The President's Tax Reform Panel is expected to report soon with a recommendation (among others) that Congress abolish the alternative minimum tax (often referred to as the "AMT") applicable to individual taxpayers. The AMT is a significant part of our federal tax system set out in sections 55-59 of the tax code. In a few years, it is projected to cost more to repeal the AMT than to repeal the regular income tax. Burman et al, The AMT: Projections and Problems, 100 Tax Notes 105 (July 7, 2003). So it is an issue that merits consideration and understanding.
Odds are, though, that ordinary Americans do not know much about the AMT--either its purpose or its effect. That is because ordinary Americans who earn no more than the average salary generally have not been subject to the AMT except under extraordinary circumstances. If they received a stock option grant shortly before the 2000 crash, they may have had a rude awakening to the power of the AMT when they were forced to pay a tax on gains that were lost as quickly as they appeared. Or if they received an award in a defamation or employment discrimination suit where their attorney worked on a contingent fee basis, they may have had little left after paying the taxes on the part of the award they paid over to the attorney. In most cases, however, ordinary Americans have not been required to pay the AMT.
Why, then, is the AMT a subject of particular interest at this point? The answer is that the tax cuts over the last few years of the Bush Administration, with their focus on reducing rates at the upper end of the income scale, have created an anomaly. The AMT, which originally had a broader base and significantly lower rates than the regular income tax, will increasingly impose higher rates on that broader base for many Americans in the middle-income range. Those taxpayers caught in that AMT trap will therefore be required to pay some additional tax under the AMT. Because of the broader reach, even those who do not have to actually pay more under the AMT will have to expend some considerable effort to determine their potential for AMT liability.
What is the individual AMT? It is essentially a "back-up" tax system that exists alongside the regular tax system. It has flatter rate brackets of 0%, 26%, and 28%. The zero bracket is created by permitting taxpayers an AMT exemption amount based on their status as married or single. There is no separate AMT exemption amount for taxpayers who file as heads of household under the regular tax. The current exemption amounts are $58,000 for married taxpayers and $40,250 for other taxpayers. The first $175,000 of income included in the AMT base above the applicable exemption amount is taxed at a rate of 26%. Any included income above that is taxed at 28%.
The AMT also has a broader tax base than the regular income tax. The AMT base includes more items of income than the regular tax base because of various adjustments and disallowances of the regular tax system's preferential treatment of particular items (referred to collectively as "AMT adjustments"). For example, the AMT disallows any standard deduction or personal exemption that a taxpayer may have taken under the regular tax. The idea here is that the AMT exemption amount substitutes for the various specific deductions as the measure of the taxpayer's ability to pay taxes.
The AMT similarly disallows the various "miscellaneous itemized deductions" that a taxpayer may have been able to take under the regular tax system. Those include, of course, the deduction for attorney fees paid by litigation plaintiffs (who have a corresponding income inclusion for the attorney fee award). The AMT also disallows state and local taxes that are deductible under the regular tax. While the AMT permits a deduction for extraordinary medical expenses, it is more restricted than under the regular tax. It is limited to amounts in excess of 10% of adjusted gross income rather than 7.5%. Gain realized on an incentive stock option exercise is includable in the AMT base for the year of exercise, whereas gain is not taxed in the regular tax system until the stock is sold (if certain requirements for the deferral are satisfied).
Some of the AMT adjustments make a good deal of sense and others do not. None can be understood without considering the overall goals of the tax system and the objectives of the AMT, as evidenced in its origins and in congressional development of a more expansive system.
In a series of future postings, I will explore these questions, as well as the rationales for particular AMT adjustments. I will also describe the fiscal context in which any decision about AMT reform or repeal (as well as other tax reforms) must be made. My goal is to suggest ways that the AMT can be reformed to protect ordinary Americans from its reach while simultaneously making the overall federal tax system more progressive in accordance with the consistent views of U.S. taxpayers.
For readers who prefer a more detailed exposition of these ideas, an introduction is available in my recently published article on this subject: Congress Fiddles While Middle America Burns: Amending the AMT (and Regular Tax), published in 6 Fla. Tax Rev. 811 (2004), available on the SSRN network at http://ssrn.com/author=83521.