A potentially taxing predicament
There is a fleeting and frightening image of a really large gorilla hiding in the weeds for those who are trying to manage their money this year — especially for those who will earn more than $75,000 in 2012, have several children, a business or an interest in an S corporation, an interest deduction from a second mortgage, capital gains, state and local tax payments and incentive stock options.
These individuals are the ones SmartMoney.com said are the most vulnerable to being sucked into the Alternative Minimum Tax, a federal tax system that runs parallel to the standard 1040 scheme that, of course, mandates a higher-than-standard tax payment.
Originally created to ensure that the wealthiest of Americans paid at least some income tax, the AMT has captured more unintended taxpayers than the original lawmakers intended. In 1970, the AMT only had 19,000 payers. Now the number reaches into the millions because the AMT brackets and exemptions haven’t been indexed for inflation, while the 1040 scheme is.
To make the situation worse, the personal tax credits and the increased exemption amount that have applied to the AMT and helped some middle-class taxpayers to stay out of its grasp expired Dec. 31 and aren’t in effect for 2012 because last year Congress didn’t get around to the usual patching job it has done for decades.
“When they just do things for kind of the short term, in terms of how long they run, they have to keep on going back to decide if they’re going to renew these things,” said William Roth, a tax expert and a partner at BDO in Grand Rapids, of Congress. “Perhaps the biggest single one for a lot of people is the AMT patch.”
Roth said a recent tax publication calculated that taxpayers would have paid an additional $400 billion just since 2001 without the patching relief Congress has applied to the AMT. The last time Congress acted on the AMT was at the end of 2010, and that two-year patch reportedly saved taxpayers from shelling out another $153 billion in 2010 and 2011.
“That is what would have been paid had they not passed the patch. When they did the patch in 2001 and 2003, that cost was about $13 billion a year back then. Now over the last two years, it’s been $153 billion,” said Roth.
“More and more people have fallen into the AMT over the years. A lot of middle and lower-middle taxpayers would fall into the AMT if not for every couple of years having kind of a temporary patch so more people aren’t pulled into the AMT than what would otherwise be,” he said.
In addition, because it was initially designed for the wealthiest, the AMT ignores some of the itemized deductions the 1040 system recognizes. The AMT doesn’t allow deductions for investment expenses, business expenses that relate to employees, and some medical and dental expenses. It also charges taxpayers for the “spread” they might have between the market price and the exercise price of incentive stock options.
What this means for individuals who are paper rich but not cash wealthy is a higher tax tab, one that treats them as if their paper wealth is actually liquid. These people have to fill out Form 6251 to see if their AMT is higher than their 1040. If so, they have to pay the AMT rate or face the IRS music.
The AMT individual exemption amount for the almost-here April 17 filing date is $48,450, or $74,450 if a married couple is filing jointly. For a married person filing separately, it’s $37,225. Exemptions can be taken this year by single taxpayers whose income isn’t more than $112,500, and $150,000 for married persons who are filing jointly. Married taxpayers who file separately can take an exemption if their income isn’t more than $75,000.
Whether Congress will patch the AMT again isn’t certain, so more middle-income taxpayers could get hit hard next year if lawmakers don’t take action and make it retroactive for this year. But if the “Warren Buffet rule” that President Barack Obama has pushed becomes law, then the AMT could likely disappear for good. The rule would require those who make $1 million and more to pay a minimum of 30 percent.
“There are a couple of provisions in 2012, too, that deal with the AMT that are expiring. There is kind of a combination of a few different provisions depending upon which years you’re looking at that have impact on the alternative minimum tax,” said Roth.
“If the provisions that have already expired aren’t renewed, the alternative minimum tax will increase for certain taxpayers, if they fall into the alternative minimum tax — which, I think, can be a surprise for some folks. They just don’t quite understand how they calculate their tax one way and then go back and calculate it a different way for purposes of the AMT tax. They have to take the greater of the two as the tax they have to actually pay,” he added.
Besides the AMT, Congress has a few other key tax issues to deal with that expire at the end of this year and will affect money management next year. The most notable of these is what most call the “Bush tax cuts,” which reduced the marginal rates in 2001 and the tax on capital gains in 2003.
“For the years after 2012, those are the big items. Fourteen or 15 months ago, we went through that debate right at the end of 2010 to extend those for two years, and they’re coming back up at the end of this year. So they’re going to have to debate those probably again,” said Roth, who writes the Money Matters financial column for the Business Journal. “If they don’t extend it, everyone will be affected.”
Also, nine provisions related to the estate tax, or as some call it, the “death tax,” expire Dec. 31. In 2010, the tax was zero. Now the maximum rate is 35 percent and the exemption is $5 million. “But that’s obviously scheduled to sunset, and a lot more folks could be back in the Estate Tax if they don’t do something with that limit. Now there is some debate: Does it stay at five (million) or does it go back to something under five (million)? I think politicians agree that it has to be extended in some fashion; it’s what’s the rate and what’s the amount,” said Roth.
“They’re certainly concerned about family businesses, family farms and how the Estate Tax impacts them because it could impact their ability to pass their business on to their children or grandchildren. If there is an estate tax on the estate, that may mean they may have to look at selling the business just to pay the tax.”
While many of these federal tax provisions can affect a substantial number of individuals, there are a few that don’t. The Leaking Underground Storage Tank Trust financing rate is one. Warmly referred to as the LUSTT tax, it expires at the end of this month.