Millions of people soon will be fat cats in IRS eyes

Author: David Nicklaus

Published: February 1, 2004

Say you're a married homeowner with four kids living in a high-tax state. Does that make you a fat cat?

A couple of years from now, it will, at least in the eyes of the Internal Revenue Service. If Congress doesn't make some changes, millions of middle-income Americans are about to become familiar with something called the alternative minimum tax.

The AMT, enacted in 1969 to catch rich people who were using loopholes to avoid paying income tax, has become a threat to folks whose only tax shelter is the roof over their heads.

It works like this: First, you calculate your regular income-tax liability. Then, you add certain "preference items" back to your income and calculate your liability under the AMT, which has a flat rate of 26 percent. The higher of the two numbers is what you owe the IRS.

The preference items include some of the favorite tax breaks of the upper classes, like oil-depletion allowances and accelerated depreciation. What's also disallowed under the AMT are the personal exemptions for you, your spouse and your children, as well as the deduction for state and local taxes.

The AMT affected only about 2.4 million people in 2001, but it will hit 12 million people by 2005 and 33 million by 2010 - about one-third of all tax returns.

"It's going to start hitting people it was never intended to hit," said Jeffrey Rohaly, director of tax modeling at the Tax Policy Center in Washington.

The majority of the new AMT victims will be people with incomes under $100,000 a year. Among married couples with two or more children, 85 percent would be subject to the AMT by 2010.

As if paying the tax weren't bad enough, understanding it is a nightmare. The IRS estimates that in 2000, taxpayers spent 29 million hours filling out AMT forms.

How did we get into this fix? Simple: Congress and President George W. Bush cut regular tax rates significantly, but they didn't cut the AMT. Also, the AMT brackets aren't indexed for inflation.

Last year's tax law provided some temporary relief. It increased the standard amount that can be excluded from your income for AMT purposes. That exemption is $40,000 for an individual and $58,000 for a married couple. But the increase was just for last year and this year. In 2005, it drops back to $33,750 for a single person and $45,000 for a couple.

By then, Congress might have a taxpayer revolt on its hands. The taxpayer advocate at the IRS recently called the issue "a time bomb on a short fuse."

"It has finally, just recently, gone on to Congress' and the president's radar screen," said Greg Geisler, assistant professor of accounting at the University of Missouri at St. Louis. "Both had neglected the issue for many years."

But fixing the AMT won't be cheap. Repealing it would cost $660 billion over the next 10 years, Rohaly estimates, and that's assuming the 2001 tax cuts expire as scheduled. If those cuts are extended, as Bush wants, then killing the AMT would cost $1.1 trillion.

Even a modest fix, indexing the AMT for inflation and allowing an exemption for children, would cost $450 billion over 10 years.

The Tax Policy Center suggests recouping some revenue by making capital gains subject to the AMT. That would take the AMT back to its original mission of soaking the rich, but it would be a tough sell for the Bush administration, which made a lower capital-gains rate the centerpiece of last year's tax cuts.

"There is no easy solution," Rohaly said.

Still, doing nothing isn't an option. The AMT makes our tax system needlessly complex, and it's about to impose a stealth tax increase on millions of middle-income Americans.