Itemized Deduction Cap Under AMT
Coordinating with proposed limit under regular tax
By Kaye A. Thomas
Posted September 21, 2009
A flaw in the logic.
The Obama administration has proposed to limit the tax benefit high-income taxpayers can obtain from itemized deductions. The basic idea, discussed in this companion article, is to cap that benefit at 28% of the amount deducted. The proposal includes features designed to coordinate it with the alternative minimum tax (AMT). In the context of the proposal, one of these features makes sense and the other does not.
Alternative Minimum Tax (AMT)
The AMT is supposed to prevent relatively high-income taxpayers from using so many tax benefits that they pay little or no tax. It requires a recalculation of income tax under a different (alternative) set of rules that determine the minimum amount of tax you have to pay. If your regular income tax is at least equal to the amount of tax determined under the AMT rules, you simply pay the regular income tax. If your regular income tax is less than this minimum, you pay additional tax to make up the difference.
Example: Your regular income tax is $20,000. If your tax under the AMT rules is $18,000, you pay only the regular income tax. If your tax under the AMT rules is $23,000, you pay $20,000 of regular income tax and $3,000 of AMT.
The tax calculation under the AMT differs from the regular income tax in various ways. One difference is in the rate structure. The AMT has just two tax rates for ordinary income, 26% and 28%. However, the treatment of a special deduction allowed in the AMT calculation, called the AMT exemption amount, results in rates that begin at 0%, then go to 26%, 32.5%, and 35%, and finally drop down to 28%.
Another difference, and the only other one important for this discussion, is in the treatment of itemized deductions. Some deductions allowed under the regular income tax, such as the deduction for state and local taxes, are not allowed under the AMT. Other deductions, such as the charitable contribution deduction, are allowed in both tax calculations.
In connection with the proposal to cap the benefit from itemized deductions at 28%, no adjustment is necessary in connection with the deductions that aren't allowed under the AMT. As to these items, the taxpayer is already receiving zero AMT benefit. The adjustments described below apply only to itemized deductions that are allowed under both the AMT and the regular income tax.
Capping the AMT benefit at 28%
As described above, the AMT can apply at effective rates as high as 35%. For a taxpayer whose income is within this range, the tax benefit of an itemized deduction can be as great as 35%. This result would be inconsistent with the notion of capping the federal tax benefit of an itemized deduction at 28%, so the proposal includes an adjustment designed to negate this possibility. It says, in effect, that if you claim a deduction that's allowed under the AMT, and your income is within the range where it's taxed at 32.5% or 35% under the AMT, your tax under the AMT calculation will be increased by the amount required to reduce your tax benefit from the deduction to 28% (4.5% or 7%). This adjustment makes sense in the context of the proposal. However, the proposal also includes another adjustment based on flawed logic.
Transferring the regular tax add-on to the AMT
In this other adjustment, we determine how much of an increase in regular income tax comes from application of the 28% limit to itemized deductions that are allowed under the AMT, and apply that number as an increase in the AMT tax calculation as well. The official explanation includes an example where someone is in the 36% bracket under the regular income tax and claims $30,000 in itemized deductions, consisting of $20,000 for state and local taxes (not allowed under the AMT) and $10,000 for charitable contributions (allowable under the AMT). Under the regular income tax, the 28% limit increases this person's tax by $2,400 ($30,000 times 8%, which is the difference between the 36% tax rate and the 28% limit). One-third of the deductions are allowed under the AMT, so this adjustment would add one-third of the regular tax adjustment, or $800, to the taxpayer's AMT.
Without this adjustment, the taxpayer might be indifferent to the cap under the regular income tax. Suppose, for example, that his regular income tax is $100,000 and his tax under the AMT calculation is $120,000. If we apply no adjustment to either tax, he must pay $100,000 of regular income tax and $20,000 of AMT, for a total of $120,000. When we apply the cap on itemized deductions under the regular income tax, we increase his regular income tax by $2,400. Without an adjustment in the AMT calculation, he will now pay $102,400 in regular income tax and $17,600 in AMT. The total is still $120,000, so the deduction cap hasn't caused him to pay additional tax. Apparently, the person responsible for determining how the deduction cap would work under the AMT recognized this possibility and saw it as a problem. However, it is not a problem. On the contrary, in a world where the tax benefit from itemized deductions is capped at 28%, this is precisely the correct result.
Before this adjustment applies, the taxpayer's benefit from the deduction under the AMT has already been limited to 28%, either because his income is in the range where it is taxed at this rate under the AMT, or because of the first adjustment described above. Making a further adjustment that transfers the regular income tax add-on to the AMT tax calculation has the effect of further reducing the AMT benefit. The amount of this further reduction depends on the taxpayer's bracket under the regular income tax. As we saw, a taxpayer in the 36% bracket will have his regular tax increased by 8% of the allowable itemized deductions. Applying this increase also under the AMT, where the taxpayer's benefit has already been limited to 28%, results in a tax benefit of 20%. In this situation, a $10,000 charitable contribution would produce only $2,000 in tax savings. The effect is even worse for an AMT taxpayer whose regular income tax in in the highest proposed tax bracket of 39.6%. The adjustment in regular income tax required to cap his itemized deduction benefit at 28% is 11.6%. Applying this adjustment to the AMT would leave a residual tax benefit of 16.4%, so that a $10,000 charitable contribution would produce only $1,640 in tax savings.
This result makes no sense at all. It is not a problem that the taxpayer described above is indifferent to the increase in his regular income tax, because a taxpayer in that situation is not receiving any benefit from his itemized deductions under the regular tax to begin with. The amount of tax he pays is determined entirely by the outcome of the AMT calculation. What's more, there's no conceivable reason to penalize someone under the AMT for having a higher tax rate under the regular income tax. The AMT is designed to capture revenue from high-income people who pay a low rate under the regular income tax, not a high one.
The proposal would also have the perverse consequence of creating an AMT benefit for certain tax preference items, exactly the reverse of what is intended. A preferential tax deduction could be used to reduce the regular income tax bracket to 28% from a higher one. Although the deduction isn't allowed under the AMT, the reduction in the regular income tax bracket would eliminate the adjustment in itemized deductions, and as a result it would indirectly reduce AMT.
An adjustment that transfers the regular tax add-on to the AMT tax calculation is unnecessary and inappropriate. If the proposal is enacted without correction of this error in logic, the AMT, already perverse in many ways, will become even more so.
