AMT Problem Looms Over Fiscal Cliff Debate

For many taxpayers, the AMT, or alternative minimum tax, has always been a vaguely understood feature of the federal income tax system with no real effect on their lives. But that may be about to change. Unless Congress fixes it, the AMT will ensnare about 33 million U.S. taxpayers--or one out of every five--for the 2012 tax year, including 28 million who normally wouldn't be subject to it, according to the Internal Revenue Service. About 4.3 million paid the AMT in 2011, according to estimates from the Tax Policy Center.

Based on the center's calculations, nearly half of those newly hit by the AMT will be taxpayers with adjusted gross incomes between $100,000 and $200,000, who will pay $2,868 more on average as a result of the tax. Millions more with adjusted gross incomes between $75,000 and $100,000 will also feel the sting for the first time to the tune of $1,350 extra in taxes on average, while those newly subject to the AMT and with adjusted gross incomes between $200,000 and $500,000 will pay an extra $6,093. Some taxpayers outside these ranges also will have to pay the AMT for the first time. Those who had already been paying the AMT are likely to see their tax bills get worse, as well.

Caught Up in the Fiscal Cliff
Historically Congress has passed periodic fixes--sometimes called "patches"--to help keep many middle-class taxpayers from having to pay the AMT. In fact, since the earliest form of the AMT was enacted in 1969, there have been numerous revisions, including at least 10 in the past decade alone. And, while patching the AMT has become a regular occurrence on Capitol Hill, this year doing so has become part of the larger debate over how to address the fiscal cliff, the collection of federal tax increases and spending cuts set to go into effect Jan. 1. But while most of the fiscal cliff tax provisions pertain to the 2013 tax year, the lack of an AMT patch would be felt early next year as taxpayers prepare their 2012 returns--many of them likely unaware of the AMT's effect on them.

So what's different about the AMT this year that threatens to draw in so many more taxpayers? The problem centers on the fact that the AMT tax structure, unlike the regular income tax structure, is not indexed to inflation. In the past Congress has stepped in to address this problem by raising the AMT exemption and changing other components of the tax. These fixes had the effect of lowering many taxpayers' AMT amounts and thus keeping the taxpayers from having to pay any more than they would under the regular income tax. 

But without a patch for 2012, the AMT exemption and tax credit rules revert to those in place in the year 2000. That means that for married taxpayers the AMT exemption falls from $74,450 last year to $45,000 this year while for singles it drops from $48,450 to $33,750. (This reversion to 2000 exemption levels nearly happened in 2010, as well, but that December Congress patched the AMT for two additional years in the process of extending the Bush tax cuts.)

If all or part of the Bush tax cuts are extended, regular income tax rates will remain where they are, potentially making many more taxpayers vulnerable to an unpatched AMT than would be if the tax cuts expired and rates increased. However, it seems unlikely that Congress would approve the tax cuts without addressing the AMT.

A Complex Calculation
The AMT was designed to prevent taxpayers--the wealthy, in particular--from avoiding paying any income tax. It basically serves as a parallel tax calculation that uses different exemption amounts and is more restrictive with regard to deductions and credits than the standard calculation method. Given the many tax breaks that have been added to the tax code over time, some taxpayers would not be required to pay anything or pay minimal amounts if not for the AMT.

The formula for determining the AMT is complicated but basically begins by calculating one's taxable income without many of the deductions allowed under the regular tax code. (You'll find the IRS' Form 6251 for the AMT here.) This new amount is the alternative minimum taxable income, or AMTI. An AMT exemption amount is then subtracted from the AMTI (this exemption is reduced by 25% for any amount of AMTI above $150,000 for joint filers and above $112,500 for individuals). The AMT tax liability is then calculated by taking the remaining amount and multiplying the first $175,000 (the limit is the same for both single and joint filers) by 26% and anything above that by 28%. Various tax credits may also be applied against the AMT, though many of these have expired for 2012.

If, at the end of this calculation, the AMT owed is greater than the amount owed under the regular income tax formula, the taxpayer must pay the higher AMT amount. It's also worth noting that even taxpayers who don't have to pay the AMT might be affected by it because some personal tax credits are limited to the amount by which the taxpayer's regular income tax liability exceeds what he or she would owe under the AMT.

Characteristics of the Vulnerable
As my colleague Christine Benz wrote in this article, households that make between $150,000 and $500,000are often most vulnerable to the AMT, particularly if they take a lot of deductions, exemptions, and credits that are not allowed under the AMT formula. For example, under the regular income tax code, a taxpayer with a large family would get extra exemptions for each child, but under the AMT he or she gets no additional tax savings as a result of having more dependents. The AMT also does not allow for the deduction of state and local income taxes, meaning that those who live in higher-tax areas are more at risk. Other deductions, including property taxes, interest on home-equity loans (if the loan is not used for home improvements), and investment-related expenses also are not deductible under the AMT.

In addition to missed deductions, people can get pushed into the AMT column by having income from certain sources. For example, incentive stock options are a common trigger of the AMT. That's because, unlike the regular income tax, the AMT factors in any increase in the value of those options from the grant price to the price of the stock when the options are exercised. Income from private activity bonds also is taxable under the AMT but not under the regular income tax.

Permanent Fix Would Be Costly
So why not just index the AMT to inflation and solve this mess once and for all? Because doing so would cost the government money in the form of lost revenue. The Congressional Budget Office estimates that indexing the AMT to inflation would cost $804 billion during the next 10 years, and that's if the Bush tax cuts are allowed to expire. Extending the Bush tax cuts adds another $920 billion to that initial $804 billion cost of indexing the AMT to inflation, according to the CBO, for a total price tag of $1.7 trillion. As you can see, the fates of the tax cuts and the AMT are inextricably linked.

It's hard to envision Congress and the president allowing an eight-fold increase in the number of taxpayers falling subject to the AMT, but it is possible. Experts, including acting IRS commissioner Steven Miller, say the matter is among the most urgent components of the fiscal cliff because it affects tax returns that are due in April. In a letter to the Senate Finance Committee, Miller said that failure to patch the AMT by the end of this year could delay the processing of millions of tax returns and the issuing of some refunds.