling to find ways to pay for reducing or eliminating the AMT, the extension of Bush’s tax cuts past 2010 will be that much harder to pay for.

One solution that’s gotten widespread support is the so-called “tax gap,” representing taxes owed but not paid. Roughly $300 billion a year goes uncollected for a variety of reasons.

Some have suggested hiring more IRS workers to go after those who aren’t paying, but it’s not clear just how much money better enforcement would generate.

“While it's easy for the (IRS) to estimate this as the shortfall, they haven't shown us how to go after it,” said Rep. Charles Rangel, D-N.Y., who chairs the House Ways and Means Committee. “But (the tax gap) will be on the agenda, no question about it.”

Skeptics of the proposal to use the tax gap to pay for eliminating  the AMT also worry that a new system devised to improve compliance could end up burdening honest taxpayers with yet another layer of paperwork.

With so many conflicting proposals, progress on a solution has been slow, as “both sides stare at each other like cats,” according to Phillips of the Tax Foundation.

“They’re going to kick the can down the road to 2010,” he said. “There aren’t going to be any long-term fixes. And if there is, it’s going to be something horrible like adding deductions and exemptions to the AMT — which, of course, was the whole point of the AMT in the first place, to not have any of these deductions and exemptions.”

Even the idea of adding back those deductions and exemptions has opened up a “red-state-blue-state” divide, according to Phillips. One way to ease the AMT impact would be to restore the deduction for state and local taxes that AMT filers lose.

That solution has strong backing from high-tax, typically Democratic states like California, New York and New Jersey. On the other hand, members of Congress from lower-tax, typically Republican states favor increasing the number if personal exemptions AMT filers can claim, leaving the state tax deduction out of the formulas.