Archive

OUCH! INCOME TAX SQUEEZE TIGHTENS: WHY MORE MIDDLE-CLASS AMERICANS FACE IRS WHAMMY

Millions of taxpayers are in for a rude and expensive surprise over the next few years if Congress…

Millions of taxpayers are in for a rude and expensive surprise over the next few years if Congress doesn’t change the tax laws, and financial planners are finding it increasingly difficult to help them.

The number of taxpayer returns subject to the alternative minimum tax (AMT) is projected to increase more than 10-fold to 8.8 million by 2008, representing some 6.5% of all individual tax returns according to a report issued by the congressional Joint Tax Committee.

The reason is simple. While income levels used to calculate regular tax rates are indexed for inflation, income exemptions under the AMT remain set at $45,000 for couples filing jointly or $33,750 for single people. Taxpayers with income above those levels — about 39% of all tax returns filed in 1995 — may be subject to the AMT if they take certain types of deductions and credits, such as deductions for state and local taxes, accelerated depreciation on personal property and benefits from incentive stock options.

AMT tax rates — 26% for the first $175,000 of income, 28% for income over that — aren’t indexed for inflation, either. Taxpayers must figure out what they would owe under the regular tax vs. the AMT, and pay whichever amount is higher.

“If we do nothing we will all be AMT taxpayers at some point, which is nonsense,” says a Republican Capitol Hill staff aide.

The tax, enacted in its current form in 1986, was originally devised to “catch rich people who take tax shelters,” says Diana Furchtgott-Roth, a resident fellow at the American Enterprise Institute, a conservative Washington-based public policy research group. “Now it’s catching more upper middle-income people and it’s going to catch more middle -income people who have high state and local income taxes and large numbers of children.”

For 1998 the number of taxpayers subject to the alternative minimum tax is projected to be 856,000, 0.7% of the total number of individual tax returns filed. By 2008 the amount of extra taxes paid under th
e AMT compared to the regular tax will more than quadruple to $19.8 billion, up from $4.3 billion for 1998.

Those socked with the AMT are hardly filthy rich. By 2008 half of them will have incomes of less than $100,000, and 1.8 million will have incomes less than $75,000.

But the rise of the AMT is compounding fears that middle- and upper middle-income Americans are increasingly losing deductions and credits that are phased out as income rises. Some 33 million taxpayers already pay higher effective tax rates — in many cases more than 50% — because of such income bars, according to the office of House Ways and Means Committee Chairman Bill Archer (R-Texas).

fewer deductions

Repealing, or at least taming, the AMT is at the top Mr. Archer’s wish list for any tax bill, and many Democrats support such a move. But the Clinton administration, despite expressing support for some sort of a solution, has not addressed the AMT in its budget proposals, and many predict that political wrangling this election year will make it impossible to pass a tax-cut bill.

Those subject to the AMT not only pay higher taxes, they’re also shut out of many popular tax reduction tactics, creating big headaches for financial planners.

For instance, new tax credits enacted under last year’s Taxpayer Relief Act, such as the $1,500 Hope scholarship credit for college costs and the $500 child credit, can’t be used by taxpayers subject to the AMT — basically, an income cutoff that tends to hit at around $100,000. Nor can they use tax credits proposed this year by President Clinton for child and dependent care.

Because deductions for dependents and state and local taxes cannot be taken under the AMT, taxpayers in high-tax states like New York and California and those with many children are more likely to be subject to the penalty.

Abram Serotta, an accountant with Serotta Maddocks Evans & Co. of Augusta, Ga., expects the number of his 3,000 clients subject to the AMT will grow to 250 this year, compared to 50 in 1996, and he proj
ects the numbers will grow to 500 to 750 for the 1999 tax year. Some 30% of his 1996 AMT clients made less than $100,000. The chief reason is they were forced to pay: deductions for employee business expenses.

Some financial planners are not aware of the tax consequences, Mr. Serotta says. One client who sold an interest in his business for $2 million ended up paying an extra $30,000 because his financial planner had him prepay his state income tax. Under AMT, deductions cannot be taken for state and local taxes.

As incomes rise with inflation, planners find it harder to protect their clients from the tax. But Herbert Daroff, a lawyer and CFP with Baystate Financial Services LLP, a $120 million asset management firm in Boston, says that Roth IRAs, variable annuities and variable life insurance plans can protect taxpayers from the AMT because they allow tax-deferred growth of assets.

To a point, however: couples can’t contribute to Roth IRAs if their income is above $160,000.

Even if the administration wins approval of its proposal to tax exchanges of variable annuity contracts or exchanges between subaccounts in contracts, Mr. Daroff believes “more and more variable life insurance and variable annuity subaccounts will offer asset allocation mutual fund subaccounts.” Instead of investors moving among subaccounts, money managers would rebalance the asset allocation. Clients could merely switch their contributions from aggressive to moderate or conservative as they age, he says.

Robert Hanlon Jr., president of RPH Financial Services, a $30 million asset management firm based in Stroudsburg, Pa., says the government is “putting the squeeze on” through the AMT.

careful calculation

RPH has contracts to provide financial planning services for executives of the Schering-Plough and Parke-Davis pharmaceutical companies, all of which experienced huge stock price increases last year. He must carefully calculate how much of his clients’ stock options to exercise in order to avoid triggering
the AMT because they must report the discounts they receive on the stock under the alternative tax.

“It’s harder to get clients out of AMT,” he says. “The government is on a mission to raise their revenue. They’re basically a vise — taking all kinds of tax (avoidance) techniques out for the higher-income people.”

Other planners, such as Diane Blakeslee of Blakeslee & Blakeslee Inc., a San Luis Obispo, Calif., firm with $200 million in assets under supervision, is careful to stick to municipal bond funds that contain no “AMT bonds,” such as private activity bonds which cannot be deducted under the AMT.

If a tax bill does emerge from Congress this year, there may be a chance it will address the AMT issue.

But Democratic staffers on Capitol Hill blame the Republicans for enacting last year’s tax credits without finding ways to finance an AMT solution. Republicans retort that early versions of the House and Senate tax bill passed last year would have indexed or increased personal exemptions under the AMT, but the provisions were knocked out when the administration objected.

“We would have been happy to index the AMT if they (Republicans) would have given up some of their estate tax or capital gains proposals that they were holding so strongly to,” responds a Treasury spokesman.

In addition to Ways and Means Chairman Archer’s interest in the bill, Sen. Daniel P. Moynihan (D-N.Y.), ranking minority member of the Senate Finance Committee, would like to see the tax curbed, and bills introduced by Rep. Barbara Kennelly (D-Conn.) and Sen. Bob Kerrey (D-Neb.) would make it possible for taxpayers to get the benefit of tax credits enacted last year if they were subject to the AMT.

Hill staffers on both sides of the aisle offer no predictions as to what will get passed this year, even if Congress does enact a tax bill.

“There are more politically appealing things, like the marriage penalty relief, excluding a portion of interest and dividends from income, expanding
the 15% tax bracket, estate tax relief,” a Senate aide says. “We’ll have a hard time trying to use this elusive budget surplus.”

Clinton holding out on capital gains plan

Financial planners reacted favorably last week to House Ways and Means Committee Chairman Bill Archer’s proposal to shorten the holding period required to qualify for the lowest capital gains tax rates from 18 months to 12.

But the administration threw cold water on the plan, saying that Congress should first enact the targeted tax credits proposed by President Clinton.

“It would be hard to argue against” Rep. Archer’s proposal, says Mark Balasa, a principal with Balasa & Hoffman Inc., a Schaumburg, Ill., adviser managining $110 million in assets. “It would help in terms of constructing a portfolio and rebalancing it. It would help the mutual fund world as well. From the investor’s side that would be largely good news.”

At a hearing on Thursday, Rep. Archer also called for exemptions on interest and dividend income: “It would be a huge simplification for those 30 million taxpayers who would no longer have to keep track of 1099s and other investment records.” The Texas Republican also pledged to “never tip the budget out of balance” while reducing taxes.

“I’m elated,” says Gary Bowyer, a Chicago adviser managing about $20 million.”It’s a rare opportunity for investors, where they could both simplify their taxes and get a reduction in their taxes at the same time.”

The problem will be getting the administration to agree. “We believe that the holding period was included in last year’s bipartisan agreement for sound policy reasons,” says a Treasury Department spokesman. “Before we go back and change that agreement, Congress should be focusing on the targeted tax cuts which the president has proposed in this year’s budget.” Those include credits for child care, school construction bond purchases, low -income housing and small business pensio
ns.

Observes Mr. Bowyer: “The real question is, if the Republicans have any chance of getting this through, what is going to be the trade-off in higher taxes somewhere else?”

A projection of individual returns with tax liability under the alternative minimum tax

Excess of

Number Percentage AMT liability

of returns of returns over regular

paying AMT paying tax liability

Year (thousands) AMT ($ billions)

1998 856 0.7% $4.3

1999 952 0.8% $4.6

2000 1,141 0.9% $5.1

2001 1,391 1.1% $5.7

2002 1,782 1.4% $6.5

2003 2,378 1.9% $7.6