As negotiations over the fiscal cliff begin in Washington this week, a little-known part of the tax code has emerged as the greatest threat to the pocketbooks of average Americans.
The alternative minimum tax (AMT) is set to kick in December 31. It has been part of the tax code for decades, and is essentially a second tax created to ensure wealthy families pay their fair share of tax as determined by law.
However, the AMT has not been indexed for inflation—so while incomes have grown, the income levels referenced in the AMT have stayed the same.
Currently, only 4 million people pay the AMT. If no action is taken by Congress, 28 million Americans will be required to pay it. According to the Tax Policy Center, the average family affected by the AMT would have to pay an additional $3,700 in taxes. In a letter to Sen. Orrin Hatch (R-Utah), acting Internal Revenue Service Commissioner Steven Miller said the AMT would have a dramatic impact on the vast majority of Americans who would become eligible. "Without an AMT patch, about 28 million taxpayers would be faced with a very large, unexpected tax liability for the current tax year," he wrote.
[Read: Taxmageddon: What You Need to Know.]
Understanding the AMT. The AMT has been around in one form or another since 1969. It's an alternate way of calculating income tax that dictates how much someone with a specified level of income has to pay the IRS. For instance, if a taxpayer is already paying the required amount, he or she does not have to pay the AMT. But if the amount of money being paid to the IRS is below the income tax owed to the IRS specified under the normal tax code, the taxpayer is required to pay the AMT.
"The nuts and bolts is simply that the AMT is best understood as a second income tax—a competing income-tax system with a lower rate, a high standard deduction, and many fewer deductions," says Edward Kleinbard, a law professor at the University of Southern California Gould School of Law and former chief of staff of the U.S. Congress's Joint Committee on Taxation.
To get a better idea of how the AMT works, take, for example, a rich family that meets the AMT income threshold. This family owes $80,000 in regular income tax, but under the AMT, they would owe $90,000. The family would have to pay the $80,000 in regular tax, plus the additional $10,000 as an AMT payment.
The AMT was created to eliminate deduction loopholes the wealthy could use to pay less in taxes. But over the years and because of inflation, incomes levels have grown to include more and more Americans.
In the past, Congress has put in place short-term legislative fixes that have prevented more Americans from becoming eligible for the AMT. However, nothing has been done this year.
Who would have to pay the AMT. Requirements for AMT payment depend on filing status. In general, a family with a household income of $75,000 or more will be required to pay the AMT if Congress doesn't act. According to Kleinbard, those most affected will be in the upper-middle class, not the lower-middle class or the very rich.
"When you start off in life, [the AMT] doesn't bother you," says Kleinbard, "Your income goes up and you buy a bigger house, and then you're told that you do have an AMT problem. If you make enough money … you've passed the need for AMT."
The AMT would be disproportionately felt in larger cities along the coasts where incomes are higher, according to Sharon Kreider, a certified public accountant and owner of Kreider CPA, an accounting firm in California.
Remnant of a flawed, outdated tax system. Both Kreider and Kleinbard say the AMT has outlived its usefulness and needs to be reformed. "The fact that this now applies to so many people is evidence of a broken system," Kleinbard says. "Why do we have the AMT? Congress needs to raise tax revenues, but they are unwilling to do it a straightforward way."
The two also agree Congress is likely to come up with yet another short-term fix that doesn't address the underlying problems in the tax code. "They'll solve the problem for 2012. Then they have to do it again in 2013," Kreider says. "They have to look for a more permanent fix."