Alternative Minimum Tax – The Tax Trap!
Tax time has come and you have spent a great deal of time through the year learning and utilizing as many tax breaks as possible to reduce your tax liability. You smile contently as you look over all your hard work. So, you escaped the long arm of Uncle Sam and have avoided breaking the bank paying taxes this year, right? Wrong! In order to curtail people from being able to utilize perfectly legal and allowable deductions too much, the IRS created the Alternative Minimum Tax (AMT) to tax those individuals that otherwise would not have to pay much in taxes.
The idea behind the Alternative Minimum Tax (AMT) is to counterbalance certain forms of income that are given preferential tax treatment, such as certain business structures, some portfolio income, and passive income. Individuals that utilize the correct structures could get away with paying little or no tax at all. Hence the name; the AMT was designed to make people pay a minimum amount of tax.
However, there are a few pitfalls to the Alternative Minimum Tax. It seems that inflation has caused a dollar to seem like much more than it is. Income tax brackets are continuously adjusted to account for inflation. However, the AMT rates are not. Because this tax is determined primarily by income level, more people are becoming subject to the AMT and the people that are getting stuck are regular middle-class individuals, not the super rich, which is who was targeted by the implementation of the tax originally.
The tax rates for the AMT are 26% and 28%. Basically, to calculate the AMT, you are given a new set of tax rules to calculate your taxable income in which most of your deductions and credits are eliminated. Then, you compare this tax liability with your regular tax liability under the old rules. If the AMT is higher, you must pay your regular income tax and pay an additional amount of tax on the amount of AMT over your regular income tax at a rate of 26%-28%.
For example, if your income tax is $30,000, but your AMT is $35,000, you pay the regular income tax of $30,000, but then you pay AMT of $5,000 (the difference between $30,000 and $35,000). Therefore, you are basically taxed at the higher AMT taxable level.
There is an option to claim the expense of AMT as a deduction in later years; however, most of the people subject to AMT are barred for this convenience. Therefore, it provides little, if any, relief. Even if you are in the lowest income tax levels, 10%-15%, you may still be subject to AMT if you have significant capital gains. When you consider this, it does not make a lot of sense that the purpose of the AMT was supposed to be to prevent the wealthy from committing tax avoidance.