Income tax cut? U.S. law has an alternative

Minimum levy, More families abroad are liable

Author: Barbra D. Murray

Published: October 25, 2002

WASHINGTON A growing number of Americans at home and abroad who were looking forward to a reduction in their federal income tax are finding themselves largely cut out of the bonanza engineered by President George W. Bush because of a long-standing and not widely understood "class tax" that Congress left on the books. Hidden amid the hoopla of the Bush tax-cut package was a dirty little secret: the alternative minimum tax, which renders much of the promised tax cut moot.

The AMT comes into play when a person's tax bill, after deductions, falls too low relative to his income. It is calculated after disallowing many deductions that taxpayers take for granted, including the foreign tax credit. On the books since 1969, the AMT was originally intended to prevent wealthy taxpayers from cleverly using deductions to reduce or eliminate their tax obligation. (Congress discovered at the time that 155 families with incomes over $200,000 were left without a single dime of taxes to pay after calculated adjustments.)

But because the threshold for eligibility was not indexed for inflation, the definition of "wealthy" has not kept up with the times, and now more and more people are falling under the AMT definition. According to a recent study by the Urban-Brookings Tax Policy Center, a joint effort of two Washington think tanks, the Urban Institute and the Brookings Institution, about 3 percent of filers with household incomes between $75,000 and $100,000 found themselves facing the AMT this year, and 78.6 percent of all filers will face the AMT come 2010 (including 40 percent of households with annual earnings between $50,000 and $75,000).

Under AMT guidelines, for example, taxpayers may not take a deduction for state income taxes or interest on a home equity loan (if part of it was not used for home improvement), and the AMT allows for no miscellaneous itemized deductions. Americans living abroad, thought of by some in the Treasury as traitors - "economic Benedict Arnolds," as one official put it, evoking the name of the American Revolutionary traitor - will fare no better than domestic taxpayers. Normally, Americans abroad may claim a credit on taxes they pay to their host country, thereby avoiding double taxation, which certain treaties seek to prevent. But AMT rules allow a credit of only 90 percent of foreign taxes paid, thereby ensuring that some U.S. tax will always be due, even if the foreign tax bill exceeds what a domestic taxpayer would have paid on the same income.

"You are guaranteed to be double-taxed on a portion of the foreign income that gets you into the AMT range," noted Andy Sundberg, a founding member of American Citizens Abroad and the director of the organization's Geneva branch.

Figures provided by PricewaterhouseCoopers illustrate the situation of a hypothetical expatriate American married couple with two children and an annual income of $200,000. If the family lived in the United States they would pay roughly $47,000 in federal income tax. But as expatriates in Britain, they would be liable for about $70,000 in British income tax. Normally the credit on British tax paid ($70,000) would more than offset what would have been owed Uncle Sam ($47,000). But under AMT rules, the family would be assessed a further $1,500 in U.S. income tax, for a total tax bill of $71,500.

So while the Bush administration's sweeping income tax reduction package does reduce regular taxes, an increasingly large portion of the population will not fully benefit from those reductions. Many taxpayers who thought they would be in for a cut in taxes via such breaks as the child tax credit, the child and dependent care tax credit, or marriage-penalty relief will find themselves thrust into a category that forces them to pay the AMT.

Representative Richard Neal, a Democrat of Massachusetts who is a member of the House Ways and Means Committee, said, "There are unintended consequences that have developed" because the AMT "was never indexed for inflation. The problem you have with it is that it costs more to fix year after year, so that the mentality in Congress has been to postpone action on it. But by postponing action you only aggravate the cost."

Indexing the AMT for inflation would lead to a 70 percent decrease in the population falling under that taxpaying category in 2010, the Urban-Brookings study said. However, that procedure would cost an estimated minimum of $440 billion through 2012.

"I think that it is a refusal to bow to reality," Neal said of the administration's inaction. "But people are going to start to fall into this trap of AMT, and I think they are about to become very angry citizens."

Those on the ground floor of crafting and monitoring tax policy in the Bush administration, as well as congressional leaders, are aware of the problem. In recent years the Department of the Treasury has published research with findings similar to those of the Urban-Brookings study. "Treasury is actively seeking to find potential solutions to mitigate these problems of the AMT in the future," said the assistant secretary for tax policy, Pamela Olson.

No one on either side of the political fence has come out openly in defense of the AMT as it currently exists. "It is a country-wide, system-wide problem, and we need to address it," Representative William Thomas, a Republican of California, said in April. Thomas is chairman of the House Ways and Means Committee and vice chairman of the congressional Joint Committee on Taxation.

"To fix the individual alternative minimum tax," he said, "it takes about $0.5 trillion. And if we don't begin addressing it, over the next five years it will take three-quarters of a trillion, and you can see what happens with the math."

The failure to address the issue before now, according to Michael Jones, executive director of Republicans Abroad, has more to do with the Democrats' desire to please the lower-income crowd than with the Bush administration's reluctance to confront what would be a multibillion-dollar correction to the AMT system.

"If you're a member of Congress and you're representing a blue-collar constituency, to be arguing on behalf of people who simply make $175,000 a year doesn't play well with the constituents," he said. "But nobody who's representing overseas Americans feels that the AMT is O.K. There are 4 million Americans overseas, which is larger than the individual populations of 24 states. It does represent a broad group of folks, and these folks are out there selling American products and goods, which creates jobs back at home."

Several bills are pending, both Republican and Democratic, that would address the problem. Among them are the Republican-sponsored Real AMT Relief Act of 2001, which would repeal the AMT on individuals, and an untitled Democratic-led House Resolution that would allow state and local taxes - but no provision for foreign taxes - to be deducted in computing the alternative minimum tax. For those living abroad, there is a Republican-sponsored item calling for the repeal of the 90 percent limitation on foreign tax credits under the alternative minimum tax.