Now that the stimulus package has been enacted and is beginning to take effect, the Congress and Administration are floating plans for significant changes in taxes.
There is some buzz already about limiting the deductions for charitable deductions and home mortgage interest. Many will debate the merits of such proposals given the crisis in housing and home mortgages we are facing, as well as the impact on charities. There has been some criticism with regard to whether limiting the ability to help finance a home and limiting the amount charities can receive in a severe economic situation is the appropriate level of tax reform.
Of course, the real effort should be reviewing the overall tax package and determining how all the measures fit within the overall tax policy.
As I did in 2001 at the onset of the Bush Administration, I am providing some items for all of those in Washington considering tax and budget proposals. I provide them again with the disclaimer that they are my own opinions and based on my own experiences in dealing with tax planning and compliance for business and individual taxpayers.
At the top of my list is the alternative minimum tax, or AMT, for individuals. This provision was on my list eight years ago and still remains there since there has been no serious movement to “fix” this provision of the tax code. We have the annual patch but no long-term solution has been identified or agreed to, though many admit a solution is needed for the long term.
The history of the AMT levy was, in part, to make sure that higher earning taxpayers paid some income tax or a level of income tax that was more appropriate with their ability to pay based on a modified tax base. This, in part, came out of the headlines in the late 1970s and early 1980s of millionaires not paying any income tax or only a small level of tax. The AMT was overhauled in the Tax Reform Act of 1986, and what we have today is more or less what was enacted then. The Act dropped regular individual income tax rates to two brackets (28 percent and 15 percent) in an effort to simplify and broaden the tax base. At the same time, certain deductions from what were described as “tax shelters” were limited by enacting the provisions dealing with passive activities. Interest deductions were also modified to essentially allow for deductions only for home mortgage interest (capped based on the amount of the mortgage) and to investment income on debt incurred to hold investment assets.
The AMT tax for individuals begins with using an individual’s regular taxable income as the beginning point and then adding back certain items. The most significant item is the add-back of the itemized deduction for state and local income and property taxes. This deduction add-back, in combination with an exemption that is not indexed for inflation and a tax rate that has not been adjusted with the various tax rate changes since 1990, has resulted in the bulk of AMT payers coming from the ranks of the middle and the upper middle income groups. Middle income individuals and families living in states and cities with high rates of income tax (such as New York and California) and property taxes have to add those taxes back to income for AMT purposes and pay AMT tax on their adjusted tax base.
In addition, the number of taxpayers landing in AMT land is the result of the cannibalization of the tax code with other deductions and credits since 1986 and has created a situation where, if not for the annual “AMT patch,” would result in a significant amount of taxpayers falling into the AMT black hole. This annual “bandage” on the tax code just delays the day of reckoning in many respects from being faced with AMT as more taxpayers fall into it and the revenue impact of a long-term fix becomes more expensive. If not for the annual AMT patch, many families claiming the $1,000 per child tax credit would be handing back a good chunk of the child credit to the U.S. Treasury.
The other item that has impacted the AMT is the growth in small business. Most small businesses are taxed by taxing their owners, by the fact that they are sole proprietorships, partnerships, limited liability companies or S corporations. This method of operation places the tax burden for the business on the owner and his individual Form 1040 tax return. Under the AMT calculation, depreciation is recalculated for depreciation claimed on machinery and equipment purchase over the tax life of the asset.
The AMT method of depreciation requires that it is calculated over a longer time, and the difference between the depreciation deduction allowed for regular tax purposes and the depreciation deduction for AMT purposes is determined by extending the life of the depreciation deduction, in many cases, from 7 years to 12 years for equipment, and also slowing the actual rate of depreciation as a percentage of the asset cost.
Thus, a $100,000 asset may have a deduction of $15,000 for regular tax purposes and only $9,000 for AMT purposes; that difference ($6,000) is added back to the business owner’s income and then the AMT tax is levied on the adjusted income. The growth of small business since 1986 has created a situation where most small business owners end up with significant add-backs for AMT purposes. Thus, an additional cost for doing business is the part of the economy that creates a significant amount of the new jobs. “Joe the Plumber” feels the impact each year of this adjustment when he files his tax return.
In short, a long-term fix and not a patch is needed for AMT. I liken the patch to many of our roads after winter. The patch can temporarily get us through another season, but until a major resurfacing is done, it is likely the same pot holes will need to be patched next year.
Another suggestion for the tax writers is to provide more realistic tax lives assigned to capital assets and deprecation rates for those assets. The changes in technology often have made certain tax lives in capital assets unrealistic. The tax code provides a five-year life for computers. We all realize that getting two or three years out of computers and other hardware is the best that be achieved in many cases. The bonus depreciation provisions enacted in the days after 9/11 and most recently help the effort but do not make permanent the need to allow for quicker tax lives and depreciation rates for capital expenditures.
The final item on my list is finding a way to reduce rates by eliminating the myriad of tax credits available to lower- and middle-income earners in an effort to simplify the tax system and make it more transparent. Gone are the days of an individual preparing his/her own tax return by hand. Even the simplest returns need the help of software or an outside preparer.
The last long-lasting business downturn was that of the late 1970s and early 1980s; many have said the simplification and broadening of the tax base in the 1980s helped contribute to an impressive period of prosperity. Looking back, we can learn from both our mistakes and our successes.
William F. Roth III is a tax partner with BDO Seidman LLP. The views expressed are those of the author and not necessarily those of BDO Seidman LLP or its employees.