AMT is a parallel tax system that ensnares taxpayers with so-called “excess” deductions, such as state income and property taxes, too many dependents and itemized miscellaneous deductions. The AMT calculation is mind-boggling in its complexity, but in general, it is based on a taxpayer’s gross income (with few allowable deductions), rather than on net income (gross income less all the deductions allowed under the regular system). Taxpayers calculate their taxes under the regular tax system then under the AMT, and pay the higher amount.

AMT offers a standard “exemption” amount. This amount varies depending on a person’s income and filing status. Practically all gross income left after taking this deduction is subject to AMT and taxable at 26% on the first $175,000, and 28% on any balance. In contrast, the regular system has graduated marginal rates from 10% to 35%, with most AMT victims falling in the 28-35% regular tax brackets. Even though the applicable marginal tax rate is usually lower under AMT, the amount of income subject to AMT rates is much higher which produces an overall higher tax.

The minimum tax (forerunner to AMT) was enacted in 1969 because Congress believed that wealthy taxpayers should not radically reduce their tax burden by using various tax deductions and preferences allowed in the tax code. Wealthy taxpayers were considered to be those with adjusted gross incomes of $200,000 or more, based on 1964 dollars.

Today, AMT – originally enacted to ensure that the very wealthiest taxpayers, who at that time were escaping the payment of any tax – applies to middle-class workers. Why? Because, AMT’s exemptions have not been adjusted for inflation and AMT rates have increased from 10% to 28%. In contrast, tax rates under the regular system have fallen from a high of 70% to 35% over the same period.

Factoring in inflation, $200,000 in 1964 equates to $1,200,000 in year 2000 dollars. However, because AMT has not been adjusted, approximately 65% of taxpayers earning between $100,000 to $500,000 will be victimized by AMT. In fact, some commentators speculate that by 2008 the government would realize more revenue by abolishing the income tax and keeping AMT intact than it would receive by abolishing AMT.

Unfortunately, the courts have not struck down AMT, even though its original purpose has been distorted beyond recognition. The courts claim it is Congress’s job to fix the problem and thus far, our legislators are enamored with AMT’s revenue generating capabilities since, through AMT, they can raise revenues without voting for tax increases.

AMT's Impact Depends on Where You Live

Quick, which states with large populations voted Democratic last presidential election? Now, guess which residents are disproportionately hit hardest by AMT? The answer is, of course, California and New York, because each has high state income and property taxes which are deductible under the regular tax system, but not under AMT.

According to the San Francisco Chronicle’s Kathleen Pender (Business Section, April 15, 2004) in 2001, California filed 11.3% of all tax returns, but paid 22.7% of the nation’s AMT. By contrast, the President’s home state, Texas, filed 7% of all AMT returns, but paid only 3.5% of the AMT. In other words, California paid twice as much and Texas paid half as much as the national average

Deductions disallowed under AMT include: (i) dependency exemptions; (ii) itemized miscellaneous deduction expenses, such as professional, investment and legal expenses, unreimbursed employee business expenses; (iii) state and local income and property taxes; (iv) interest on home-equity loans; and (v) the standard deduction. Added to AMT income are (i) the “spread” on incentive stock options; and (ii) interest on private-activity municipal bonds.

Unfortunately, there are limited tax planning opportunities to avoid AMT, other than to moving to Nevada, Washington, Texas, Florida or other states where there is no state income tax. Tax advisors recommend shifting income or deductions from one year to the next, depending on the impact of AMT. But this requires accurate tax calculations and predictions prior to the end of the year and flexibility regarding the timing of deductions which may be adversely impacted by AMT.

The definitive solution: Congress needs to substantially increase AMT exemptions and lower AMT tax rates. State taxes and itemized miscellaneous deductions should remain deductions under AMT, and the spread on an ISO should be calculated on the lower of the stock’s fair market value on the date of exercise or the end of the year. Or, Congress could just repeal AMT in total.