Taxing Times: For investors, is there an alternative to the Alternative Minimum Tax?

Alternative Minimum Tax in 2011, without reform

Sources: Urban-Brookings Tax Policy Center Microsimulation Model (versions 0304-3, 1006-1, 0309-1, 0509-2); Harvey and Tempalski (1997); private communication from Jerry Tempalski; and IRS.

Introduction to the AMT

If you are not yet familiar with the Alternative Minimum Tax (AMT) this tax season, you probably will be in the future due to this inexorable fact: When Congress created the minimum income tax of 1969, it failed to index to inflation the income level and exemptions set for the jurisdiction of the law. The tax came into being after the Secretary of the Treasury gave testimony citing that 155 individuals with adjusted gross incomes above $200,000 had paid no federal income tax on their 1967 returns; public letters of outrage to Congress were so potent that they exceeded written complaints against the Vietnam war and compelled passage of the tax.1

While the tax passed in 1969 was designed to compel a few wealthy individuals who were not paying enough taxes to pay a minimum level, over time, Congress has had to recalibrate the parameters of the AMT to ensure that their designated targets continue to pay a target level. At its inception the levies raised from the AMT amounted to a tiny fraction of overall tax revenues.

Where we are today

For ordinary Americans, inflation and the passage of time have caused increasing numbers of taxpayers to fall prey to this parallel tax. Since 2001, lawmakers have increased the exemptions allowed under the AMT’s parallel system several times to stem the number of Americans subject to the tax. Temporary measures in 2001, 2003, and most recently in 20102 required a “patch” (or in other words, increased outlays by the Treasury to subsidize the loss of anticipated revenues.)

Under current law, personal exemptions would return to earlier levels prior to 20013 at the end of 2012 if another patch is not authorized or nothing is done to repeal the AMT. According to the Congressional Budget Office (CBO), in 2011 33 million taxpayers would be subject to the AMT system if nothing were done to alleviate the additional tax burden dictated by the AMT above regular rates due to the march of time and inflation erosion. This year’s “patch” aims to narrow affected individuals to 5 million Americans instead of 33 million. The CBO estimates that the number of affected taxpayers in 2012 would be 45 million.

Two Very Expensive Proposals to deal with the AMT

Obama’s preliminary 2012 budget provides two proposals to deal with the AMT and, they are both expensive. According to the Joint Committee of Taxation, one proposal would freeze 2011 exemption amounts to make them permanent and index these amounts thereafter. The cost of eliminating 28 million taxpayers (from a potential 33 million to 5 million) from the AMT requirement would cost the US Treasury $683 billion over a 10 year period. To put this figure into perspective, $683 billion is about 3% of the almost $20 trillion revenues from individual tax payers over the next ten years. Proposal two would simply eliminate the AMT at a projected cost of $814 billion over a 10 year period.4

Patching an old garment forever?

While tax reformers have advocated eliminating the AMT for at least a decade, we note that little has been mentioned about the AMT amidst competing tax and budget proposals swirling around Washington, D.C. As we have noted in previous Taxing Times, revenues need to go up to make headway on the deficit and burgeoning debt. Americans’ average tax burden is 2% less than the fifty year average. Nevertheless, the Bush Tax cuts are difficult to take away. So is it surprising that there is little incentive to eliminate a tax structure that acts as a tax hike already by collecting additional revenues above normal income tax rates? The AMT may be kept in place if for no other reason, than to raise taxes by default.

Our advice to investors

While the situation in Washington is very fluid, we recommend that investors consider tax efficiency when making portfolio decisions and to consider planning for a higher tax regime. It is more likely than not that the tax burden will increase going forward.

1 For history on the AMT, refer to “The Alternative Minimum Tax for Individuals: A growing burden” published by the Joint Economic Committee, US Congress, May 2001.

2 Under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 as described by the CBO in the analysis titled “Reducing the Deficit: Spending and Revenue Options”, page 214, March 18, 2011.

3 “Before 2001, the exemptions were $33,750 for single filers and $45,000 for joint filers. The 2010 tax act raised these amounts to $48,450 for single filers and $74,450 for joint filers in 2011r 2011.” Ibid.

4 Estimates from the Joint Committee on Taxation. Refer to the Analysis of the President’s Budgetary Proposals for Fiscal Year 2012 published by the CBO on April 15, 2011.

RFS 12120-a

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