A Creeping Disaster

By Terence K. Heaney, CPA, JD, LLM, and Kenneth J. Chin, CPA

February 14, 2006

When the alternative minimum tax (AMT) was originally enacted in 1969, the intent was to assure that the highest of high earners would pay their fair share of taxes. Unfortunately, these provisions are now encroaching on a vast number of taxpayers. Except for some temporary relief recently passed by Congress, the AMT could affect 19 million Americans in the year 2006, and as many as 30 million Americans by the year 2010. Not only is this provision producing an unfair burden on an expanded group of taxpayers, but it is also complex and difficult to understand.

The original concept behind the AMT has been lost. It now affects middle-income taxpayers with large families, penalizes average taxpayers for their state and local taxes and residential mortgage interest payments, and burdens individuals with high medical expenses. This problem is exacerbated by the fact that the exemptions granted under the AMT have not been adjusted for inflation. Bracket creeping and a rise in two income households have expanded the number of individuals affected by the AMT.

The average American neither understands nor is even aware of the AMT. Therefore, expect to see numerous tax returns filed in 2006 and beyond that may be subject to the AMT, and taxpayers will not even be aware of the problem. They will receive notices of tax deficiencies in the mail, and their attempts to address the inquiries will further clog the IRS's already strained capability for handling the administrative aspect of tax collection.

The AMT issue is exacerbated in Pennsylvania by the high local tax structures in many communities. High real estate taxes and high state and local income taxes substantially increase the possibility that Pennsylvania taxpayers will be subject to AMT.

Correcting the creeping crisis of the AMT is not easy. Based on the mandate that requires Congress to balance the budget, elimination of the AMT can occur only if alternative proposals are introduced to raise revenues. Unfortunately, we have to be careful for what we wish for because we are liable to get something far more onerous.

One of the current proposals in Congress to remedy the expansion of the AMT is to eliminate the deduction for state and local taxes and mortgage interest payments. This would have a far greater impact than the AMT that currently exists. It will effectively alienate most homeowners and places a difficult burden on state and local governments who are trying to raise revenues in an atmosphere where no deductions would be permitted for these tax expenses.

Any solution, unfortunately, is going to be complex. However, there are several steps that should be adopted that will help minimize the impact of the AMT. Some of the suggestions that should be considered are as follows:

• Eliminate state and local income and other taxes as add-back items when computing AMT
• Eliminate the standard deduction, miscellaneous itemized deductions, and personal and dependency exemptions as adjustments in calculating the alternative minimum taxable income
• Increase and index the AMT brackets and exemption amounts, and eliminate phase outs
• Establish a basis floor for adjusted gross income before subjecting a taxpayer to the AMT
• Lower the AMT rate to a rate below the regular tax rate
• Allow certain tax credits for purposes of computing the AMT, such as the low income housing credit and tuition tax credits
• Expand the capital loss limitation rules when calculating AMT associated with incentive stock options
• Change the definition of "qualified housing interest" and allow all deductible residence interest as a deduction for purposes of computing the AMT.

Congress should realize that paying high state income taxes, having a large family, and purchasing a home with a mortgage are not tax shelters, so these variables should not be penalized. The provisions of the AMT computations should be reviewed to include a higher level of fairness. The AMT provisions of the Internal Revenue Code should be modified to ensure that they meet the original purpose of taxing high-income individuals who do not pay taxes, and not middle-income individuals who pay their fair share.