Alternative Minimum Tax

Definition: A second system Congress created for computing a person’s income taxes when it saw that under the rules of its regular income tax system, a few people were able to legally reduce their taxes down to zero, a level that it thought was unfair.

Example: The AMT is complicated and it is difficult to illustrate in a simple manner without being inaccurate. Instead, let’s take a very high-level look at the idea of an income tax system and the wisdom and equity of the AMT:

An income tax system seems fair enough. If a person receives income, he or she is better off and is able to pay a portion of that income to the government. No income, no tax. So far, so good.

Over the decades since the income tax was put in place, Congress has tried to make the system more fair by allowing different ways for people to reduce the income on which their taxes will be computed. For example, recognizing that children cost money to raise, Congress allowed parents to reduce the amount of their taxable income by a few thousand dollars per child.  Lowering their taxable income lowers their tax because the tax is a percentage of their taxable income.

Another well-known and frequently used deduction is mortgage interest. Congress believes that it should promote home ownership and to own a home, most people have to take out a mortgage (ie, borrow money to buy the home). Allowing the interest on this loan to be deducted from a person’s taxable income is a way to help people afford to buy homes.

Now, imagine that, following the rules, a few people whose unusual personal situations give them numerous deductions that greatly reduce their taxable income, perhaps even to $0. The Congress sees these few cases and says, “Hey, that’s not fair!” The response from these few taxpayers is, “What do you mean? You made the rules. We just followed them.” Congress, not to be deterred, says, “Well, we’ll just have to see about that!” Try again they did. The AMT is the result. After the creation of the AMT, certain taxpayers have to compute their taxes due under the regular income tax system and also under the AMT, paying the higher of the two!

Investeach explains: The details of the AMT, from its beginnings to its handling by each Presidential administration, will make your eyes glaze over. Still, a few highlights are worth knowing:

1. The AMT got its start in 1969 when Congress saw that 155 taxpayers with high incomes (over $200,000) owed no income taxes. Now, mind you, there were 15,669 total taxpayers with high incomes that year, so 155 who legally didn’t owe any federal income taxes represents one out of every 100 high income taxpayers. If you think passing a law to target one out of every 100 taxpayers goes a little overboard, consider that there were 71.7 million taxpayers that year. Dividing 155 into that number reveals that Congress wrote a law to target one out of every half million taxpayers!

2. Instead of creating a new tax system, Congress could have reformed the existing system, putting limits on the tax deductions that the 155 taxpayers had used to zero-out their tax liabilities.

3. Deciding to pass an alternative tax system, Congress forgot to have it keep up with the times. The income limit above which a taxpayer had to compute his or her taxes both ways should have kept up with inflation (ie,  the general increase of the prices of the things we buy). For example, $200,000 in 1969 was the equivalent of making well over $1 million in today’s dollars because the things we consumed cost so much less back then. Several decades later, earning $200,000 as the combined income for two working professionals isn’t so special. In fact, in high cost metropolitan areas, with ordinary homes costing a half-million dollars or higher and property taxes being $20,000 per year or more, its middle class. The result? Today, millions of ordinary Americans must calculate their income taxes two ways, and pay the higher of the two.

4. Since 1969, Congress has raised the income thresholds 19 separate times. Finally, as part of the “Fiscal Cliff” deal struck on January 1, 2013, Congress “indexed” the incomes subject to the AMT to the rate of inflation.

Riddle me this:

1. What are two deductions that our primary income tax system offers taxpayers to help them lower their taxes owed?
2. Why did the Congress create the AMT?
3. What is the effect of the Congress not having the income limits move up with inflation over the decades since the AMT was implemented?
4. When did Congress finally fix the AMT system so that the income thresholds to which the AMT applies automatically move up by the inflation rate each year?