Over the past three Congresses, the Alternative Minimum Tax (AMT) has morphed from a little-known “stealth tax” into a widely known, highly discussed, and almost universally despised parallel income tax system with unintended consequences.
With millions of taxpayers now being affected by the AMT, the current, 110th Congress likely will focus more attention than the 109th and 108th Congresses on how to address certain aspects of the AMT that are particularly urgent and compelling.
Intended for Super-Wealthy
Congress enacted the AMT nearly 40 years ago to ensure a handful of super-wealthy Americans could not completely avoid paying taxes. It worked, but subsequent inflation and other economic factors have gradually extended the AMT’s reach to millions of middle-class households. This year the tax will affect 23.4 million Americans and could hit as many as 53 million by 2017, according to IRS estimates.
The growing level of awareness and discontent is turning to anger among taxpayers, and as a result many members of Congress want to reform or eliminate the AMT. However, Congress’s challenge is daunting. If left alone, the AMT will bring in more than $1 trillion over the next 10 years.
Congress instead has been focusing on adjusting the AMT for inflation each year, thereby protecting many American families from its grasp. Meanwhile, the potential harm to taxpayers and the need for reform grows.
Although the solution is now up to the 110th Congress, the last act of the 109th Congress broke new ground in targeting and addressing an aspect of the AMT that was having particularly severe unintended consequences for some taxpayers, paving the way for a step-by-step approach toward AMT reform.
Options Tax Ruinous
Specifically, the 109th Congress modified the AMT provision that devastated families who exercised incentive stock options (ISOs).
Congress created ISOs in 1981 in order to allow fledgling businesses to attract and retain skilled employees of every level without paying high salaries, to encourage employee dedication to these businesses, and to promote long-term investments by employees in the company.
ISOs have the advantage that employees do not owe regular tax upon exercise of options, but rather when the stock is later sold. ISOs have become the compensation element of choice for young, entrepreneurial companies and are generally given out broadly, not just to management and executives but also to rank-and-file employees.
The AMT, however, imposes a tax on ISOs when an employee exercises the option and purchases the company stock, independent of sale and irrespective of gain or loss in stock value. Tens of thousands of families have ended up owing tax on paper gains.
For many families, their taxes on ISOs have greatly exceeded actual income. As a result, the IRS has seized assets, including children’s college savings, retirement accounts, insurance policies, and homes.
Taxpayers have sought administrative and judicial relief, occasionally finding sympathy but never a solution.
Targeted Tax Relief Granted
The 109th Congress acted in a strong, bipartisan effort to provide targeted relief to these stricken taxpayers. Congress also passed a related amendment that would increase taxpayers’ compliance with the AMT’s ISO provision, virtually offsetting the revenue impact of the relief.
This AMT legislation likely is the first of many “bites” at realigning the AMT with its original intent. Rep. Sam Johnson (R-TX), sponsor of the bill upon which the legislation was based, noted, “Democrats and Republicans both recognized this problem as an unintended consequence of the AMT, and worked over the last three Congresses to address the problem in a manner that would synchronize final tax owed with actual gain received. The 109th Congress achieved this goal in significant part, while recognizing more work remains to be done to fairly rectify the situation.”
Johnson added, “This AMT-ISO situation demonstrates once again why we should repeal the AMT altogether, but this particular problem deserves attention now. I’m glad that we took the first bite of the apple and got to help the rank-and-file employees hurt by the AMT-ISO inequity. I hope that we can build on that success and [in 2007] end this problem for everyone.”
Democrat Chairman on Board
Sen. Max Baucus (D-MT), incoming Senate Finance Committee chairman, shares Johnson’s desire to repeal the tax, but doubts that’s politically realistic in the near future.
“If I had my choice, I’d repeal the individual AMT entirely and stop this stealth tax on American families once and for all,” Baucus said. “I think what’s realistic in the immediate future is a provision to prevent AMT from snagging more taxpayers in 2007 while we mount a strong effort to deal with the AMT longer-term in a fiscally responsible way. Fixing the AMT problem without adding to the nation’s debt is a tall order, but that’s how we need to approach it.”
Sen. Charles Grassley (R-IA), ranking member of the Senate Finance Committee, agrees the AMT needs to be repealed, and he cautioned Democrats to recognize Congress should not “rely on revenue that was never supposed to be collected in the first place.”
Congress will likely embark on a deliberate and extended process of reversing the AMT’s effects, in part through continuing the inflation-adjustment approach. Targeted reforms are expected where taxpayers are most unfairly affected, including extending AMT-ISO relief to families left out due to income phase-outs.
Tim Carlson ([email protected]) is president of the Coalition for Tax Fairness. Brian Trauman ([email protected]) is an attorney specializing in tax issues at Mayer, Brown, Rowe & Maw LLP in New York City.