Tax aimed at rich is bane of many middle-income taxpayers

Author: Susan Feyder

Published: March 27, 2005

A tax aimed at the rich is now the bane of a growing number of middle-income taxpayers.

A retired widow with $25,000 in income from Social Security and investments who sold stock to meet living expenses had to fork over an extra $381 to the state of Minnesota after her home mortgage and charitable contributions were disallowed. A married couple who operate their own small business with an adjusted gross income of less than $75,000 saw their state tax bill rise from $2,824 to $4,686.

The culprit: the alternative minimum tax (AMT), a federal and Minnesota law that's taking a maximum tax bite out of an increasing number of Minnesotans.

Congress established the AMT in the late 1960s as a way to ensure that America's wealthiest couldn't use excessive deductions to escape paying taxes. Until recently, the AMT affected a limited number of taxpayers, with fewer than 3 percent of federal and state taxpayers ensnared by its provisions in 2002.

By 2010 -- barring any changes in the law -- more than one-third of all taxpayers will fall under the AMT's sway. According to the Urban-Brookings Tax Policy Center, nearly 80 percent of taxpayers with adjusted gross incomes of $75,000 to $100,000 will be subject to the federal AMT by 2010.

Taxpayers in relatively high-tax states, including Minnesota, are especially vulnerable to the AMT. The Urban Institute found that Minnesota ranks sixth among states in the proportion of filers who pay the federal AMT. And because Minnesota has its own version of the AMT, some residents are finding themselves subject to a double dose of higher-than-expected taxes.

This year about 56,000 Minnesota taxpayers can expect to have to pay the state AMT, up 27 percent from last year. By 2006, the number is expected to rise to more than 80,000.

"The net is getting tighter," said David Prem, a St. Louis Park tax preparer who, until recently, never had to calculate an AMT during the 13 years he has been filing clients' returns. "Once you're in it, you're in it year after year," he said.

How did a tax law designed to catch the ultra-rich work its way down to the middle class?

Unlike the standard income tax, the AMT has not been indexed for inflation. Thirty years of rising incomes means more people are subject to the AMT provisions, even though the cost of living also has gone up during those 30-plus years.

Federal tax cuts enacted in the past couple of years have lowered taxes for some people but increased the number subject to the AMT.

While the federal AMT generally permits a larger exemption and features a lower marginal tax rate, it disallows a variety of standard deductions, including those for children, some work-related expenses, state and local income taxes and property taxes.

Tax preparers must calculate tax liability under both the regular and AMT systems, and the higher bill is the one clients must pay.

Minnesota's AMT roughly follows the federal AMT with some key differences. The federal AMT allows deductions for home mortgage interest and all charitable contributions, while Minnesota's version excludes mortgage interest payments and limits charitable donations to anything over 1 percent of the filer's adjusted gross income.

Unlike the federal AMT, the Minnesota AMT disallows deductions for gambling losses that offset winnings and casualty losses on income-producing property. The standard deduction on the state AMT is not indexed for inflation and also is lower than the federal AMT's standard deduction.

As a result, in some cases the state AMT is creeping up faster and taking an even bigger bite out of middle-income taxpayers than its federal counterpart, something that was all but unheard of years ago.

Those differences have made reform of the state AMT "the No. 1 lobbying effort" of the Minnesota Society of CPAs, according to Jim Daleiden, an Edina CPA who is heading the organization's task force assigned to the issue.

Daleiden said his group is working with the legislature on measures that would boost the standard deduction and allow deductions for home mortgage interest and all charitable contributions. Although Gov. Tim Pawlenty has not included AMT reform in his tax proposal, House Tax Committee Chairman Phil Krinkie, R-Shoreview, said he is hopeful that the governor would sign a reform bill. Similar proposals last year did not make it past the conference committee, Daleiden said.

Meanwhile, Nate Wenner, a financial planner at Wipfli Hewins Investment Advisors in St. Paul, said people should keep these things in mind as they try to reduce the bite of the state and federal AMTs:

? Some strategies that reduce regular income taxes, such as deferring income and accelerating expenses in a given year, can push you into the AMT. Remember that the more ordinary income you have relative to your deductions, the less likely you'll be subject to the AMT.

? Postponing estimated state and local income tax payments, especially if you expect your income to rise, may help you avoid the AMT.

? Plan carefully if you exercise stock options. The spread between the exercise price and market price is taxed for AMT purposes.

Tax preparation software automatically calculates whether a person is subject to the state or federal AMT. People who do their own taxes can use an online calculator: H&R Block has one on its website, hrblock.com , to help determine whether they must pay an AMT.