By James J. Maroney, Timothy J. Rupert, and Carol M. Fischer
A Case of Unintended Consequences
In his testimony to the House Ways and Means Oversight Subcommittee in May 1999, David A. Lifson, chair of the AICPA Tax Executive Committee, indicated that many anecdotal examples show how middle-income taxpayers may be subject to the alternative minimum tax in the next several years.
A comprehensive analysis demonstrates that the potential effects of the AMT system on different groups of middle-income taxpayers are not isolated horror stories. A closer look reveals that the unintended consequences of imposing the AMT on those with annual incomes of less than $100,000 are very real. By understanding which groups of middle-income taxpayers are most affected by the AMT system, taxpayers and their advisors can identify the hazards and prepare for the AMT's toll.
This article illustrates, by income level, filing status, and family size, the groups of middle-income taxpayers most susceptible to the AMT in 1999. It also provides policy recommendations to alleviate the detrimental effects of the AMT system on middle-income taxpayers. Ultimately, this type of information may also contribute to more effective tax legislative policy.
Even though Congress proposed full repeal of the alternative minimum tax (AMT) last year, the Republicans and Democrats could not create a bill that would have won the President's signature. Consequently, the Tax Relief Extension Act of 1999 includes no major changes to the AMT system. Unless the two parties can compromise on tax legislation, the detrimental effects of the AMT system on middle-income taxpayers will only worsen.
The AMT was intended to affect higher income taxpayers. The following quote from the Senate committee reports in 1986 describes the legislative rationale for the AMT:
The committee believes that the minimum tax should serve one overriding objective: to ensure that no taxpayer with substantial economic income can avoid significant tax liability by using exclusions, deductions, and credits (Senate Report No. 99-313, 1986-3 C.B. vol. 3, p. 518).
The instructions for Form 6251, Alternative Minimum Tax: Individuals, are clear:
The tax laws give special treatment to some types of income, allow special deductions for some types of expenses, and allow credits for certain taxpayers. These laws enable some taxpayers with substantial economic income to significantly reduce their regular tax. The AMT ensures that these taxpayers pay at least a minimum amount of tax on their economic income.
Nonetheless, the courts have been unwilling to rule that middle-income taxpayers are entitled to relief from the AMT. Congress's failure since 1986 to adequately revise the AMT system has created a situation in which an increasing number of middle-income taxpayers, including those that have only personal exemptions and take the standard deduction, will be subject to an AMT liability for 1999 and following years until the law changes.
Growth of the AMT System
Relatively few taxpayers were affected when the AMT was first established by the Tax Reform Act of 1986. However, Exhibit 1 shows that the number of taxpayers subject to AMT grew from 87,893 in 1988 to 590,649 in 1997--a 572% increase. The tax revenues generated by the AMT system during this 10-year time period have also grown, from approximately $711 million to approximately $3.5 billion--a 392% increase.
Absent modifications to the AMT system, the rapid growth in both taxpayers subject to the AMT and tax revenues generated by the AMT will probably accelerate. For example, in 2006, a projected 6.2 million taxpayers will have a tax liability under the AMT. Many of these taxpayers will probably be middle-income taxpayers with no tax preference items within the meaning of IRC section 57.
Lacking a generally accepted definition of a middle-income taxpayer, this analysis of the AMT system focuses on taxpayers with adjusted gross incomes (AGI) under $100,000, from 1988 to 1997. During this 10-year period, the number of taxpayers subject to the AMT with AGI under $100,000 quadrupled, from 39,351 taxpayers in 1988 to 160,709 in 1997. But these numbers are relatively small compared to the explosive growth that may occur in the future, a primary factor being the failure to index the AMT exemption amount for inflation. In addition, because the AMT exemption amount is not adjusted for family size, taxpayers with large families are more likely to have an AMT liability.
How Inflation Affects AMT Exemption Amounts
The Table shows the AMT exemption amounts set by the Tax Reform Act of 1986. They have been adjusted only once, as shown, for tax years beginning with 1993.
If the exemption amounts had been indexed for inflation beginning in 1987, they would now be approximately as shown in the last column. Thus, the exemption amounts would be $14,400 higher for married filing jointly status, $10,850 higher for single or head of household status, and $7,200 higher for married filing separately status if they had been indexed for inflation. The exemption amounts are reduced if the taxpayers' alternative minimum taxable income exceeds a threshold amount.
The calculations are based on data from the Consumer Price Index--All Urban Consumers (CPI-U), which is the basis for indexing a number of tax provisions subject to inflation adjustments (e.g., standard deductions and personal exemptions).
Upping the AMT Ante for Middle-Income Taxpayers
The following analyses assume that the middle-income taxpayers in question do not have any tax preferences within the meaning of IRC section 57 and, therefore, would not be expected to be subject to the AMT.
Taxpayers Using Standard Deduction. Determining whether a middle-income taxpayer using the standard deduction will be subject to an AMT liability requires knowing the taxpayer's filing status and number of dependents.
Exhibit 2 shows, by filing status, the number of dependents that cause head-of-household and married-filing-jointly taxpayers using the standard deduction to be subject to the AMT system. Single and married filing separately status taxpayers are not shown because single taxpayers will probably not have enough dependents to make them subject to an AMT liability, and married taxpayers filing separately would probably not use the standard deduction.
Exhibit 2 shows that a single parent filing as head of household is most susceptible to the AMT system. For example, head-of-household taxpayers with AGI of $52,37567,200 are subject to the AMT system if they have four or more dependents. Example 1 in Exhibit 3 calculates the effects of the AMT system on a taxpayer filing as head of household with four dependents and an AGI of $55,000. The tax liability of this hypothetical taxpayer would increase by $244 due to the AMT system.
Exhibit 2 also shows the number of dependents that will cause married filing jointly taxpayers using the standard deduction to be subject to the AMT. Middle-income taxpayers with AGI of $66,550100,000 are susceptible to the AMT. Taxpayers in this income range with six or more dependents will be subject to the AMT. For example, a married-filing-jointly couple with six dependents, AGI of $72,000, and using the standard deduction would have a $600 increase in their tax liability due to the AMT system.
Taxpayers Itemizing Their Deductions. Determining whether middle-income taxpayers that itemize their deductions will be subject to an AMT liability requires knowing the filing status, number of dependents, and type and amount of itemized deductions. Medical expenses are excluded from the exercise because the deduction is rarely available. For purposes of this discussion, it is assumed that the middle-income taxpayer would have itemized deductions for interest expense, taxes, and miscellaneous expenses. An average percentage was calculated and used to compute the amount for each deduction based on recent IRS data. The percentages, based on the average deduction for U.S. taxpayers within the $50,00075,000 and $75,000100,000 income ranges, simulate the average itemized deductions for a middle-income taxpayer.
Exhibit 4 shows, by filing status, the number of dependents that cause average middle-income taxpayers itemizing their deductions to be subject to the AMT. Because a single taxpayer would probably not have several dependents, the data are presented for head-of-household, married-filing-jointly, and married-filing-separately taxpayers.
Taxpayers that itemize deductions and file as head of household or married filing separately are most susceptible to the AMT system. Exhibit 4 also shows the number of dependents that will cause an average U.S. married couple filing jointly to be subject to the AMT.
The average taxpayer with four dependents that itemizes and files as head of household will be subject to the AMT system in 1999. Some of these taxpayers will be subject to the AMT system with as few as three dependents (AGI of $82,700100,000).
The average middle-income, married-filing-separately taxpayers are subject to an AMT liability if they have two dependents. Exhibit 4 also shows that for married-filing-jointly taxpayers the income level most susceptible to AMT is AGI of $77,450100,000. Average taxpayers in this income range are subject to the AMT system if they have five or more dependents.
As shown in Example 2 in Exhibit 3, a middle-income taxpayer that itemizes deductions, files as head of household, and has four dependents would have a $625 increase in tax liability due to the AMT system, primarily because of the add-back of taxes and miscellaneous expenses for AMT purposes.
The add-back of taxes in determining AMT income is particularly damaging in high tax states, such as New York and California, where taxpayers are more likely to incur an AMT liability.
Exhibit 5 uses the percentages for itemized deductions based on New York State data supplied by the IRS. Taxpayers that itemize their deductions and file as head of household or married filing separately are most susceptible to the AMT system. The average New York State taxpayer filing as head of household is subject to the AMT system in 1999 if he or she has three dependents, with some of these
taxpayers subject to the AMT system with as few as two dependents ($88,750100,000). The average married-filing-separately New York State taxpayer will be subject to the AMT system in 1999 if she has two dependents, with some of these taxpayers subject to AMT if they have only one dependent. Exhibit 5 shows that married-filing-jointly New York State taxpayers with AGI of $77,050100,000 are subject to the AMT system if they have four or more dependents.
The Single-Parent Trap
Exhibits 4 and 5 show that single parents filing with head of household status and married taxpayers filing separately are most likely to be ensnared by the AMT system, especially in a high tax state such as New York.
A middle-income taxpayer may also be subjected to the AMT system if the amount or type of itemized deductions varies from the average amount used for Example 2 and Exhibits 4 and 5. As the amount of deductions such as taxes, medical expenses, and miscellaneous expenses increases, a liability under the AMT system is more likely because under IRC section 56 these deductions are an add-back to arrive at AMT income.
Additional analysis shows that middle-income taxpayers with head-of-household or married-filing-separately status are most susceptible to AMT. In fact, even if taxes and miscellaneous expenses do not vary from the average, a married-filing-separately taxpayer with two dependents is likely to incur an AMT liability in 1999. Once taxes and miscellaneous deductions vary from the average by 35% (as low as 20% at certain income levels), a taxpayer with two dependents and AGI of $65,000 or more that files as head of household is likely to be subject to AMT in 1999.
The percentages are much higher for married couples filing jointly. For example, if a married couple has two dependents and AGI of $75,000, taxes and miscellaneous expenses have to vary from average by 115% before the couple is subject to AMT. The percentages decline as AGI rises, so a similar couple with AGI of $95,000 is likely to be subject to AMT if their taxes and miscellaneous expenses vary from the average by 55%.
A single taxpayer's deduction for taxes and miscellaneous expenses must vary significantly from average before triggering AMT. For example, the deduction for taxes and miscellaneous expenses of a single taxpayer with AGI of $75,000 must vary from the average by 145% before being subject to AMT.
Can We Correct the Inequities of the AMT System?
The primary factors that cause a middle-income taxpayer without preference items to have an AMT liability are a large family or above-average IRC section 56 adjustments (e.g., taxes and miscellaneous expenses).
Single parents filing as head of household and married taxpayers filing separately are most likely to have an AMT liability in 1999. These taxpayers are likely to incur AMT liability if their family size is moderately large or if their taxes and miscellaneous expenses slightly exceed the average deduction amounts for head of household filing status (e.g., as low as 20%) or are equal to the average for married taxpayers filing separately. While married couples filing jointly are less likely than head-of-household or married-filing-separately taxpayers to incur an AMT liability, many taxpayers in this group will be subject to the AMT system as well.
Congress probably never intended to create a tax system that penalizes large families, single parents filing as head of household, married taxpayers filing separately, or place of residence. But such are the unintended effects of the AMT system. Several groups have recommended repeal of the AMT, but this may not be possible due to the revenue loss and the current political climate.
To rectify the inequities that the AMT system has created, Congress should consider the following proposals:
* Index the AMT exemption amounts for inflation.
* Eliminate personal exemptions as an adjustment to regular income in arriving at AMT income.
* Eliminate itemized deductions as an adjustment to regular income in arriving at AMT income.
* Allow the education and child credits as permanent offsets to the AMT rather than continuing to revisit the issue.
The AICPA made similar proposals during testimony before the House Ways and Means Oversight Subcommittee in May 1999. These recommendations would exclude most middle-income taxpayers from the AMT system, unless they have tax preference items within the meaning of IRC section 57. The potential revenue loss to the government would be minimal because only a small portion of the revenues raised by the AMT system are from such taxpayers (approximately 10% in 1997). In addition, the change would substantially reduce the complexity of the tax system.
Finally, and most importantly, excluding most middle-income taxpayers from the AMT system would enhance perceived equity--middle-income taxpayers never were the intended targets of this tax. *
James J. Maroney, PhD, CPA, and Timothy J. Rupert, PhD, are assistant professors at Northeastern University.
Carol M. Fischer, PhD, CPA, is an associate professor at Saint Bonaventure University.
The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.
©2006 CPA Journal. Legal Notices
Visit the new cpajournal.com.