Permanent AMT Fix Poses Difficult Choices

By Jeff Carlson, CCH Washington Staff Writer, and John L. Duoba, CCH Financial Planning Toolkit Staff Writer

Everybody in Congress complains about the alternative minimum tax (AMT), but nobody seems to do anything about it. However, absent legislative action, there will be a significant increase in the number of middle- to upper-middle-income taxpayers affected by the AMT in the near future.

When calculating annual income taxes, certain taxpayers--because of their high number of exemptions, deductions and credits--have to do their tax calculations twice and then pay the greater of the two amounts. In 2005, married couples with taxable income of at least $58,000 are subject to AMT. For them, their deductions (such as local property taxes, state income taxes, child exemptions, etc.) are added back into their taxable income and a flat rate is assessed. This often results in a higher tax liability. (Those taxpayers with the highest incomes are usually unaffected by the AMT, as their tax liability under the regular income tax is usually higher than under the AMT.)

In 1969 when the AMT became law, 155 taxpayers were affected by it. In 2004, about 3.5 million taxpayers were subject to the AMT, but by 2006, up to 21.6 million taxpayers could be subject to the AMT.

According to a Congressional Research Service report, "The Alternative Minimum Tax for Individuals: Legislative Initiatives and Their Revenue Effects," there are two main reasons for the increase in the number of taxpayers affected by the AMT.

First, the regular income tax is indexed for inflation, but the AMT is not. Over time, this has produced a reduction in the differences between regular income tax liabilities and AMT liabilities at any given nominal income level, differences that will continue to shrink in the absence of AMT indexation. The second reason is that the 2001 and 2003 reductions in the regular income tax have further narrowed the differences between regular and AMT tax liabilities.

Congress wants to fix the problem, but worries about potential lost revenues have created somewhat of a quandary. Even though Congress never intended these taxpayers to be caught up in the AMT, they are still counting on these expected future revenues from this growing tax "reverse-loophole" when scoring legislation to determine its financial and budgetary impact.

In devising a permanent AMT fix, Congress needs to determine whether the 2001/2003 tax cuts will be allowed to expire after 2010 as scheduled or extended beyond 2010. This will determine how many taxpayers would be removed from the AMT rolls because the current lower tax rates expose more potential taxpayers to AMT calculations than under the pre-2001 tax laws. The more people exempted from AMT calculations, the greater the impact on estimated government revenues. If the 2001/2003 tax cuts are extended, then, the CRS estimates most options for modifying the AMT could result in a loss of twice as much revenue than if the tax cuts had expired.

Repeal of the AMT would be the most drastic policy option. According to estimates by the Congressional Budget Office (CBO), repeal of the AMT would reduce federal revenues by approximately $337 billion over five years and by $611 billion over 10 years if the tax cuts expire as scheduled. The Treasury Department estimates that if the 2001/2003 tax cuts are extended, then repealing the AMT would reduce federal revenues by over a trillion dollars between FY2006 and FY2015. In fact, the Treasury Department has estimated that by 2013, revenues would be less affected by repealing the regular income tax than repealing the AMT.

Maintaining the current higher exemption levels and indexing the AMT for inflation would hold the AMT "harmless," estimating lost revenue at $191 billion over the first five years and $385 billion over 10 years if the 2001/2003 reductions in the regular income tax expire as scheduled. If the 2001/2003 tax cuts are extended beyond 2010, then this option would reduce revenues by $642 billion over 10 years.

Of course, all Congressional budget estimates are based on static scoring, which states that any reduction (or increase) in taxes results in an equal reduction (or increase) in government revenue. In a dynamic economy like the United States', such equal outcomes are rarely the case. When approved into law, the 2001/2003 tax cuts were originally estimated to reduce government revenues, but in practice the resulting economic expansion in recent years has resulted in record revenues coming into Washington.

For its part, Congress hopes to pass a temporary "patch" for one year when it resumes legislative activity in 2006.

The Senate on November 18, 2005, approved the Tax Relief Act of 2005, which extends AMT tax relief through 2006. The bill includes both an extension of the higher AMT exemption level and an extension of the treatment of nonrefundable credits against the AMT. In addition, the bill would also index the AMT exemption level for inflation. It is estimated that these changes would reduce revenues by $31 billion.

On December 7, 2005, the House approved a stand-alone measure extending the higher AMT exemption for one year and indexing the exemption for inflation, but does not address the tax treatment of nonrefundable tax credits under the AMT. It is estimated that the one-year cost of this legislation would reduce federal revenues by $30 billion.

President George W. Bush's administration did not address the AMT issue in its 2006 budget proposal; instead it appointed a tax reform panel to explore different options for overhauling the tax code. Among its suggestions, the reform panel recommended holding the AMT harmless by maintaining the higher exemption levels and tying them to inflation.

For its part, the IRS has unveiled a new online tool called "AMT Assistant," to help taxpayers determine if they are about to be caught in the AMT web. By answering a few simple questions and referring to your Form 1040, taxpayers can complete the whole process in a few minutes.

Related items:

Congress Ends 2005 Session; Tax Reconciliation Conference Ahead in 2006

Congress Finalizes Katrina Tax Relief, Turns to Reconstruction Funding

Congress Wraps Up More Economic Gifts: New Tax Relief

Tax Reform Panel Releases Final Report

IRS Still Trying to Deliver 2005 Refunds

AMT Negates Tax Relief for High Earners

Tax Rate Projections for 2006

IRS Temporarily Raises Standard Mileage Rate

IRS Launches Study of S Corporation Tax Compliance

New Law Can Save Consumers Energy, Money

Sales Tax Holidays Offer Consumer Savings and Business Opportunities

Beware of Potential Pitfalls When Donating Vehicles to Charity

New Reforms of Flexible Spending Accounts Will Benefit Employees

National Tax Reform Panel Listens to Options, Obstacles

CEA Report Examines Tax Reform Options, Predicts Sustained U.S. Economic Growth

Over $2 Billion In Unclaimed Refunds From 2001 Faces Looming Deadline

Posted January 10, 2006.