Article 2

The Alternative Minimum Tax andIts Impact on the Middle Class—Part 1

by John McQuilkin, JD, CPA, MBA

Thomas P. Langdon, JD, LLM, CFA, CFP

Abstract: The Alternative Minimum Tax (AMT) was

originally designed to combat aggressive tax planning

used to eliminate or substantially eliminate the tax-

able income of high-income taxpayers. In 2012 the

number of taxpayers subject to the AMT is expected to

explode by 661%, from 4.1 million in 2010 to 31.2 mil-

lion. The AMT is no longer a tax imposed only on high-

income individuals; it has descended to the ranks of

middle-income taxpayers. This article, the first in a

two-part series, reviews the history of the AMT, shows

how the AMT impacts middle-income taxpayers, and

suggests policy changes for lawmakers. A second arti-

cle will review possible planning options for advisors to

help their clients avoid the AMT.

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS / MARCH 2013

62

Introduction

hould a husband and wife with 10 dependentchildren and an adjusted gross income (AGI)of approximately $80,000 be forced to pay an

additional income tax over and above their regular taxliability? Most citizens, and probably most lawmakers,would say no. Unfortunately, the Tax Code says yes.Under current tax law, this family is punished for takingadvantage of too many tax preferences and is forced topay an additional tax, thanks to the Alternative Mini-mum Tax (AMT).1

The original intent of the AMT was to force high-income taxpayers who had been avoiding the annual pay-ment of income taxes by engaging in various tax planningactivities to pay a minimum tax based on their income eachyear. Over time, the AMT has achieved its original objec-tive, and more. As time goes on, more and more taxpayersare being caught in the AMT tax trap even if they are notdirectly engaging in tax planning that is designed to min-imize or eliminate their tax liability. The Urban Instituteand Brookings Institution Tax Policy Center, in its June2011 Baseline AMT Projections, highlighted that whilethere were 4.1 million AMT taxpayers in 2010, this num-ber was projected to reach 31.2 million taxpayers in 2012(a 661% increase) if the Bush-era tax-cut measures expire.2

Without AMT relief, recent estimates indicated that within10 years (by 2022) approximately 54.9 million Americantaxpayers could be subject to the AMT.3

The purpose of this article is to explore the AMT’slegislative intent, its regulatory and legal history, andthe practical implications for clients and planners, withparticular emphasis on the impact of the AMT on mid-

This issue of the Journal went to press in February 2013.Copyright © 2013, Society of Financial Service Professionals.All rights reserved.

S

The Alternative Minimum Tax and

Its Impact on the Middle Class—Part 1

dle-class taxpayers. A second article will review plan-ning-oriented strategies designed to help advisors andtheir clients avoid the sting of the AMT.

Legislative Intent

The need for revenue is a persistent concern of thosecharged with the task of governing. In 1969, Secretary ofthe Treasury Joseph W. Barr testified before Congress that155 individuals had incomes above $200,000 (about$1.2 million in 2012 dollars), yet did not pay a dime infederal income tax.4 How is this possible? Quite simply,by engaging in tax planning. In the United States, citi-zens may, through legal means, take action that results inthe reduction of their tax liability. The courts have longrecognized this principle, which was eloquently opinedby Judge Learned Hand in Gregory v. Helvering:

Anyone may arrange his affairs so that his taxesshall be as low as possible; he is not bound to choosethat pattern which best pays the treasury. There isnot even a patriotic duty to increase one’s taxes.Over and over again the Courts have said that thereis nothing sinister in so arranging affairs as to keeptaxes as low as possible. Everyone does it, rich andpoor alike and all do right, for nobody owes anypublic duty to pay more than the law demands.5

Justice Sutherland’s opinion (affirming JudgeLearned Hand’s ruling when the case was reviewed by theU.S. Supreme Court) further stated, “The legal right ofa taxpayer to decrease the amount of what otherwisewould be his taxes, or altogether avoid them, by meanswhich the law permits, cannot be doubted.”6 Americanshave a long-standing tradition (dating back to revolu-tionary times) of minimizing exposure to taxation, a tra-dition that the courts have recognized and protected.

The legislative and executive branches of the govern-ment, unlike the courts, were not amused with this taxavoidance behavior of individuals, and were particularlyannoyed with the games played by high-income taxpayersto avoid current tax liability. When Treasury Secretary Barrwas testifying before Congress in 1969, the Vietnam warwas upon us, Congress had recently created government-provided health care for retirees and indigents (Medicareand Medicaid), and the federal government needed morerevenue.7 In an effort to combat the tendency of Americans

to engage in too much tax planning, with the ensuingresult of a reduction in current tax collections, Congresspassed the Tax Reform Act of 1969, which included thefirst version of the AMT. Over time, several changes andadjustments (summarized below) have been made to theoriginal AMT. The current AMT structure that appliestoday was implemented in the Tax Reform Act of 1986.

There is widespread agreement that Congress’s pur-pose in imposing the AMT was to limit tax planningopportunities so that individuals with specified mini-mum income amounts pay some tax, on an annual basis,to the government. This was succinctly stated by JudgePaul J. Kelly, Jr. in his concurring opinion in Klaassen v.Commissioner of Internal Revenue, where he stated, “Thelegislative history supports an argument that the originalpurpose (intent) of the AMT, one of the more complexparts of the Internal Revenue Code, was to insure thattaxpayers with substantial economic income pay a min-imum amount of tax on it.”8

The AMT in History

The first attempt at an AMT was included in the TaxReform Act of 1969, and was referred to as an “add-onminimum tax.” The initial provision introduced an add-on minimum tax of 10% of the sum of an individual’s orcorporation’s tax preference income (i.e., income whichwould be taxed had it not been excluded as an item of taxpreference) to the extent it exceeds $30,000 plus the tax-payer’s regular income tax. The preference items that trig-gered the add-on minimum tax under the 1969 TaxReform Act included: (1) excess investment income, (2)accelerated depreciation on personal property subject toa net lease, (3) accelerated depreciation on real property,(4) amortization of rehabilitation expenditures, (5) amor-tization of certain pollution control facilities, (6) amorti-zation of railroad rolling stock, (7) tax benefits from stockoptions, (8) bad debt from financial institutions, (9)depletion, and (10) capital gains.9 Many of these prefer-ence items still subject income to the AMT today. In1970, 1971, 1976, and 1977, various changes were intro-duced with the intent of ensuring that taxpayers withsubstantial economic income would pay at least somecurrent tax. The most significant of these provisions wasadded in 1976, when the tax rate was increased from


63



10% to 15%. It reduced the exemption to $10,000 orone-half of the regular tax liability, whichever was greater,in place of the $30,000 exemption. The 1976 changesalso added new preference items to the add-on mini-mum tax base, including: (1) the excluded one-half ofrealized capital gains (prior law exempted one-half ofcapital gains realized by a taxpayer from income taxa-tion), (2) the excess of percentage depletion over the basisof the property, (3) accelerated depreciation on real prop-erty, (4) the bargain element of stock options, (5) accel-erated depreciation on personal property subject to a netlease, (6) the excess of amortization of on-the-job train-ing and child-care facilities over regular depreciation, (7)the excess of amortization of pollution control facilitiesover regular depreciation, (8) the excess of amortization ofrailroad rolling stock over regular depreciation, and (9)excess bad debt reserves of financial institutions.10

The Revenue Act of 1978 formally introduced theAMT as it is known today. The 1978 Act created a sep-arate but parallel tax calculation in addition to the reg-ular tax system. Instead of replacing the old add-on min-imum tax provisions, the AMT was initially introducedalongside, and operated in concert with, the previousadd-on minimum tax provisions. The goal of this newalternative minimum tax was to add personal anddependency exemptions, certain itemized deductions,and capital gains back into the tax base when calculatingthe AMT.11 While prior legislation had subjected varioustypes of business and investment income to the add-onminimum tax, the 1978 legislation began to treat somepersonal expenses, deductions, and exemptions as pref-erence items for AMT purposes as well.

Under the 1978 legislation, the AMT had graduatedrates of 10%, 20%, and 25% and an exemption amountof $20,000. The public as a whole did not respond wellto this development, and the middle and upper classeswere outraged. The new legislation did not impact low-income taxpayers because of the AMT’s $20,000 stan-dard exemption amount. Few of the wealthiest taxpayerswere affected because they were already subject to tax atthe highest tax rate.12

Partly in response to public dissatisfaction with theAMT tax rates imposed in 1978, the 1981 legislationlowered the AMT tax rates to correspond with the reduc-

tion in regular income tax rates.13 The add-on minimumtax provisions, first introduced in 1969, were repealed in1982. In the same year, the AMT was imposed at a flatrate of 20% after applying exemptions of $30,000 forindividuals and $40,000 for joint return taxpayers.14

The Tax Reform Act of 1986 substantially modifiedthe alternative minimum tax. It increased the AMT taxrate to 21%, changed the exemption amount, consider-ably broadened the tax base, and revamped the alternativeminimum tax credit. It also introduced a phase-out of theAMT exemption amount for taxpayers whose AlternativeMinimum Taxable Income (AMTI) exceeded certain lim-its. A major change introduced in 1986 was the elimina-tion of long-term capital gains as a tax preference item forAMT purposes. The 1986 Act also introduced an incometax credit for prior year AMT liability. The availability ofthis credit suggests that the real purpose of the AMT is tochange the timing of the payment of tax, but not the totaltax burden a taxpayer shoulders over time. While theAMT may require a taxpayer to pay more tax in the cur-rent year, in future years, thanks to the AMT credit, reg-ular tax liability could be offset with the additional taxpaid.15 While subsequent legislation continued to permitan AMT credit for investment and business tax prefer-ences that trigger AMT liability, personal preferencestriggering AMT tax liability were classified as “exclusion”preferences, causing a permanent increase in tax liabilitywhen a taxpayer is subject to the AMT.

The Omnibus Budget Reconciliation Act of 1990raised the AMT rate to 24%.16 In 1993, legislation intro-duced graduated AMT rates of 26% and 28%. The 26%tax rate was applied to the first $175,000 of a taxpayer’salternative taxable income in excess of the AMT exemptionamount, and the 28% rate to the AMT taxable amount inexcess of $175,000. The 1993 Legislation also increased theAMT exemption amounts to $33,750 for individuals and$45,000 for joint returns, and implemented rule changesconcerning gains on small business stock.17

In 1998, the AMT was adjusted for the new capitalgains rates.18 Legislation in 1999 brought additional rulechanges concerning nonrefundable credits.19

The Economic Growth and Tax Relief ReconciliationAct of 2001 (EGTRRA 2001) permitted certain tax cred-its to be claimed when calculating AMTI, with limita-


64



tions based on the amount of the individual’s incomeand AMT. The permanent credits that are permitted toreduce AMT liability include the child tax credit, theadoption credit, and the IRA contribution tax credit, allof which were extended by the Tax Relief, UnemploymentInsurance Reauthorization, and Job Creation Act of 2010(TRUIRJCA 2010) through the end of 2011.20 TheAmerican Taxpayer Relief Act of 2012 (ATRA 2012),signed by the President after this article was completedbut just before it went to press, extended the use of per-manent regular tax credits to reduce AMT tax liability.

A summary of the legislative history of the AMTmay be found in Appendix 1.

For several years, Congress has enacted a series oftemporary fixes (often referred to as an AMT “patch”) tothe AMT exemptions for individuals and married cou-ples in an attempt to prevent some taxpayers from join-ing the ranks of AMT taxpayers. The AMT exemptionsover the last several years are listed in Table 1.

As Table 1 illustrates, Congress has enacted a seriesof temporary fixes (or patches) to the AMT exemptionfrom 2003 through 2011. Immediately before this arti-cle went to press, Congress passed ATRA 2012, whichpermanently increased the exemption in 2012 and pro-vided for inflation adjustments in following years. TheIRS has announced in Rev. Proc. 2013-15 the inflationadjustments for 2013, which are reflected in Table I.By making the exemption increase permanent in ATRA2012, Congress prevented the AMT exemption for alltaxpayers reverting back to its 1993 level.

Meet the Klaassens

Our article began by posing a seemingly hypotheticalquestion that turned out to be very real to the Klaassen fam-ily. The Klaassens were members of a Presbyterian churchthat encouraged large families, and they had 10 dependentchildren. On their 1994 joint income tax return, Mr. andMrs. Klaassen claimed 12 personal exemptions—one eachfor themselves and their 10 children—totaling $29,400. Mr.& Mrs. Klaassen’s Schedule A Itemized Deductionsincluded medical expenses of $4,767 and state and localtaxes of $3,264. They claimed an additional $11,532.96 formortgage interest and charitable deductions, for total item-ized deductions of $19,563.96. This total appears to be a

reasonable amount for a family of 12.21

The Klaassens filed their regular income tax returnwith the IRS in a timely manner, but did not provide anycomputations to determine whether they were subject tothe AMT. After an examination of their income taxreturn, the IRS determined that the Klaassens were sub-ject to the AMT, and issued a statutory notice of defi-ciency. Specifically, the IRS concluded that IRC Secs. 55-56 required three adjustments, or increases, to the taxableincome that they showed on line 37 of their Form 1040for purposes of calculating the Klaassen’s AMT: (1) stateand local taxes claimed on Schedule A of $3,263.56were added back to their taxable income;22 (2) allowablemedical expenses were reduced by setting the deductibil-ity floor at 10% of adjusted gross income (AGI) (asopposed to 7.5% for regular tax purposes),23 resulting ina net addition of $2,076.42 to their AMTI; and (3) theKlaassens were deprived of the $29,400 personal anddependency exemption amounts that they claimed online 36 of their Form 1040.24 After adjusting their tax-able income by these three amounts, the IRS calculatedan alternative minimum taxable income of $68,832.44.After applying the AMT exemption of $45,000, theAMT tax rates were used to determine a total tax liabil-ity of $6,196.43 (26% x $23,832.44). The differencebetween this figure and the Klaassen’s regular tax was theAMT, which was $1,085.43 greater than the Klaassen’sregular tax liability. A detailed calculation of theKlaassen’s AMT liability may be found in Appendix 2.


65

TABLE 1

AMT Exemptions, 2003-2013

Year Individual Exemption Joint Exemption

2003 $40,250 $58,0002004 $40,250 $58,0002005 $40,250 $58,0002006 $42,500 $62,5592007 $44,350 $66,2502008 $46,200 $69,9502009 $46,700 $70,9502010 $47,450 $72,4502011 $48,450 $74,4502012 $50,600 $78,7502013 $51,900 $80,800



The Klaassens did not dispute the numbers or themechanics used to calculate the AMT deficiency. Instead,the Klaassens contended that a uniformly applied AMTviolated their First Amendment rights, as well as theirrights to equal protection and due process of law. First,the Klaassens claimed that by disallowing the personalexemptions for their children, the statute impermissiblyburdened their free exercise of religion. Second, they con-tended that their equal protection and due process rightswere violated, because the statute deprived them of fulldeductions for medical expenses and for state and localtaxes, whereas these deductions are allowed for familiesthat have similar incomes, but fewer than eight children.

The Tax Court agreed with the IRS and concludedthat the Klaassens were subject to the AMT. The Courtconcluded that, “The uniform application of the AMTprovisions furthers a compelling governmental interest,and therefore concludes that it [the AMT] does not vio-late the Free Exercise Clause of the First Amendment.”Likewise the Court found that the AMT provisions “beara rational relation to a legitimate governmental purpose”and thus found no equal protection or due process vio-lation. The U.S. Court of Appeals affirmed.

What makes the Klaassen case so interesting is notthe Constitutional arguments raised by the taxpayers,but rather the clear illustration that the application of theAMT is no longer limited to tax-avoiding-high-incomeearners, as it was originally intended. The reason theKlaassens were required to pay an additional tax was nota function of tax planning; it was the result of having “too

many” children and, consequently, claiming too large apersonal exemption on their tax return. As the Klaassencase illustrates, the AMT has the potential to descend intothe ranks of middle America. ATRA 2012 permanentlyincreased the AMT exemption and permits it to beadjusted for inflation, which will save millions of tax-payers from being added to the roll of AMT taxpayers.

Why the AMT Now Taxes Middle America

Why would a tax that was originally targeted at 155rich people who engaged in a lot of tax planning affectthe middle class? There are several reasons, some ofwhich are explained by legislative changes over time andsome that are merely the result of the passage of time.

One of the most obvious reasons for the increase in thenumber of taxpayers subject to the AMT is the fact that theAMT exemption was not adjusted for inflation prior to2013. Figure 1 shows the historical AMT exemption overthe period 1978-2020 (including a pro-forma projection ofthe exemption before enactment of ATRA 2012).

As Figure 1 illustrates, the 1978 legislation provideda uniform AMT exemption of $20,000 regardless of filingclassification. In 1982, Congress increased the exemptionfor individuals to $30,000 (which, incidentally, perfectlymatches the amount the exemption would have climbedto had it been inflation adjusted), and took away some,but not all, of the marriage penalty for married couples byincreasing the exemption for those filing jointly to$40,000. The 1993 legislation again raised the exemption,and throughout the 2000s, AMT patches were enacted byCongress to temporarily increase the exemption amount.Just prior to this article going to press, Congress perma-nently extended the increase in exemption amount inATRA 2012. Had Congress not done so, the exemptionswould have reverted back to their 1993 levels.

To analyze the impact of inflation, we adjust the AMTexemption for the consumer price index (CPI) beginningin 1978. The actual CPI is used from 1978-2011, with aforward CPI of 2% for years 2012-2020. A comparison ofthe actual AMT exemption to an inflation-adjusted exemp-tion is presented in Figure 2 for individuals and in Figure3 for married couples filing jointly. The analysis, which wascompleted before enactment of ATRA 2012, assumes thatthe exemption would revert to its 1993 levels upon expira-


66

FIGURE 1

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

AMT Exemption over Time

Exe

mp

tio

n A

mo

un

t ($

)

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

2011

2014

2017

2020

■ Individual■ MFJ



tion of EGTRRA 2001 and its extenders. While theexemption amounts will increase for the years 2012-2020,this analysis is still instructive in demonstrating why mid-dle-income taxpayers are increasingly subject to the AMT.The planning implications of the extension of the increasedexemptions under ATRA 2012 will be explored more fullyin part two of this two-part article.

For tax year 2012, had the exemption been adjustedfor inflation using the CPI, the individual exemptionwould be $74,237 (vs. $33,750 if the temporary exten-sion expired, a difference, or gap, of $40,487) and theexemption for married couples filing jointly would havebeen $98,983 (vs. $45,000 if the temporary extensionexpired, a difference of $53,983). A close examination ofFigures 2 and 3 reveals that the gap between the actualAMT exemption and the inflation-adjusted exemptiongrew during the 1990s, but throughout the 2000s, theAMT patches enacted by Congress were closely tied tothe CPI, although there was no attempt to “catch up” theexemption for the lost inflation adjustments in the 1990s.By 2020, the AMT exemption inflation gap (using theassumptions noted above) for individuals will be $53,231($86,981-33,750), and for married couples filing jointlythe inflation gap will be $70,974 ($115,974-$45,000). Bypermanently extending the increased AMT exemption inATRA 2012, Congress reduced the gaps illustrated inFigures 2 and 3, but did not address the loss of inflationadjustments for years prior to 2001.

Simply stated, as incomes and expenses rise while taxexemptions are static, more middle-income taxpayers willbecome subject to the AMT for no reason other than thepassage of time. Given enough time, if the AMT exemptionremained constant but incomes continued to rise, all Amer-icans at some point would be subject to the AMT. ATRA2012 provided some relief by permanently extending theincrease in the AMT exemption and inflation-adjusting itfor years after 2012. Due to the AMT exemption phase-outrules, very high-income taxpayers are not able to use theAMT exemption amount when calculating their tax liabil-ity. Ironically, this implies that, prior to the enactment ofATRA 2012, middle-income taxpayers would have moreexposure to the AMT as inflation erodes the value of theAMT exemption, but high-income taxpayers were unaf-fected by the government’s failure to apply automatic infla-

tion adjustments to the AMT exemption. The failure toinflation-adjust the AMT exemption amount, therefore,imposed an increased tax burden on middle-income taxpay-ers as each year passed. ATRA 2012 helped relieve some ofthat burden for moderate-income taxpayers.

While there are several statutory provisions designed tosubject items of tax preference to the AMT, many of theseprovisions do not typically apply to middle-income families.The adjustments that are most frequently associated withthe payment of AMT for middle-income families are: (1)the loss of personal exemptions, as illustrated in the Klaassencase (discussed above); (2) the disallowance of deductions forstate, local, and foreign taxes claimed on Schedule A; (3)


67

FIGURE 3

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

MFJ AMT Exemption vs.

Inflation-Adjusted Exemption

Exe

mp

tio

n A

mo

un

t ($

)

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

2011

2014

2017

2020

■ MFJ ■ MFJ Inf Adj

FIGURE 2

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

100,000

Individual AMT Exemption vs.

Inflation-Adjusted ExemptionE

xem

pti

on

Am

ou

nt

($)

1978

1982

1986

1990

1994

1998

2002

2006

2010

2014

2018

■ Individual■ Individual Inf Adj



adjustments to medical expense deductions; and (4) theinclusion of non-public-purpose municipal bond income inAMTI. Some upper-middle-income families may also besubject to the AMT when they exercise incentive stockoptions (ISOs) granted to them by their employers.

The Klaassen case (discussed above) illustrates a rare,although probably unintended consequence of the AMT. Ifa family is large (such as the Klaassens or, perhaps more noto-riously in recent memory, the Duggar Family with their 19children or Nadya Suleman, the “Octomom”), the loss of thepersonal exemption for the taxpayers and their dependentchildren can cause them to become AMT taxpayers. Theevil that the AMT sought to remedy was extreme tax plan-ning for the purpose of avoiding current tax liability. It seemsunlikely that the authors of the AMT would have wanted topunish taxpayers for having children. Given the relativelysmall tax benefit provided by the dependency deduction, itmight be appropriate for Congress to consider allowing tax-payers to claim the dependency deduction otherwise allow-able for regular tax purposes when calculating AMTI.

The disallowance of deductions for state, local, andforeign taxes is particularly troublesome in today’s environ-ment. One might say that a perfect storm is brewing to sub-ject more individuals to the AMT on this basis alone. Mid-dle- and upper-middle-income individuals living in high-taxstates and localities are particularly susceptible to this prob-lem. Furthermore, as the federal government continues tocut state and local aid in an attempt to keep its own fiscalhouse in order, state and local governments are increasingtaxes that they assess, not for the purpose of increasing thegovernment services they provide, but rather to pay forservices that are already in place. Additional federal man-dates, like those found in the Affordable Care Act, will alsoplace pressure on the states to increase taxes. The states, inresponse to reduced federal funding, are reducing the aidthat they offer to towns and cities, which is forcing townsand cities to increase their taxes (usually in the form ofproperty taxes and, in some cases, income taxes).

While state and local income taxes, and ad-valoremproperty taxes are deductible for regular tax purposes, thosedeductions are eliminated when it comes to calculating theAMT. As more of the burden of taxation shifts to the locallevel, state and local taxes that are deductible for regular taxpurposes will increase, and, as a consequence, so will the like-

lihood of a given taxpayer being subject to the AMT. Dual-income middle-class families living in high-tax jurisdictionssuch as New York City (which imposes property taxes on realestate plus a city income tax in addition to the New YorkState income tax) have already felt the pinch of the AMT.The irony of this is particularly cruel to middle-income tax-payers, since a reduction in federal assistance to states andcities may result in an increase in federal revenues due to agreater number of moderate-income individuals being sub-ject to the AMT. The AMT, in these circumstances, providesan incentive for the federal government to reduce state andlocal transfer payments in an effort to raise more revenue foritself that will come largely from the pockets of middle-income taxpayers who become subject to the AMT as fed-eral transfer payments decrease, forcing state and local taxesto increase. Thankfully, ATRA 2012’s increase in the AMTexemption, plus prospective inflation adjustments, will mit-igate the AMT exposure of many middle-income taxpayers.

While deductions for large medical expenses have, in thepast, assisted individuals in becoming AMT taxpayers, as ofJanuary 1, 2013 that problem has been resolved. Under theprovisions of the Affordable Care Act signed by the Presidentin 2010, individuals will only be able to deduct medicalexpenses for regular tax purposes to the extent that theyexceed ten percent (10%) of AGI. (A special exception is pro-vided for taxpayers who will attain age 65 by the end of2016—these taxpayers can continue to use the 7.5% hurdle.)Through the end of 2012, the hurdle was 7.5%. Since themedical expense deduction hurdle, beginning in 2013, willbe the same for both regular and AMT tax purposes, excessmedical expenses will no longer be factored into AMTI.

Some middle- and upper-middle-income individualsallocate a portion of their portfolios to municipal bonds.Public-purpose municipal bonds generate interest incomethat is exempt from both regular tax and the AMT. Theinterest earned on non-public-purpose municipal bonds is stillexempt from regular tax, but is included in taxable incomewhen calculating the AMT. It is unlikely that large amountsof non-public-purpose municipal bond income will pose anAMT tax problem for middle-income individuals, for tworeasons. First, most middle-income individuals will not havea significant portion of their portfolios allocated to municipalbonds. Second, given the current interest rate environment,even if the client has a large portfolio of municipal bonds, the


68



income generated on those bonds will be relatively small. The policy implications for Congress are clear. Absent

Congressional action to fix the AMT rules as they now stand,a growing number of middle-income Americans will be sub-ject to the increased tax burdens imposed by the AMT. ATRA2012 has permitted the AMT exemption amount andexemption phase-out ranges to be automatically adjusted forinflation on an annual basis. Should Congress wish to furtherminimize the impact of the AMT on middle-income taxpay-ers, it could consider removing personal deductions andexemptions from the list of AMT preferences, reverting to therules in place before 1978 that imposed adjustments solely forbusiness and investment tax preferences.

Implications for Financial Advisors

While a growing number of Americans have become,through experience, familiar with the AMT, over the next tenyears those numbers will explode absent Congressional action.The Urban Institute and the Brookings Institution Tax Pol-icy Center have indicated that in 2010, approximately 4.1million taxpayers were subject to the AMT, and that thisnumber is likely to grow to 31.2 million in 2012 if the Bushtax cuts expire. Projections prior to the enactment of ATRA2012 estimated that by 2022, approximately 54.9 millionAmerican taxpayers would have been subject to the AMT.The growth in the number of AMT taxpayers based on thoseprior projections is illustrated in Figure 4. Thankfully, Con-gress took action to avert this explosion in the number of tax-payers subject to the AMT by adopting ATRA 2012.

While uncertainty created by government inaction fos-ters a horrible planning environment, financial advisors needto be aware of the potential danger facing their clients andshould begin to prepare their clients for the possibility thatthey may become AMT taxpayers. As highlighted in our dis-cussion above, higher income clients, and clients with highstate/local/foreign tax burdens are particularly at risk.

Conclusion

The immediate risk to middle-income taxpayers has beenaverted with the enactment of ATRA 2012, but the AMTcontinues to pose challenges for taxpayers. Financial advisorsshould keep abreast of recent legislative updates impacting theAMT, and should consider the longer term impacts of this taxwhen making planning recommendations.

This article is Part 1 of a two-part series that focuses on thepolicy-related issues associated with the AMT, with particularemphasis on how the AMT has the potential of impacting mid-dle-income clients. The second article in this two-part series willdiscuss some of the planning opportunities that advisors andclients can use to help avoid the sting of the AMT.

Of course, as in all matters concerning the provision offinancial advice to clients, forward-looking planners shouldconsider the variables that could trigger AMT tax status,and the planning options to deal with them, in light of thegoals, objectives, and specific needs of their clients. ■

John S. McQuilkin, JD, MBA, CPA is an assistant professor of

accounting at Roger Williams University, where tax is his pri-

mary focus. In the past, he worked for Arthur Andersen and

Deloitte Touche before serving as a CFO in the mortgage bank-

ing industry. He may be reached at [email protected].

Thomas P. Langdon, JD, LLM, CFA, CFP, is a professor of business

law at Roger Williams University. Thomas also teaches financial

planning courses at Georgetown University, and conducts a law and

tax planning practice in Connecticut. He is former chairman of CFP

Board’s Council on Examinations, and has coauthored several books

on financial planning. He may be reached at [email protected].

(1) See, generally, Klaassen v. Commissioner of Internal Revenue (83 AFTR 2d 99-1750 (182 F.3d 932), 04/07/1999. The hypothetical question posed at the begin-ning of our paper is derived from a court case that will be discussed in detail, infra.(2) Tax Policy Center. Baseline AMT Projections: Current Law. TableT11-0130, Aggregate AMT Projections (AMT Taxpayers in millions),1970-2022. June 3, 2011. http://www.taxpolicycenter.org/numbers/displayatab.cfm?DocID=3011.


69

FIGURE 4

0

10,000,000

20,000,000

30,000,000

40,000,000

50,000,000

60,000,000

Taxpayers Subject to the AMT

(Projected 2011-2022)

1970

1974

1978

1982

1986

1990

1994

1998

2002

2006

2010

2014

2018

2022

■ AMT Taxpayers




70

(3) Ibid.(4) Bonnie Goodman, How Did the Present Alternative Minimum TaxCome into Existence? History News Network, June 20, 2005.http://hnn.us/articles/11819.html.(5) Gregory v. Helvering 69 F.2d 809, 810 (2d Cir. 1934).(6) Gregory v. Helvering 69 F.2d 809, 810 (2d Cir. 1934), aff ’d, 293 U.S.465, 55 S.Ct. 266, 79 L.Ed. 596 (1935).(7) Bonnie Goodman, 2005. (8) Klaassen v. Commissioner of Internal Revenue (83 AFTR 2d 99-1750(182 F.3d 932), 04/07/1999.(9) General explanation of the Tax Reform Act of 1969, H.R. 13270,91st Congress, Public Law 91-172 (1970). (10) Tax Reform Act of 1976. P.L. 94-455, p.16.(11) Steven Maguire, The Alternative Minimum Tax for Individuals. Con-gressional Research Service. August 23, 2011, p.2.

(12) A.Chamberlain, P. Fleenor, Backgrounder on the Individual Alterna-tive Minimum Tax (AMT). The Tax Foundation, May 24, 2005. May 1,2012, http://www.tax foundation.org/news/show/498.html.(13) Economic Recovery Act of 1981. P.L. 97-34.(14) Tax Equity and Fiscal Responsibility Act of 1982. P.L. 97-248.(15) Tax Reform Act of 1986. P.L. 99-514.(16) Omnibus Reconciliation Act of 1993. P.L. 103-66.(17) Ibid.(18) Tax Technical Corrections Act of 1998. P.L. 105-206.(19) Tax Relief Extension Act of 1999. P.L. 106-170.(20) Economic Growth and Tax Relief Reconciliation Act of 2001. P.L 107-16.(21) Klaassen v. Commissioner of Internal Revenue.(22) IRC Sec. 56(b)(1)(A)(ii).(23) IRC. Sec. 56(b)(1)(B).(24) IRC Sec. 56(b)(1)(E).

APPENDIX 1

Legislative History of the Alternative Minimum Tax, Pre-EGTRRA, 2001

Tax Reform Act of 1969 (P.L. 91-172)Introduced the “add-on” minimum income tax of10% in excess of an exemption of $30,000.

Excise, Estate, and Gift Tax Adjustment Act of 1970 (P.L. 91-614)Allowed deduction of the “unused regular tax carry-over” from the base for the minimum tax.

Revenue Act of 1971 (P.L. 92-178)Imposed minor provisions regarding foreign income.

Tax Reform Act of 1976 (P.L. 94-455)Raised rate of minimum income tax to 15% and low-ered exemption to $10,000 or half of regular taxes.

Tax Reduction and Simplification Act of 1977 (P.L. 95-30)Reduced minimum tax preference for intangiblecosts of drilling oil and gas wells.

Revenue Act of 1978 (P.L. 95-600)Introduced AMT alongside minimum income tax andmoved certain itemized deductions and capital gainsto AMT. AMT had graduated rates of 10%, 20%, and25%, and an exemption of $20,000.

Economic Recovery Tax Act of 1981 (P.L. 97-34)Lowered AMT rates to correspond with reductions inrates of regular income tax.

Tax Equity and Fiscal Responsibility Act of 1982 (P.L. 97-248)Repealed “add-on” minimum tax. Made AMT rate aflat 20% of AMT income after exemptions of $30,000for individuals and $40,000 for joint returns.

Deficit Reduction Act of 1984 (P.L. 98-369)Made minor changes concerning investment taxcredit, intangible drilling costs, and other items.

Tax Reform Act of 1986 (P.L. 99-514)Raised AMT rate to 21%. Made high-income taxpay-

ers subject to phase-out of exemptions. Increasednumber of tax preferences. Allowed an income taxcredit for prior year AMT liability.

Revenue Act of 1987 (P.L. 100-203)Made technical corrections related to Tax ReformAct of 1986.

Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-647)Made technical corrections related to Tax ReformAct of 1986.

Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239)Made further technical amendments.

Omnibus Budget Reconciliation Act of 1990 (P.L. 101-508)Raised AMT rate to 24%.

Energy Policy Act of 1992 (P.L. 102-486)Made changes regarding intangible costs of drillingoil and gas wells.

Omnibus Reconciliation Act of 1993 (P.L. 103-66)Introduced graduated AMT rates of 26% and 28%.Increased exemption to $33,750 for individuals and$45,000 for joint returns. Changed rules about gainson stock of small businesses.

Taxpayer Relief Act of 1997 (P.L. 105-34)Changes regarding depreciation and farmers’installment sales.

Tax Technical Corrections Act of 1998 (P.L. 105-206)Adjusted AMT for new capital gains rates.

Tax Relief Extension Act of 1999 (P.L. 106-170)Changed rules about nonrefundable credits.

Source: Joint Economic Committee, U.S. Congress.




71

APPENDIX 2

Calculating the AMT—The Klaassen Case

Although there have been changes in the AMT since 1994, for purposes of illustration we will be using the figures fromthe Klaassen 1994 tax return, as the general principles have not changed. The basic formula for computing AMT is:

Regular Taxable Income (TI) $34,092.47Plus: Adjustments

State and local taxes 3,263.56Net adjustment in medical expenses (10% AMT floor-7.5%) 2,076.41Personal and dependent exemptions 29,400.00

Equals: TI after AMT adjustments $68,832.44Plus: Tax preferences 0.00Equals: AMTI $68,832.44Minus: AMT exemption (1994) 45,000.00Equals: AMT base $23,832.44Times: AMT rate (1994) 26%Equals: Tentative AMT $6,196.43Minus: Regular tax liability 5,111.00Equals: AMT $1,085.43

The Klaassen 1994 Form 1040 return is extremely simple and yet it illustrates the basic mechanics of the AMT.Note that the AMT is a parallel tax system computation; the regular tax liability with all its adjustments andpreference items needs to be computed first.

Adjustments

Adjustments can be either positive or negative. If the deduction for regular income tax purposes exceeds thededuction allowed for AMT purposes, the difference is positive. Plus, adjustments frequently include itemsdeducted as itemized deductions under regular tax rules but not recognized for AMT purposes. These include realand personal property taxes, net differences in medical expenses (based on an AMT rate floor of 10% and a regulartax rate of 7.5%), miscellaneous itemized deductions in excess of the 2% floor, state income or sales tax, homeequity interest expenses (unless used to acquire or substantially improve the home), and at times tax-exempt inter-est from private activity bonds (bonds used to fund private activities i.e., baseball stadium, as opposed to publicactivities, i.e., road); interest from private activity bonds was not added back if issued in 2009 or 2010.

Itemized deductions that are allowed for both regular tax purposes and AMT purposes and thus need notbe added back include: casualty losses, gambling losses, charitable contributions, medical expenses in excessof 10% of AGI, estate tax on income in respect of a decedent, and qualified interest.

The other major adjustments that are added back are the standard deduction and the personal anddependency exemptions, as we saw in the Klaassen case.

Conversely, if income reported for regular income tax purposes exceeds the income reported for AMT pur-poses, the difference is a negative adjustment. Common examples include state income refunds included inregular tax income and gain or loss on the sale of depreciable assets.

Depreciation can be either a plus or a minus adjustment. Taxpayers must compute depreciation under theregular tax method, which in most cases is more accelerated than under the AMT method. If the regular depre-ciation exceeds the AMT depreciation, the difference is a plus adjustment. If AMT depreciation exceeds the reg-ular tax depreciation, this is a negative adjustment.

Note that this explanation is greatly simplified for our purposes and that the following topics should alsobe considered when thinking about adjustments: circulation expenditures, post-1986 real property depreciation,post-1986 personal property depreciation, pollution control facilities, expenditures requiring 10-year amortiza-tion for AMT purposes (mining exploration and development cost and research and experimental expendi-tures), completed contracts, incentive stock options, adjusted gains or losses, passive activity losses, and alter-native tax net operating loss deductions.

Preferences

Common preference items, most of which are not applicable to middle-income taxpayers, include: percent-age depletion, intangible drill costs, interest on private activity bonds, and exclusions for certain small businessstock. Note that the Klaassens did not have any preference items.

The AMT exemption amounts and tax rates have previously been discussed. It is also important to notethat there is a phase-out rule. Once the tentative AMT is determined, the regular tax is subtracted to calculatethe additional add-on tax due.

Copyright of Journal of Financial Service Professionals is the property of Society of Financial Service

Professionals and its content may not be copied or emailed to multiple sites or posted to a listserv without the

copyright holder's express written permission. However, users may print, download, or email articles for

individual use.

Documents

Article 2