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Problematic `alternative minimum tax' on Democrats' agenda

WASHINGTON—When the Democrats take over Congress next month, they're almost certain to pass a temporary measure that will spare 23.4 million upper middle class taxpayers—about one in four tax filers—from a nasty surprise—at least for a year.

Like the Republicans before them, however, the Democrats are likely to put off finding a permanent solution to the controversial "alternative minimum tax" because the Treasury needs the revenue it generates.

The AMT, which would be applied parallel to the income tax, was created in 1969 to prevent the very wealthy from using deductions to escape paying taxes. Now, though, the AMT increasingly snares the upper middle class, those with household incomes greater than $100,000 but less than $200,000. It often comes as a surprise, and it typically falls to a certified public accountant or financial adviser to deliver the bad news.

"Usually we broach that topic lightly ... it's certainly not a pleasant conversation," said Angela Alvig, manager of private-client services for Wipfli LLP in Minneapolis.

Income levels subject to the AMT don't rise year by year to offset inflation. That means that earnings that were considered wealthy decades ago but are fairly common today are exposed to the AMT tax. Income levels subject to the conventional income tax are adjusted for inflation.

Over the next decade, more than half of all households with incomes greater than $50,000 could be subject to the AMT. By 2010, households with incomes exceeding $500,000 will account for only 16 percent of AMT revenue, while almost half of households with incomes from $75,000 to $100,000 will have to pay the AMT.

"It doesn't matter what state you come from, it's just evil, and it's outlived it's usefulness," said Jay Cena, a co-founder of ReformAMT.org, a citizens group in Cupertino, Calif., that was formed to lobby against the tax.

The AMT sets separate definitions of income, tax rates and allowable deductions. Eligible taxpayers must calculate their tax liabilities under the conventional income tax, then calculate it again under the alternative rules and pay the larger of the two tax amounts.

Deductions in the ordinary tax code aren't allowed under the AMT. For example, the AMT treats real estate and children as tax shelters that need to be closed. It doesn't allow deductions for children who'd be treated as dependents under the conventional tax. Nor does it allow taxpayers to deduct the real estate taxes they pay, hitting tax filers in areas where property values have skyrocketed particularly hard.

Democrats have a tremendous political incentive to fix this problem. It's already a big issue in the Northeast, the party's stronghold, and in California, the nation's most populous state, with some of its priciest real estate. Within a few years, the AMT could threaten middle-income taxpayers across the nation.

"Everyone realizes that morally, politically, legislatively it just shouldn't have been there. And the only problem is how you're going to pay for it," said Rep. Charles Rangel, the New York Democrat who'll head the tax-writing House Ways and Means Committee next year.

Sen. Max Baucus, D-Mont., the incoming chairman of the Senate Finance Committee, which oversees tax law, pledged an AMT patch for 2007 and an eventual long-term solution.

Repealing a tax that threatens the middle class would seem to be a political no-brainer. The problem is that each year the AMT generates more revenue for the Treasury.

"Part of the problem is it's very costly. Even a patch is costly," said Sen. Trent Lott, R-Miss., who'll become the Senate's second-ranking Republican as party whip next year.

How much would a fix cost? Roughly 3.5 million tax filers will be hit with the AMT this year. If Congress were to hold that number constant next year—the fix that Democrats intend to make—the Treasury would lose almost $45 billion, according to tax experts.

A one-year fix in 2010 would cost the Treasury more than $80 billion; a similar fix a decade from now in 2016 would cost more than $170 billion. That's about what President Bush proposed to spend this year for the departments of Transportation, Education, Energy, Treasury and Justice.

If the AMT were repealed next year, and if President Bush's tax cuts of 2001 and 2003 were allowed to expire on schedule in 2010, the Treasury would lose $750 billion through 2016 in projected revenue, according to the Tax Policy Center, which is operated jointly by the Urban Institute and Brookings Institution, two center-left think tanks in Washington.

But if the AMT were repealed and the GOP-passed tax cuts continue beyond 2010, the combined cost to the Treasury over the next decade would be more than $1.3 trillion. This underscores the degree to which the AMT is offsetting the costs of Bush's tax cuts, which were intended to put more money in the pocket of Americans.

"The 2001-2003 tax cuts doubled the number of people subject to the AMT and roughly doubled the cost of fixing the AMT," said Leonard Burman, the co-director of the Tax Policy Center. He estimates that in 2010, the AMT will take back about 28 percent of the regular income tax cut that taxpayers would have received.

In a background paper last year, The Tax Foundation, a conservative policy group, concluded that "the Bush tax cuts will be responsible for most of the expansion of the AMT through 2011."

Here's another way to view it: If Bush's tax cuts expired on schedule in 2010, 17.3 million tax filers would be subject to the AMT. But if those tax cuts were extended and no fix were made to the AMT, 33 million taxpayers would be hit by the tax, according to the Joint Committee on Taxation, a nonpartisan congressional body whose mission is to estimate the revenue effects of changes in the tax code.

"I think middle-class America is getting ready to find out ... you can have deductions, you can have everything else, but the alternative minimum tax takes all that away," said Sen. Tom Coburn, R-Okla., a fiscal conservative who favors overhauling the tax system.

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Under the conventional income tax, single filers with incomes below $7,550 are taxed at a rate of 10 percent; incomes from $7,550 to $30,650 are taxed at 15 percent; from $30,650 to $74,200 at 25 percent; from $74,200 to $154,800 at 28 percent; from $154,800 to $336,550 at 33 percent; income above $336,550 at 35 percent.

The Alternative Minimum Tax usually hits household incomes above $150,000, especially two-earner families, since personal exemptions are disallowed. Once income is calculated, a standard AMT exemption is subtracted—$42,500 for single filers, $31,275 for married couples filing separately and $62,550 for married couples filing jointly. The remaining income is taxed at 26 percent on the first $175,000 ($87,500 for married couples filing separately) and 28 percent for income above that.

To see if you might be subject to the AMT, go to this IRS Web site: http://apps.irs.gov/app/amt/

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AN EXAMPLE

A two-earner family that has pretax 2007 income of $150,000, three children and lives in a high-tax state would be liable for $22,597 in conventional federal income tax.

But that family would be liable for $27,300 under the AMT. That's a whopping $4,703 in additional tax liability.

These calculations come from Alan Viard, a tax expert at the American Enterprise Institute, a conservative think tank in the nation's capital.

The calculation assumes that under conventional income tax, the family would have taken five personal exemptions worth $17,000 that wouldn't be allowed under the AMT and deducted $14,000 in state income and property taxes that couldn't be written off under the AMT. The family is also hit with a 1 percentage point increase in the marginal tax rate under the AMT, taxed at a rate of 26 percent vs. 25 percent under conventional income tax.

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(c) 2006, McClatchy-Tribune Information Services.

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