The Taxpayer’s Worst Nightmare: The Alternative Minimum Tax

Posted on 05. Jan, 2006 by in Taxes

As reported by The Wall Street Journal, last year thousands of taxpayers were shocked when they discovered that they were subject to the alternative minimum tax, or AMT, which disallows a number of common deductions and exemptions. But as the new tax-filing season gets under way, the Internal Revenue Service is launching an online tool that will help eliminate the surprise factor. It takes your financial information — which you enter anonymously — and calculates whether the tax applies to you for your 2005 income. Instead of spending an hour working through a paper worksheet, most people can complete the whole process in about five to 10 minutes, the IRS says.

Dubbed “AMT Assistant,” the program can be found at apps.irs.gov/app/amt/. In order to complete it, taxpayers must answer several questions and copy data from their Form 1040. The program will tell you only if you definitively do not have to fill out the AMT form, not how much tax you owe.

The AMT is a controversial parallel tax that was designed in 1969 to ensure that the 155 wealthiest citizens couldn’t avoid paying income taxes by taking multiple exemptions and deductions. But because the AMT isn’t indexed for inflation, it affects a larger group of people with every passing year. This year four million taxpayers are expected to be hit with the AMT for their 2005 income, up from 3.5 million in 2004.

The AMT affects taxpayers who have what are known as “tax preference items.” These include long term capital gains, accelerated depreciation, percentage depletion, and certain tax-exempt income, which are all considered to have favorable tax treatment and could trigger the alternative minimum tax. Certain tax credits can also trigger the AMT. Some of the problems with the AMT are:

  • It is an extremely complicated system of rules, leading to high compliance costs.
  • It does not correct for inflation, leading to unplanned effects as time goes by. Starting around 2004, the AMT began affecting middle-class incomes, at least by the standards of areas with high cost of living.
  • It disproportionately affects citizens of states with high taxation, since local and state taxes are considered deductibles under current federal tax law but not under the AMT. Because many of these states have voted Democratic in recent Presidential elections (for example New York, California, New Jersey) and many of these states also have high per capita incomes but also high cost of living, AMT is sometimes refered to as the “Blue State Tax”.

The median household income in the United States was $44,389 in 2005, and households making over $75,000 per year make up the top quartile of household incomes. Since those are the households generally required to compute the AMT (though only a fraction currently have to pay), some argue that the AMT still hits only the wealthy or the upper middle class. However, some counties, such as Fairfax County, VA ($88,133), and some cities, such as San Jose, CA ($71,765), have median incomes which are near or exceed the typical AMT threshold. The cost of living is generally higher in those areas, leading to families which are middle class for their area having to pay AMT, while in poorer locales with lower cost of living still only the wealthy pay AMT. In other words, many who pay the AMT have incomes which, in dollar terms, would place them among the wealthy when considering the United States as a whole, but in real terms are only middle class. This is an inherent issue in federal taxation, but the onerous burden of computing AMT magnifies the issue.

AMT, Alternative Minimum Tax, Taxes, IRS

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