Thursday, December 6, 2012

The Alternative Minimum Tax - Red vs. Blue

Tax filing delay looms if no fix for minimum tax: IRS
IRS Chief Warns Again About AMT Hit

If you aren't familiar with the alternative minimum tax - commonly known by its initials, AMT – you might want to get acquainted with it. Congress created the AMT back in 1969 to make sure that certain high-income citizens couldn't skip out on paying taxes altogether by gaming the system. So under the present regime, you pay either your regular taxes or the AMT (which is essentially a flat rate that eliminates most deductions), whichever is higher. A definite hassle (because you have to calculate your taxes twice), but at least it sounds fair, right? 

Well, there's one major problem: The AMT is not indexed for inflation. In other words, the
income level at which you potentially trigger the AMT has been unchanged (apart from
occasional Congressional band-aids) over the years. Seems like a pretty glaring and obvious
mistake to me, but there it is. When it was first passed, only a tiny handful of people were
potentially subject to the AMT - just a few thousand, all of whom could fairly be described as

But millions more Americans could be subject to the AMT in their 2012 returns if Congress fails
to reach a deal on the fiscal cliff before year-end. That's because the AMT is currently scheduled
hit individuals making as little as $33,750 a year and joint filers making $45,000.
However, the usual vehemence heard over taxes from the Republicans as well as the concerns
over middle class tax rates championed by the Democrats seem to have been lost over this issue.

In large measure part of the problem is purely political. Each side sees itself as having leverage
in the fiscal cliff debate when it comes to the AMT. That is a direct result of the geographic
impact of the tax.

As NEWSMAX reported on December 4th, “U.S. Republicans may have some leverage in their fiscal cliffhanger with President Barack Obama: the threat of forcing a disproportionate number of Democrats to pay the so-called alternative minimum tax.
“Under U.S. law, taxpayers each year must pay the greater of regular federal income tax, or the AMT. The latter requires taxpayers to give up certain tax breaks, typically exemptions and deductions for state and local taxes and medical costs….
“States with the wealthiest taxpayers and the steepest state taxes, which typically cannot be deducted under the AMT, include New York, California and Illinois - Democratic strongholds.”

The issues are crystallized in a report issued by The Congressional Research Service on
December 4th titled Alternative Minimum Taxpayers by State: 2009, 2010, and Projections for
. It breaks down states by the percentage of taxpayers in each who are subject to the
Alternative Minimum Tax. Anyone with any familiarity with the recent election and the
Geographical distribution of Democratic vs. Republican strength will see a clear pattern.

Political Color Scheme Added

2005 article in the Orlando Sentinel nicely stated why those in the red states would favor maintaining the AMT.

Those of us who live in what the politicians in Washington, D.C., call the red states ought to think twice when we hear them talk of repealing the Alternative Minimum Tax.
That's because those folks want to put one over on us by repealing a levy we in the red states pay less frequently, with the likelihood of replacing it with one that would cost us more.
This bizarre reality stems from the AMT being the only tax that discriminates based on geography among those with similar incomes.
There's also a political twist. Republicans generally want to cut taxes, while Democrats are more skeptical because they want more government spending.
But on this one, the situation is much more complex because of how the tax falls.
Every state that voted for President Bush in 2004 would be net losers if the AMT is repealed and another sales or income-based tax were created to capture that revenue. Those in most states that voted for John Kerry would be net gainers.
That's why when you hear the politicians in D.C. talking about making the tax system more fair, make sure you ask them: Fairer for whom?
Think of the AMT as an alternative, and higher, federal income tax. It has different rules for deductions and credits than the one most of us live under. The deduction for a state income tax makes the most difference in creating this geographically uneven playing field.
Those who pay the AMT can't write off state income or sales taxes, as other filers can. In addition, there are a series of other deductions and exemptions -- disproportionately enjoyed by those who live in the blue states -- that are available to most taxpayers that do not count for those paying the AMT.
States that voted for Bush are much less likely to be hit by the levy because those are the same states where the politicians in power (mostly Republican) have created a system of either minimal or no income taxes. In addition, those states, because of living costs, tend to have lower salaries for jobs that pay more elsewhere.

However, if the Congress fails to address the lurking consequences of failure to fix the AMT, this perceived advantage could rapidly turn into a liability. The Congressional Research Service study notes:

In 2010, 4.02 million taxpayers were subject to the AMT, a slight increase from 3.88 million taxpayers in 2009. In 2010, New Jersey, Connecticut, the District of Columbia, and New York had the highest percentage of taxpayers subject to the AMT. Mississippi, Tennessee, Alabama and South Dakota had the lowest percentage of taxpayers subject to the AMT.

In 2012, absent an increase of the AMT exemption amount, 32.4 million taxpayers will be subject to the AMT. At that time, whether a married taxpayer has itemized deductions for state and local taxes or miscellaneous deductions will become a much less important factor than it is at present in determining AMT coverage. This occurs because, whether they itemize their deductions or not, married taxpayers across a wide range of incomes will be subject to the AMT because personal exemptions are not allowed against the AMT.

According to  William Perez, the alternative minimum tax exemption amounts for 2012 are scheduled to revert to the following levels:

$33,750 for single and head of household filers,
$45,000 for married people filing jointly and for qualifying widows or widowers, and
$22,500 for married people filing separately.

When calculating the alternative minimum tax, various adjustments are made. Some income is added which is not subject to the regular tax. Some deductions are adjusted downwards or eliminated entirely.

The following items may trigger an AMT liability:
Itemized deductions for state and local taxes, medical expenses, and miscellaneous expenses
Mortgage interest on home equity debt
Accelerated depreciation
Exercising (but not selling) incentive stock options
Tax-exempt interest from private activity bonds
Passive income or losses
Net operating loss deduction
Foreign tax credits
Investment expenses

AMT Tax Rates
The exemption amounts mean that this amount of AMT taxable income is not subject to the AMT. Income over these amounts may be subject to AMT. Unlike the ordinary tax rates, the AMT has only two tax brackets. The AMT tax rate is assessed only on AMT income over the exemption amount. The AMT tax rates are:

  • 26% on the first $175,000 of AMT taxable income, and
  • 28% on the remainder of AMT taxable income

This is opposed to the following marginal rates for those to whom the AMT does not apply:
(Each tax rate applies to a range of income, which is called a tax bracket. Each tax rate applies to a specific range of taxable income, which is income after various deductions have been subtracted.)
Single Filing Status
10% on taxable income from $0 to $8,700, plus
15% on taxable income over $8,700 to $35,350, plus
25% on taxable income over $35,350 to $85,650, plus
28% on taxable income over $85,650 to $178,650, plus
33% on taxable income over $178,650 to $388,350, plus
35% on taxable income over $388,350.

Married Filing Jointly or Qualifying Widow(er) Filing Status
10% on taxable income from $0 to $17,400, plus
15% on taxable income over $17,400 to $70,700, plus
25% on taxable income over $70,700 to $142,700, plus
28% on taxable income over $142,700 to $217,450, plus
33% on taxable income over $217,450 to $388,350, plus
35% on taxable income over $388,350.

Clearly a comparison of the alternative rates indicates a distinct disadvantage for lower income wage earners.

This chart shows that, by the CBO’s calculation, families earning a poverty-level amount of money can face marginal tax rates of up to 60 percent.

If at first that doesn’t seem remarkable, consider the current political drama over the fate of the “Bush tax cuts” for top incomes. That dispute concerns whether the top rate will go up from 35  to 39.6 percent. If families earning $250,000 a year taxed at a top rate of about 40 percent is cause for concern, clearly a 60 percent rate for a family of four making $23,050 (which would put them right at the federal poverty level) is a problem.

Another problem, of course, is that people might stop working altogether because of the incentives they face. The CBO report doesn’t include estimates of marginal tax rates facing the unemployed, because they don’t have tax return data that can be analyzed. But at such low levels of income, it’s not hard to imagine people becoming discouraged by the low returns to work.

The President’s FY2013 Budget proposes an alternative budget baseline where the AMT is permanently indexed for inflation based on 2011 parameters.*

So the opening question remains – will the fate of lower and middle income wage earners become hostage to  the AMT in the fiscal cliff negotiations?

Note: The ranges in red are the phaseout bands. The rates are higher because you lose AMT exemptions as your income goes up. If you are subject to AMT, remember your marginal tax rate can be higher than what you think it is. Since state income tax is not deductible under AMT, to get your combined federal and state marginal tax rate, just add your marginal state income tax rate to the federal rate when you are under AMT.

1 comment:

  1. Let the cliff come! Bet you won’t see another Republican elected to Congress for decades.


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