Alternative minimum tax, personal

From the NTA Encyclopedia of Taxation and Tax Policy

David Weiner
Congressional Budget Office

An additional tax paid by some individuals that can result from the use of certain tax preferences. (See also alternative minimum tax, corporate.)

The personal alternative minimum tax (AMT) requires individualsto calculate their income tax a second way, differently from the regular income tax. Separate tax rates and definitions of taxable income apply in both of these tax systems. The AMT limits the use of certain tax preferences, or exceptions to a comprehensive measure of income. A taxpayer’s final liability is the greater of the tax liabilities calculated under the regular tax system and the AMT system. The AMT is defined as the amount by which the tax calculated under the broader AMT base, the tentative minimum tax, exceeds regular tax liability. The AMT can also increase taxes by limiting the use of certain tax credits. The tax base under the AMT is broader than that under the regular tax, and the top marginal tax rates are lower than under the regular tax. While few taxpayers currently pay the AMT (as of 2004), the number of taxpayers it affects and the dollars collected from it are expected to grow unless it is reformed to mitigate the effects of inflation and scheduled reductions in the regular income tax.

History of the AMT

The AMT has its origins in the "add-on" minimum tax, which was first introduced into the tax system in 1969. Unlike the dual tax systems of the AMT, the minimum tax was a separate tax in which a flat 10 percent rate was applied to certain tax preferences in excess of an exempted amount of $30,000. A taxpayer’s total liability was the sum of the regular tax and the minimum tax. The minimum tax was introduced to collect taxes from wealthy individuals who paid little or no tax because they took advantage of tax preferences to reduce their taxable income. The minimum tax was strengthened in 1976 when the exemption amount was changed to the greater of $10,000 or half the taxes paid under the regular tax. The rate was also increased to 15 percent. The Revenue Act of 1978 introduced the AMT into the tax system, which already had the minimum tax. The preferences for certain itemized deductions and excluded capital gains were moved from the minimum tax to the AMT. By using the AMT rather than the minimum tax, taxpayers only paid additional tax on capital gains income if their AMT exceeded their regular tax liability. Congress anticipated that "capital formation will be facilitated and every individual will pay at least a reasonable amount of tax with respect to large capital gains." The AMT exempted the first $20,000 from tax and had a graduated rate schedule of 10, 20, and 25 percent.

In 1982, Congress repealed the minimum tax and expanded the AMT. Most preference items under the minimum tax were moved to the AMT. The exemption was increased to $30,000 for a single taxpayer and $40,000 for taxpayers filing jointly. A flat rate of 20 percent was applied to alternative minimum taxable income after the exemption was deducted. The next major revision to the AMT occurred with the Tax Reform Act of 1986. Additional preference items were added to expand the AMT base. One of the largest preference items - the excluded portion of long-term capital gains - was eliminated from the regular tax (and thus as a preference under the AMT). The AMT rate was raised to 21 percent, and the AMT exemption was phased out for high-income taxpayers. For each dollar that the alternative minimum taxable income exceeded a specified threshold, the exemption amount was reduced by 25 cents. For taxpayers with large amounts of income, the exemption was completely eliminated. Finally, AMT generated in the current year could in some circumstances be taken as a credit against regular tax liability in future years. In 1990 Congress raised the top marginal income tax rate to 31 percent and the AMT rate to 24 percent. The top marginal income tax rate was increased again in 1993, and a graduated rate schedule of 26 and 28 percent was introduced to the AMT. The exemption amounts were increased to $45,000 for married individuals and $33,750 for unmarried individuals.

The AMT can limit the use of certain tax credits if those credits reduce tax liability below the liability calculated under the AMT. Beginning in tax year 1998, Congress eliminated the AMT’s impact on certain personal tax credits (e.g., child credit, earned income credit, education credits, dependent care credit). As of 2004, the use of all personal credits against the AMT had not been extended permanently.

In 2001, in conjunction with reductions in regular tax rates, Congress raised the AMT exemption amounts. For tax years 2001 and 2002, the exemption amount was raised to $49,000 for married individuals and $35,750 for unmarried individuals. For tax years 2003 and 2004, the amounts were raised to $58,000 for married individuals and $40,250 for unmarried individuals. As of July 2004, the exemption amounts are scheduled to go back down to their pre-2001 levels beginning in tax year 2005.

Growing impact of the AMT

Two factors are expected to increase the number of taxpayers the AMT affects and the amount of revenue it generates. First, inflation causes an increasing number of taxpayers to be affected by the AMT because the parameters of the regular tax are indexed for inflation and the parameters of the AMT are unindexed. If a taxpayer’s income grew only at the rate of inflation, indexing parameters under the regular tax prevents tax rates from rising (see inflation indexation of income taxes). However, because AMT parameters are unindexed, inflation causes a taxpayer’s tax rate under the AMT to rise over time. Therefore, taxes under the AMT will grow more quickly than under the regular tax, and more and more taxpayers will become subject to the AMT.

Reductions under the regular income tax can also cause more taxpayers to be affected by the AMT, unless the AMT parameters are adjusted to reduce this effect. The Economic Growth and Tax Relief Reconciliation Act of 2001 along with the Jobs Growth and Tax Relief Reconciliation Act of 2003 enacted a series of tax reductions that will be phased in over 10 years through 2010. As of 2004, these tax reductions are scheduled to expire after 2010. Both of these acts raised the AMT exemption level but neither extended the higher levels permanently.

The combination of inflation and the phased-in tax reductions is expected to increase the number of returns the AMT affects from fewer than 5 million in 2002 to about 30 million in 2010. The amount of additional revenue the AMT generates is expected to grow from under $10 billion in 2002 to about $90 billion by 2010. These estimates are based on the laws scheduled to be in effect in 2010 (as of 2004) and assume that the AMT parameters remain at their currently scheduled pre-2001 levels in 2010. Under current law, the tax cuts enacted in 2001 and 2003 are scheduled to expire at the end of 2010, reducing the impact of the AMT beyond that year. However, even if the tax cuts are not extended, inflation will continue to drive more and more taxpayers onto the AMT as long as the AMT parameters remain unindexed.

Tax preferences

Tax preferences are exceptions to a comprehensive measure of income under an ideal income tax. The items considered tax preferences for purposes of the AMT have changed over time. These preferences are items that can be excluded from regular taxable income or deductions allowed under the regular tax that would not be allowed under a comprehensive income tax. Not all tax preferences are included in the AMT, and the list has changed over time. The preferences described below are among those included under the tax law in effect in 2004.

The use of exemptions and deductions is limited under the AMT. While the AMT has its own exemption level, it does not allow deductions for personal exemptions or the standard deductions allowed under the regular tax. Some itemized deductions, including miscellaneous itemized deductions and deductions for taxes paid, are completely disallowed. Others are more limited. For example, medical deductions are allowed only to the extent that they exceed 10 percent of adjusted gross income, compared with 7.5 percent under the regular tax. Deductions for investment interest and home mortgage interest are subject to separate rules under the AMT, which can reduce the size of the deduction compared with the regular tax. The itemized deductions allowed under the minimum tax are not, however, subject to the itemized deduction limitation that applies to higher income individuals under the regular tax.

Many of the other preferences under the AMT are associated with the timing of income and deductions for investors in noncorporate businesses. Deductions for depreciation of equipment, oil depletion allowances, allowances for intangible drilling costs, or mining exploration and development costs are allowed at a slower rate under the AMT than under the regular tax. The difference between deductions allowed under the regular tax and the AMT is included in the alternative minimum taxable income.

Other examples of timing preferences include deductions associated with a financial institution’s bad debt, deductions for newspaper circulation expenses, deductions for research and experimentation expenses, and the use of the "percentage-of-completion" or the "installment" methods of accounting. It is these timing preferences that generate credits that can be taken against future regular tax liability.

The AMT has grown beyond its original intent

The minimum tax and the AMT were originally designed to ensure that wealthy individuals pay some income tax. These individuals would not be able to avoid paying income taxes through the use of certain tax preferences or tax shelters. Aside from a general sense of fairness, it has been argued that overall confidence and compliance with the tax system could be undermined if nonwealthy taxpayers feel that wealthy taxpayers pay little or no income tax. The AMT improved on the design of the original minimum tax by taxing only excessive use of tax preferences and not the use of any one preference.

Largely because it is unindexed, the AMT has gone beyond its original intent and now affects taxpayers other than those wealthier taxpayers who pay no income tax. As currently structured, most taxpayers affected by the AMT are subject to it because they have large families, take the standard deduction, or live in jurisdictions with higher taxes. While the AMT still limits the use of certain preference items not available to many taxpayers, the preference items putting most taxpayers on the AMT are the basic parameters of the regular tax - the standard deduction, the personal exemption, and the lowest marginal tax rate brackets.

The AMT has been partially successful in ensuring that wealthy taxpayers pay some income tax. In 2001 nearly 1,100 tax filers with AGI over $500,000 paid some income tax because of the AMT. However, nearly 900 filers in that range paid no federal income tax despite the presence of the AMT. In general, the reach of the AMT does not currently extend to lower-income taxpayers or the highest-income taxpayers. Of the more than one million returns paying AMT in 2001, over 80 percent reported adjusted gross incomes between $75,000 and $500,000. The AMT exemption prevents most lower-income taxpayers from being affected. Most of the highest-income taxpayers do not pay AMT because more of their income is taxed at the top marginal rates under the regular income tax; this makes their regular tax liability higher than that calculated under the AMT, which has lower marginal rates.

The AMT does limit the advantage of certain tax preferences for some taxpayers and does subject some wealthier filers to tax, but it is not without cost. A growing number of taxpayers have become subject to the AMT, and many taxpayers beyond those affected must do the calculations for the AMT. These additional calculations add significantly to the complexity of the tax system, requiring more time for preparing tax returns and making the income tax less transparent for those affected.

Several options have been suggested for reducing the growing impact of the AMT. The options include indexing the basic AMT parameters for inflation and eliminating some of the preference items affecting most taxpayers (e.g., the personal exemption, standard deduction, or state tax deductions). Some proponents of reform have proposed the complete repeal of the AMT. Under current law, the AMT is expected to generate a significant amount of revenue; therefore, repeal or reform could be costly. To the extent that AMT reform requires an increase in other taxes, the benefits of reform should be weighed against the impact of policies that offset the revenue losses.

ADDITIONAL READINGS

• Burman, Leonard E., William G. Gale, Jeffrey Rohaly, and Benjamin H.Harris. "The Individual AMT: Problems and Potential Solutions." National Tax Journal 55, no. 3 (September 2002): 555-96.
• Feenberg, Daniel R., and James M. Poterba. "The Alternative Minimum Tax and Effective Marginal Tax Rates." National Tax Journal 57, no. 2 (June 2004): 407-27.
• Harvey, Robert P., and Jerry Tempalski. "The Individual AMT: Why It Matters." National Tax Journal 50 (September 1997): 453-74.
• Rebelein, Robert, and Jerry Tempalski. "Who Pays the Individual AMT." OTA Working Paper No. 87. Washington, DC: U.S. Treasury Department, 2000.
• U.S. Congressional Budget Office. The Alternative Minimum Tax. Washington, DC: U.S. Congressional Budget Office, 2004.