Who says Republicans are out to get poor people?
2003-06-18 | 7:47 a.m.

TAXES

Taxpayer, Beware!

Washington will soon be taking back a good chunk of that new tax cut. How? By using the sneakiest trap it's got: the Alternative Minimum Tax.

FORTUNE

Monday, June 9, 2003

By Shawn Tully

There will probably come a time in the next few weeks when you'll look at your paycheck, notice that the take-home dollar amount is a little bit higher and the "federal withholding" amount is a little lower, and you'll experience a feeling of contentment. It's been a hard year. The economy stinks, your property taxes have gone way up, as have your state and local taxes, and your kids' college tuition ... no, let's not talk about your kids' tuition. But, hey, the President and Congress have pushed through that tax cut--the largest since the Reagan tax cut of 1981, no less--and you're seeing the happy result already right there on your paycheck. You may even be moved to say, Thank you, Uncle Sam, for cutting me a little slack.

Well, guess what? For millions of Americans, Uncle Sam is doing a head fake: Washington fully intends to take back a large chunk of that tax cut. No, we're not talking about the much-discussed "sunset" provisions whereby Congress met its budget targets by passing cuts that phase out in a few years. We're talking about something sneakier and much nastier: the Alternative Minimum Tax, or AMT.

The AMT isn't new. It's been around for decades and often gets a passing nod in newspaper and magazine articles about tax policy. It was hardly mentioned at all during the debates leading up to the latest tax cut, however, and that's a shame. If there were ever a part of the tax code that could use some serious public discussion, this is it.

Most people don't really know much about the AMT, other than a vague awareness that it's a punitive and horribly complex chapter of the tax code that's best avoided. Put simply, the AMT is a tax regime that high-income people get thrown into when they take lots of deductions or enjoy a big jump in income, such as by exercising a heap of stock options. It's a kind of parallel tax universe that has very few deductions and forces you to pay far higher taxes in the future than you'd pay under the regular system. You lose the breaks for costs that Congress has consistently and vocally deemed break-worthy: things like property taxes, state and city income taxes, exemptions for children, the interest on home-equity loans--in fact, pretty much everything but mortgage interest and contributions to charity. You can't even deduct the fees for tax preparation, and believe us, once you're in the mind-bending universe of AMT, you'll need a tax planner like you need food, shelter, and clean underwear.

Now, you may be asking, Of all the problems in our screwed-up tax code--from deep philosophical questions, such as why we always leave payroll taxes, which impose high effective tax rates on working people, out of our rate-cutting debates, to our political leaders' increasing reliance on deficit-obscuring tricks like those sunset clauses--why focus on the AMT? Isn't this a bit like removing one piece of bad sushi and leaving the rest of the bad sushi on the platter?

No, and here's why. What's most troubling and least understood about the AMT is the growth trajectory it's now on. According to a recent study by the Urban-Brookings Tax Policy Center--class warriors, please note, this is a liberal think tank--the number of Americans exiled to AMT land is about to explode. This year the AMT will catch only 2.4 million families and individual taxpayers. By 2005 that will leap to 12.7 million, and it keeps soaring. Indeed, by 2010, 33 million taxpayers, one-third of the total, will pay the AMT if the rules aren't changed.

The AMT is even scarier when you look at this growth in dollar terms: This year it will bring in $16 billion, around 2% of all federal income tax revenue. By 2010 the AMT will harvest $124 billion, or around 1% of the total GDP. Perhaps the most shocking way of expressing it is this: By 2010, 55% of the income generated in this country will be subject to the AMT. If Washington does nothing, the AMT is on track to supplant the existing body of rules, rates, and deductions and become the dominant tax system in the U.S.

Another thing you probably don't know about the AMT, dear reader--especially if, as many FORTUNE subscribers do, you make north of $100,000 a year and live in coastal states with high taxes and high costs (and thus lots of deductions)--is that you are in the group that stands an excruciatingly high chance of getting hit by the AMT over the next few years. By Urban-Brookings's figuring, 95% of families and individuals with incomes from $100,000 to $500,000 will fall into the AMT zone by 2010. Yes, virtually everyone in that group. And here's the bill: You'll be paying an extra $10,000 a year in taxes, on average. (The Congressional Budget Office has run these numbers too, and got similar results.)

Some tax cut, huh? But wait, there's one last bitter irony. One of the things that will do the most to push you into the AMT, believe it or not, is the tax cut you thought you just got.

A few more words about you. You account for a large portion of America's most ambitious, productive people--you are executives, law firm partners, airline pilots, doctors. You're not poor, of course. Even in places like New York City and San Francisco and Chicago, an income in the low to mid-six figures is hardly poor. But with high taxes and the all-around high cost of living, you certainly don't feel rich either. Most of you are "Henrys": High Earners Not Rich Yet.

Bill Simmelink is a textbook Henry who's had a recurring real-life AMT nightmare. He's had success both as a tech entrepreneur and as a highly paid manager in a big company. The AMT's sneak attacks have this 54-year-old engineer and divorced father of three seething, and for good reason. The AMT first mangled Simmelink's finances three years ago when he exercised the incentive stock options (ISOs) he'd received when the software startup he worked for was sold to Texas Instruments.

ISOs are a class of options meant to encourage recipients to keep their company's stock, and so they get special tax treatment through a convoluted formula of prepayments and credits. But large ISO grants are also automatically taxed under the AMT. The details here are complicated; in practice what happens is that you pay the AMT when you exercise the options. If the stock plummets, you can end up paying more in tax than the entire gain--and end up with a bunch of unusable credits. That's what happened to Simmelink: He exercised a bundle of options worth $6.5 million and paid $1.7 million in taxes upfront; he kept his shares; TI's stock plunged; and his gain fell to $1.8 million. And thanks to the bizarre workings of the AMT, he paid a huge tax on a phantom gain he never saw. "I paid almost as much in tax as my TI stock is worth now," Simmelink says. He's still shocked. "It was like paying a 100% tax on my gain."

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