Portfolio Perspective

Trump vows to axe a dreaded surtax on the upper middle class

By Jeff Brown, special to CNBC.com
Taxing questions
Taxing questions

Each mid-April, you can almost hear the collective nationwide cursing and sputtering as millions of U.S. taxpayers come to the end of their tax-preparation software programs, hit their computer's Enter key and find they're nailed by the reviled alternative minimum tax.

President-elect Donald Trump wants to scrap the 47-year-old tax, which was originally meant to assure the rich don't avoid paying their fair share, but which now hits more than 4 million taxpayers a year. Most are middle-class folk who've never tapped a trust fund in their lives.

"It was originally targeted at the super-wealthy when it came out, but the super-wealthy in most cases don't pay it," said certified public accountant Scott M. Aber, owner of his eponymous accounting firm in Rockland County, New York. Despite the original intent of the tax, the super-rich now typically pay more in regular income tax than they would under AMT, so the AMT has evolved into a surtax on the middle and upper middle class.

Taxpayers with lots of itemized deductions must figure their tax returns twice and pay whichever is higher: the AMT or their regular tax. The AMT denies deductions for things such as dependents and payments for real estate and state taxes.

So why not kill the AMT? Who'd win and who'd lose?

"AMT raises a lot of money for the Treasury, so if it is eliminated, it will either raise the deficit or they will have to raise taxes elsewhere," Aber noted.

The U.S. Treasury collected about $28.2 billion in AMT from 4.1 million taxpayers in 2015, according to the Tax Policy Center at the Urban Institute and Brookings Institution. In theory, scrapping the AMT could force the government to cut spending for programs and services that people like, or it could lead to a larger deficit or a tax increase on someone, or maybe everyone.

It was originally targeted at the super-wealthy when it came out, but the super-wealthy in most cases don't pay it.
Scott Aber
CPA, the Scott M. Aber accounting firm

AMT abolition would make winners out of the millions otherwise likely to pay it in the future. The Tax Policy Center projects AMT revenue totaling nearly $350 billion between 2017 and 2025.

As noted, the AMT was not intended to be a middle-class tax. It hit fewer than 1 million households at its inception and peaked at 4.6 million in 2010 before tinkering in Washington trimmed the numbers.

For 2016 the AMT exempts the first $53,900 in income for a single person and $83,800 for a married couple filing a joint return. But as income rises above $119,700 for singles and $159,700 for couples, the exemption phases out. While AMT tax rates are slightly lower than on the regular return, the lack of deductions can produce a higher tax overall.

The nonpartisan Tax Foundation says only a smattering of those affected — just 3.8 percent — have annual incomes ranging from $100,000 to $200,000 a year. About 62.5 percent earn $200,000 to $500,000. The next largest group, 43.83 percent, earn between $500,000 and $1 million. Those earning $1 million to $10 million make up 17.74 percent of those hit, and those earning $10 million and over 24.33 percent.

House Ways & Means chairman on Trump's tax plan
House Ways & Means chairman on Trump's tax plan

But the AMT troubles many more taxpayers, as nearly 10 million are in the danger zone and must do the AMT calculations, according to the Tax Foundation.

Residents of states with high income-tax rates are especially likely to fall into the AMT's clutches, because a big state-tax deduction is a triggering factor. In high-tax New Jersey, "81.6 percent of households making between $200,000 and $500,000 fall under the AMT," the Tax Foundation said. But in Wyoming, which has no state income tax, only 26.2 percent of households in that income range pay the AMT. Of course, Wyoming taxpayers do not benefit from the regular return's state-tax deduction, so escaping the AMT can be a bittersweet victory.

Other factors put taxpayers at risk for the AMT. The more children you have, the more likely you'll be hit, since each child produces a $4,050 deduction on the regular return. Taxpayers who claim itemized deductions are far more likely to be hit than ones that take the standard deduction instead, again because it is deductions that cause the AMT to kick in.

"As these statistics show, the AMT basically functions as a surtax on high-income taxpayers in high-tax states with children," the Tax Foundation said.

AMT triggers

While there are many strategies for reducing tax on the regular return, there is not much one can do to wriggle free of AMT. Declining to deduct your dependents or take credit for a big state tax bill, for instance, could just produce a regular tax even higher than the AMT.

"The AMT does often come as a surprise to many taxpayers who end up being subject to it," said Dave Du Val, chief advocacy officer at TaxAudit.com, a tax advisory service in Citrus Heights, California. "Because AMT is a tax system that runs in parallel with the regular tax system, there is no way to determine if a taxpayer is going to be hit with AMT just by looking at their documents [like] W-2s and 1099s," he said.

"With the exception of increasing withholding to cover the taxes, there is little a taxpayer can do to prepare for the AMT," he added.

While Trump's platform called for eliminating the AMT, he has yet to provide details or say if he would propose some other measure to offset the lost tax revenue.

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A compromise is always possible, such as eliminating or capping some of the deductions the AMT targets. Trump has also advocated capping deductions to perhaps $100,000 for single filers and $200,000 for joint filers, so some well-to-do taxpayers could find that what they save through elimination of the AMT could be lost by higher regular taxes.

It's not just conservatives who hate the AMT. Sen. Bernie Sanders wanted to get rid of it as well, though Democrats generally want to raise taxes on the wealthy, not lower them.

The Tax Foundation notes that an alternative to repealing the AMT would be an overhaul of the regular tax code to eliminate the breaks that led to the creation of the AMT in the first place.

"Allowing the state and local tax deduction and dependent exemptions for AMT purposes would reduce the number of households affected by the AMT from 4.1 million to just 500,000 in 2015," according to the Tax Policy Center.

Crystal Stranger, president of 1st Tax, a tax preparation firm in the Los Angeles area, believes the tax system can be repaired. "I don't see much of a case for not eliminating AMT, especially as most of the deductions that are limited as part of AMT are elsewhere limited in the tax code, and these areas could have more detailed restrictions added to create fairness in a less complex and arbitrary manner," she said.

"They could just do a [tax] surcharge based on adjusted gross income limits to target it better and eliminate AMT," Aber added. That, of course, would increase taxes for some, an inevitable outcome unless federal spending is cut enough to offset any loss of AMT revenue.

Although many dream of inserting common sense and fairness to the tax code, that has been hard because so many features are the product of lobbying, haggling and splitting the difference in Congress. That's why so many things, such as income levels for different tax brackets, seem to have no logic.

For now, experts say taxpayers at risk should make sure they will have cash on hand in case the AMT is still around come April. Unless Washington moves unusually fast, it probably will be.

— By Jeff Brown, special to CNBC.com