The alternative minimum tax (AMT) is a parallel tax system (calculated separately from regular taxes) designed to ensure that wealthy taxpayers with substantial tax preference items are subject to some income tax liability. A recent Tax Court case, however, indicates that the AMT can be applied even in the absence of the tax loopholes.
In Klaassen v. Commissioner, TC Memo 1998-241, the court decided that the AMT could be applied to large families of modest income with no real tax preference items except personal exemptions. This case shows that, because the AMT is not indexed for inflation, unwary middle-class taxpayers, whom Congress never intended to be subject to this tax, are now getting caught in its web.
The Klaassens were members of the Reformed Presbyterian Church of North America. They believed that a large family was a blessing and they opposed birth control and abortion measures. On their joint 1994 itemized return, the Klaassens reported adjusted gross income of $83,056; claimed 12 personal and dependency (10 children) exemptions; and deducted $4,767 in medical and dental expenses and $3,264 in state and local taxes.
Upon audit, the IRS determined that the Klaassens were subject to the AMT, despite the fact that they had no tax preference items for regular income tax purposes.
Following the letter of the law as outlined in form 6251, the IRS adjusted the Klaassens personal exemptions downward, disallowed their deduction for state and local taxes and limited their medical deductions to 10% of adjusted gross income instead of the 7.5% allowed for regular tax purposes. It then calculated their AMT taxable income at $68,832, substantially higher than the $34,092 of regular taxable income the Klaassens had reported on the form 1040.
The Klaassens did not challenge the IRS calculations. Instead, they argued that Congress did not intend for the AMT to have this effect on large families and that the AMT violated their religious freedom to have a large family.
The court disagreed. Leaving no room for interpretation, it concluded that, even though tax preference items were the reason for the AMTs creation, their existence is not required for the AMT to apply.
Observation: There is a large group of taxpayers who, although by no means rich, are falling victim to the AMT. CPAs must be aware that clients with modest incomes and itemized deductions for state and local income taxes, real estate taxes, home equity loans, medical expenses and miscellaneous itemized deductions (subject to the 2% test) are prime candidates for the AMT. Taxpayers claiming the new Hope scholarship credit and the Lifetime Learning credit (which are not included in the AMT calculation) may also find themselves caught in the AMT trap.
This case illustrates the need to index the AMT brackets and exemption amounts; to allow regular tax credits against the AMT; to allow more itemized deductions in calculating AMT; and to exempt from the AMT families with regular tax-adjusted gross income under a stated income level. If these changes are not made, it is estimated that, in the next 10 years, nearly 10 times more taxpayers will become subject to this tax.
Michael Lynch, CPA, Esq., associate professor of tax accounting at Bryant College, Smithfield, Rhode Island.