Official: Middle Class Trapped in Alternative Minimum Tax

The government's advocate for taxpayers predicts the alternative minimum tax (search) will be one of the biggest problems many Americans will have while filling out their returns.

In her annual report to Congress detailing the difficulties confronting taxpayers, Taxpayer Advocate (search) Nina Olson called the alternative minimum tax "a time bomb on a short fuse." Originally intended to stop the wealthy from sheltering their income from taxes, the alternative minimum tax now catches more middle-income families.

Millions of taxpayers will fall into the parallel tax system this year. The problem stands ready to explode in 2005, when 65 percent of married couples with two children and a combined income between $75,000 and $100,000 will pay the alternative minimum tax.

"It is a tax that will take people unawares. There is no way to plan for it," Olson said in an interview.

Congress developed the alternative minimum tax, or AMT, after discovering in 1969 that a handful of very wealthy individuals had hidden all of their income from taxation. Since then, the tax has steadily seeped down to less affluent families.

Families with many children, families that live in high-tax states and some people who exercise incentive stock options can get caught in its trap. The tax takes away most of the advantages built into the standard tax system, such as exemptions for children, deductions for state and local taxes and deductions for employee business expenses or legal fees.

If higher taxes weren't punishment enough, the paperwork adds another burden. Taxpayers who might face the AMT do their taxes twice -- once under the regular system and a second time under the AMT.

A taxpayer fills out a 12-line worksheet to find out if the AMT might apply. If the results show it's possible the taxpayer might owe the alternative minimum tax, the taxpayer turns to an 65-line form to compute the taxes owed. Some taxpayers go through all of this to find out they don't owe the extra tax after all.

And the tax takes people by surprise. Between October 2002 and August 2003, the taxpayer advocate's office accepted 500 cases in which taxpayers faced serious hardships because they got stuck paying the alternative minimum tax.

Olson recommends that Congress repeal the tax, but the high cost has kept Congress from eliminating it altogether. Short of repealing it, Olson recommends that Congress exempt everyone under a certain income from paying it.

While the alternative minimum tax tops the list, the report shows taxpayers face serious problems in other dealings with tax laws and the Internal Revenue Service (search):

--Taxpayers cannot always trust tax preparers, who aren't regulated by any licensing agency or subject to minimum competency requirements.

--The IRS hasn't solved many of the problems surrounding the earned income tax credit. The agency is only now starting local outreach and education campaigns to make people aware they might qualify for the credit. Credit recipients who get examined by the IRS face lengthy audits.

--The IRS is considering shrinking its community taxpayer assistance centers by closing offices, limiting hours of operation or restricting who can ask for help.

--Taxpayers and tax preparers can find it extremely difficult to find the correct IRS employee or department to resolve a tax problem.

--IRS letters identifying math errors in a taxpayer's return are confusing and offer an inadequate explanations. Taxpayers are often unsure how to respond or challenge them.

--IRS criminal investigators who suspect fraud in a tax return can withhold a refund and don't have to notify the taxpayer that the return is under investigation until it's over.

--Taxpayers face long delays in the Office of Appeals, which is supposed to help resolve tax disputes without litigation.