During the most recent tax-filing season, some taxpayers may have been hit with an unexpected bill for 1999 federal income taxes.
For most, the liability came under the regular tax system.
But another type of tax will snag more and more middle-income taxpayers - a tax many don't know exists, and if they do, they don't understand it.
The culprit is the alternative minimum tax or AMT, a complicated calculation that tax experts said will ensnare more and more average taxpayers because of a flaw in its structure.
First, a primer on the AMT.
It is a tax system with its own tax brackets that's parallel to the regular tax system.
Congress created the AMT about three decades ago when it discovered that many affluent taxpayers were paying little or no tax by cleverly using tax deductions and credits. The intent of the AMT was to ensure that the wealthy paid at least some tax.
The AMT is triggered when a taxpayer claims large deductions, such as unreimbursed employee expenses; has lots of dependency exemptions, such as for children; and has high local and state taxes.
The catch is that you lose some deductions under the AMT. Things deductible under the regular system aren't deductible under the AMT. These include personal and dependency exemptions, the standard deduction, or state income and property taxes.
The tax is clipping not-so-rich taxpayers primarily because it's not indexed to inflation, while the regular tax system is, experts said.
In fact, the number of taxpayers in the $30,000 to $39,000 income category having to pay the AMT will more than double from 7,000 in 2001 to 16,000 in 2009 if Congress doesn't change the current law, according to the Congressional Joint Committee on Taxation.
"The alternative minimum tax is a tax danger that grows more potent with each passing year because of the way in which this tax is calculated," said Bob Trinz, an editor with RIA in New York, a provider of tax information and technology. "Although personal exemptions, standard deduction and tax-bracket break points for regular tax purposes are indexed for inflation, the AMT exemption amounts and tax-bracket break points are not."
So as taxpayers' incomes have risen because of the robust economy, more are being thrown into the AMT.
That rub has nicked Bill Bradford for the AMT in two of the last three years.
"I feel like I'm being penalized," said the Carrollton film technician. "I pay way too much tax."
There are several reasons for that.
Because Mr. Bradford works for an extended amount of time in other states building movie sets, he must pay income tax for each of the states in which he works.
The regular tax system allows him to deduct state income taxes, but under the AMT, that deduction is thrown out.
As far as Mr. Bradford is concerned, dealing with the AMT is best left to his certified public accountant.
"It's so complicated," said Mr. Bradford, who admits to not understanding the tax. "All I know is, I don't like it. It costs me way too much money."
Mr. Bradford is very much like other average taxpayers who are blindsided by the AMT, said his accountant, Hunter Nibert, a partner at TravisWolff in Dallas.
"Bill is representative of the Ordinary Man, the working stiff, the innocent bystander," he said. "There's this whole other tax system out there, and they don't know about it until the thing just smacks them upside the head."
Here's how the AMT works:
You begin with taxable income computed under the regular income tax system. Then you add back to taxable income many of the important deductions you claimed to arrive at regular taxable income.
For example, state and local income tax, property taxes, miscellaneous itemized deductions and personal exemptions all may need to be added back.
Depending on the types of investments you have, there also could be other adjustments. For example, certain tax breaks for incentive stock options aren't allowed under the AMT.
After adjustments have been made, you subtract an exemption amount that varies with your income. Then what remains is taxed at the AMT tax rates of 26 percent or 28 percent to arrive at a "tentative minimum tax."
The first $175,000 of income under the AMT is taxed at 26 percent, and amounts above that are taxed at 28 percent.
You fall into the AMT if the amount you would pay under the regular tax system is lower than what you would pay under the AMT. You must pay the excess amount as AMT. For example, if your regular tax bill is $25,000 and your "tentative minimum tax" is $32,000, you would pay the regular tax bill plus AMT of $7,000 [$32,000-$25,000].
"Short of moving to a low- or no-tax state or somewhere where property taxes are low, there's little you can do to avoid the impact of these rules," Mr. Trinz said.
Avoiding the AMT
However, there are steps you can take that may keep you out of AMT territory or to cushion the impact of the AMT.
"The first step is to estimate whether or not you will have an AMT problem at tax return time," said Mark Watson, a partner in the national tax practice of accounting firm KPMG in Washington, D.C.
If you have lots of itemized deductions and you earn $75,000 or more, you should fill out IRS Form 6251, the AMT form for individuals, to see if you fall into the AMT, he said.
"The only way to really know is to run the numbers," Mr. Watson said.
A warning: You'll need lots of patience getting through the two-page form.
"It's a very complicated alternative tax system, and when you read the form, it will make your head spin," Mr. Watson said.
Other red flags that may throw you into the AMT include:
Having large amounts of miscellaneous itemized deductions, such as unreimbursed business expenses, and lots of taxes you're deducting, such as state income tax and property tax.
Having medical expenses that don't exceed 10 percent of adjusted gross income. Under the AMT, medical expenses are deductible only if they top that threshold. Under the regular tax system, the threshold is 7.5 percent.
"If you have a home equity loan, avoid using it to finance anything other than the purchase, construction or improvement of your main home or your vacation home," Mr. Trinz said. "If you use a home equity loan to buy a car, for example, the interest on the loan isn't deductible for AMT purposes."
If you do have exposure to the AMT, "the key to lessening the damage often is timing," Mr. Watson said.
That's especially important for employees who have incentive stock options or ISOs.
Paying the difference
Exercising a stock option has no impact under the regular tax system, but the difference between the exercise price at which you buy the stock and its market value counts as income under the AMT.
For example, let's say you have an incentive stock option entitling you to buy 100 shares of company stock at $50 per share.
If you exercise the option and buy the shares when the stock is $75 a share, you don't pay regular income tax, but the $2,500 bargain difference is subject to the AMT.
"If you hold lots of ISOs, one way to keep the AMT impact low is to stagger your exercise of them over a period of years," Mr. Trinz said.
But don't let tax reasons dictate your investment decisions.
"Whether to sell depends on whether you think the stock price will continue to go up," Mr. Nibert said. "If you feel it's going to go up, that's a real incentive to do the buy-and-hold scenario.
"If you think the stock will go down, you might want to exercise, sell out and lock in today's price. You may not want to take the risk of holding for that full year."
Timing also is crucial in dealing with other deductions.
"What are my deductions likely to be this year and what deductions do I have that are discretionary that I could defer?" Mr. Watson said.
Although Congress has talked about updating the AMT, no legislation on the inflation-indexing issue has yet moved through any of the tax-writing committees.
However, Senate legislation would make permanent a present exemption from the AMT for people who claim such family tax credits as the child credit, the Hope Scholarship education credit and the Lifetime Learning credit.
Pamela Yip covers personal finance for The Dallas Morning News. If you have a story idea, e-mail her at firstname.lastname@example.org.