Of all the tax issues facing Congress when it returns for a lame duck session after the Nov. 2 midterm elections, the annual rite of patching the Alternative Minimum Tax will be the most urgent.
Unlike the debate over the Bush tax cuts, which will affect taxpayers' income in 2011, the AMT applies to 2010. And the delay in patching it is already causing problems and raising alarms for large numbers of middle-income taxpayers -- as many as 25 million Americans, according to one expert -- who could face a huge increase in their tax payments if Congress doesn't act.
Enacted in 1969, the Alternative Minimum Tax was originally aimed at 155 extremely wealthy taxpayers who had avoided paying federal taxes completely. It was an add-on tax designed to ensure that everyone paid some income tax every year. Since then it has evolved into the primary tax mechanism for taxing high income taxpayers.
Under the original system, taxpayers who earned more than $200,000 -- a very high income 30 years ago -- were required to calculate their taxes differently, resulting in a larger tax payment for the wealthy.
But unlike most other income tax rates, the AMT was never indexed to inflation, and since 1982 the AMT has become a parallel tax system and a critical element in funding the government. It covered more than 4 million high-income taxpayers in 2009, according to the Congressional Budget Office.
But the $200,000 ceiling is no longer a small fortune, nor is it the sole criteria for triggering the AMT tax. Today a complex formula that looks at the differences between income and deductions determines who will pay. And each year Congress has to act to raise the exemption limits of the tax to prevent it from targeting increasing numbers of less affluent people.
If Congress is unable or unwilling to act on the patch, then “as many as 25 million taxpayers may see their tax liability rise by anywhere from $3,000 to $5,000,” according to Leigh Mutert, of H&R Block, “The primary victims will be middle-class taxpayers.”
In 2008 Congress set the exemption for the AMT at $70,950 for married couples filing jointly, the largest group impacted by the AMT. If it fails to enact a post-election patch, that exemption will revert to $45,000, the original exemption amount, ensnaring millions of taxpayers in a tax hike that would total $70 billion, according to Bill Ahern of the Tax Foundation.
Under the system, high-income taxpayers are required to calculate their tax returns twice. If tax returns completed under the normal procedures meet certain income and deduction criteria, the taxpayer is then required to complete the process again using AMT rules. Whichever tax is higher is the one the taxpayer must pay.
For example, according to the Congressional Budget Office, a married couple with four children and earned income of $160,000 who paid $10,000 in mortgage interest and $25,000 in state and local taxes using normal filing procedures would pay $18,150 in taxes this year.But when they recalculate their taxes under AMT procedures, they would be required to use the single $70,950 deduction but lose their deductions for the four children and local taxes. Their tax liability would then jump to $20,553.
While Congress has been embroiled over the expiration of the Bush tax cuts, there has been little debate about the AMT -- other than promises that it will be taken care of before next year’s tax season begins. Usually a bipartisan and uncontroversial procedure where the inflation rate is added to last year’s exemption, no one is certain what will happen this year.
“It is getting alarmingly late in the year, and with Congress recessing for the election followed by a brief lame duck session before year end, it is not certain that Congress will get this done,” Mutert worried.
“I told everyone that Congress would never let the estate tax lapse. I was wrong. We just don’t know what will happen this year,” Ahern added.
Press secretaries for several Senate Finance Committee members from both the Democratic and Republican parties said that the patch is expected to be handled in the lame duck session, but no one is “sure” if it will be. “There are a lot of pressing tax matters this Congress hasn’t dealt with,” one said.
Even if Congress does act, tax preparers are sweating bullets that the delay will throw next year’s income tax season into disarray, because no matter what Congress agrees on, putting new rates into effect will take time. Aside from the debate over the size of the patch, tax preparers say the Internal Revenue Service will need at least six weeks to upgrade its software and issue schedules reflecting the changes to the AMT.
When Congress delayed fixing the patch until December in 2007 the IRS wasn’t able to accept tax forms from a significant number of AMT filers until Feb. 11, 2008. If Congress acts on Nov. 15, there shouldn’t be any delays this year. But if Congress gridlocks over the Bush tax cuts, or declines to act for other reasons, then the impact would be almost immediate.