The Alternative Minimum Tax—CNBC Explains

The alternative minimum tax, or AMT as it's known, has trapped more and more American taxpayers over the years and become one of the most dreaded phrases in tax terminology.

AP

To help better understand and unravel the complicated AMT, CNBC explains how it all works.

What is the AMT?

The alternative minimum tax (AMT) is an extra tax some people have to pay on top of their regular income tax.

It has its own set of rates and rules for deductions, which are less generous than the non-AMT rules.

The idea behind the AMT tax was to prevent people with very high incomes from using special tax benefits to pay little or no tax.

But the AMT has kept expanding its reach over a 42 year history and now applies to taxpayers who don't have a very high income or who don't claim lots of special tax benefits.

How do you know if you have to pay the AMT?

This is the hardest part to figure. A taxpayer can have AMT liability because of one big item on a tax return, or because of a combination of many small items.

Any taxpayer is a possible candidate for the AMT. But a common suggestion is that anyone, or a couple filing a join return, with an income of $75,000 or more should definitely figure out the AMT calculations.

Most vulnerable to the AMT are taxpayers with children—tax dependents—and who take mortgage interest deductions, have capital gains, and have high state and local taxes. Those items are not deductible when it comes to calculating the AMT and usually put taxpayers at risk of having an AMT bill.

What taxpayers—and/or their accountants—have to calculate is if the regular tax is higher then the AMT figure. If it is, then there's no AMT to pay. But if the regular tax calculation is lower, the difference between the two taxes is the amount of AMT that has to be paid on top of the regular taxes.

The average AMT bill is between $2,000 and $15,000.

When did the AMT start?

In 1969, government officials noticed that 155 people with high incomes were legally using so many deductions and other tax breaks and that they were paying absolutely nothing in federal income taxes.

That caused plenty of public outrage and embarrassment, so Congress passed a bill authorizing the AMT to start in 1970. Just 19,000 people ended up paying the AMT that year. More than 4 million are expected to pay it for 2011.

Why do people in upper middle to middle incomes pay the AMT?

In a word, it's inflation. While non-AMT or regular tax brackets have had their exemptions and standard deductions adjusted annually for inflation, the AMT brackets and exemptions have never been adjusted to inflation. So, many more people whose income has grown with the economy, end up caught in the AMT zone each year.

Why the AMT hasn't been tied to inflation is one of the main criticisms of the tax.

But it's not just inflation that's catching more taxpayers. Changes in the AMT during 1980's and 90's eliminated more deductions and put a great number of people into the AMT.

More recently, the Bush tax cuts of 2001-2006 lowered regular rates for most incomes but did nothing to change rates and exemptions for the AMT. That ended up pushing more middle to upper middle incomes into the AMT.

What are AMT patches?

To help keep some middle and lower income people from being hit by the AMT, Congress has enacted temporary relief during each of the past several years by passing what's called a patch. These one year 'deals' have raised AMT income exemptions so that fewer people—mostly with incomes between $45,000 and $75,000—will end up paying the AMT.

How much tax revenue does the AMT bring in?

A lot.The original AMT collected just $122 million—about $700 million in today's dollars—which was just over one-tenth of one percent of all individual income tax revenue.

Fast forward to the last tax year of record, 2010, and some $102 billion was collected.