The Alternative Minimum Tax

ABOUT THE AMT

I was talking with a close acquaintance who has a CPA and a background in finance. He had fallen behind in his tax preparation work and had just completed all the information needed for his tax return, including the complexities of accounting for his wife’s small business. He was talking about the various deductions, exemptions, etc… that he received and then I told him that he was wrong about most everything. Why was he wrong?

It was because of the AMT.

What is the AMT? The AMT stands for the “Alternative Minimum Tax”. It runs in parallel to the current Federal tax code. After you calculate your standard tax liability (what you owe), you also run the AMT calculations, and then if the AMT amount is HIGHER, then the higher number becomes your new tax liability.

You never win with the AMT.

The background on the AMT is that in the past there were many rich people who used various loopholes, tax shelters and tax strategies to minimize to their taxes to the extent that they didn’t owe any money. Note that this was a prodigious feat; in the past tax rates were much higher than they are today.

Thus for the AMT they started with a much simpler model – they basically took your gross income (not your net income) which is relatively straightforward for most individuals (i.e. how much cash you brought in), picked a lower tax rate than the Federal “standard” rate, applied a (very) few deductions, and recalculated your tax liability. If this number was higher, you pay the higher amount (the AMT amount).

The following AMT example is simplified but pretty close for most people:

- take your gross income (from your W2)
- use the AMT exemption
- you get a deduction for mortgage interest
- there are a few other deductions, mostly minor
- multiply it by the AMT rates
- voila! Calculate your AMT liability

The AMT is toxic because 1) they don’t “index” the brackets for inflation, which means that every year your income goes up, the cost of living goes up, but the tax brackets stay the same 2) the AMT also does not allow you to deduct state and local taxes nor property taxes, which is a huge hit on people in high tax states like New York and California. It can even trap people in states like Illinois, which have a 3% state rate and high property taxes. Wikipedia has a decent summary of the AMT here.

There are myriad other deductions and exemptions that don’t make it over to the AMT; but the 2 killers are the non-indexed brackets and the inability to deduct state and local taxes. These two items pull more and more people into the AMT world every year.

Those people, like my close acquaintance CPA, don’t understand (at first glance) that they are getting “cheated” of deductions. This is due to the fact that the tax software everyone uses nowadays STARTS with the Federal liability and calculates AMT at the end; to the developers’ credit, this is the way that the tax form calculates it, too, so they are just following along.

Thus you type in all these great deductions that the Federal tax code provides and your software cheerily calculates your tax liability; but you never really see the machinery grinding (in parallel) that is stuffing you into the AMT.

From a high level perspective, once you are “Stuck” in the AMT jail you are living there forever, even though theoretically you could “back out’ of the AMT and go to the regular code; this would mostly happen because you retired or suffered a major fall in income.

If you KNEW that you were going to be eligible for the AMT, your tax return preparation would be much faster; gross income, a couple of deductions, and you would instantly know how much you owed. If you paid AMT in the past, this is how you SHOULD think of your tax liability, because it is how it will be calculated, in the end.

How can you tell if you are in the AMT? Easy. Look at your last tax return. See if your AMT liability was higher than your regular liability. If so, then you are an AMT taxpayer, and are very likely to remain so for the foreseeable future.

WHY THE AMT MATTERS

If you go back to the first line of this post, you can see that I am bickering over the AMT and its impact on tax liability with a CPA. The formula and impact of the AMT aren’t readily known, even among (some) financial professionals.

The AMT also confuses everyone because it is on the “end” of the tax return, like it was “tacked on” as an afterthought. In reality, this tail is wagging the overall dog.

Let’s assume as a given that the average person, even a pretty educated one, doesn’t really understand the AMT, and that once you are in the AMT “penalty box” all those pretty deductions on the Federal form don’t matter at all. Why should this matter?

It matters because if you don’t understand the AMT, you are probably operating under some bad assumptions for tax and financial policy.

Think of a home, for example. Pretty much everyone takes the cost of mortgage plus taxes to calculate the “after tax” cost of a home, and then compares this against the cost of renting. But if you are in the AMT, this calculation is incorrect, because property taxes are not deductible.

Not only are property taxes not deductible, unlike other areas of your mortgage, you can’t renegotiate property taxes or fix them over the 30 year life of the loan; they are out of your control and inexorably GO UP.

Thus with your home purchases you are wrong twice; you are starting with the wrong metric on your rent / buy decision, and then you aren’t taking into account the fact that this equation will continue to worsen as long as you own your house because property taxes are generally going UP, UP, UP.

THE TAX CODE IS MEANT TO IMPACT BEHAVIOR

Even though I am not in favor of it, clearly the tax code is meant to “encourage” some kinds of behavior through deductions (like owning a house or making gifts to charitable institutions) and “punish” other kinds of behavior through higher rates or non-deductibility (like “sin” taxes on alcohol and cigarettes).

You will hear politicians trumped their latest “tax cut” or a “break for working families” for education credits, deductions, etc….

However, most of these signals (which don’t work well too begin with) are completely lost when you are on the AMT. The AMT has few deductions and they are pretty clearly laid out; there isn’t a lot to tinker with here. You can change the rate or exemption and while this reduces (or increases) the overall tax liability, it doesn’t really impact behavior (except at the highest level) and doesn’t induce specific behaviors.

However, the public debate on this topic is very muted. People don’t like the tax code nor understand it in the first place; the fact that the AMT is “tacked on” to the rest of the code makes it even less accessible. And I haven’t seen very many articles at all about the impact of the growing mass of AMT payers on 1) real estate 2) public policy.

A FINAL NAIL IN THE COFFIN; OR A SAVIOR (OF SORTS)

The US tax system is already a tottering, schizophrenic beast. Don’t get me wrong; the rise of information technology and the continued use of “withholding” where the government takes your money FIRST without (most) people even realizing it, makes the IRS an effective tax collector. Revenues are at an all-time high.

Note that I always get a chuckle out of financial advisors such as Suze Orman (who generally gives decent advice) because they always repeat “pay yourself first” like a mantra… but it is really the government that is best at this tactic.

But as far as the philosophical underpinnings of the tax code, it has never been in worse shape. Local (property taxes), state and federal taxes are all swinging around wildly, without a coherent framework. The only thing that all of these policies agree on is that they need to extract a large amount of money from working citizens to pay for the “services” that they provide with armies of slow moving “workers”; and in this measure they are ruthlessly effective.

However, this works in a police state, but can’t hold on forever in a democracy. The inconsistencies of these polices are too great; some politicians are going to go in and use this as a negotiation or “wedge” issue and exploit it.

There are three answers, and I am ranking them from best to worse as far as the country. The options are:

1) “fix” the problem with some sort of a flat tax (I am ruling out the “Value Added Tax” or VAT as it exists in Europe)
2) Use the AMT as a sort of “retarded stepson” of the flat tax, since it is (mostly) a flat tax with just a couple of deductions (mortgage interest). Under the AMT poor people don’t have to go through the hassle of filing; pretty much everyone under $50,000 or so doesn't have to file
3) Leave everything as is, or just keep muddling along with band-aid, incompatible incentives and costs (the current system)

I’d accept 2) as better than 3).

Remember, once you are in the AMT, you are (mostly) always in the AMT, so don’t make bad calculations on your personal finances. And when politicians talk about the latest “tax cut”, it probably doesn’t apply to you, tell them they are lying. And tell your realtor that they are wrong when they tout the financial advantages of owning a home, at least if they throw in the deductibility of property taxes, they are lying, too.