Consider alternative minimum tax liability

A tax calculation that originally was designed to close loopholes used by the wealthiest taxpayers is increasingly being assessed on physicians and other professionals, experts say, forcing them to pay more than they would owe under the regular tax system.

In fact, use of the alternative minimum tax, or AMT, is growing so fast that the Internal Revenue Service's National Taxpayer Advocate, Nina Olson, identified it in a recent report to Congress as one of the top two problems faced by taxpayers.

"[AMT] now affects substantial numbers of middle-income taxpayers and will, absent a change of law, affect more than 30 million taxpayers by 2010," Olson wrote in the report.

While its reach expands, experts say many taxpayers are being caught by surprise by the AMT. They say it is a complex assessment that few taxpayers have seen before or understand.

"It's a problem because there are many people who are not aware of it and, especially if you're trying to do your own tax return, you can easily fall into the AMT trap," said Martha Bethea, an accountant and director with CBIZ Accounting Tax and Advisory Services of Northeast Ohio.

Bethea said the AMT is a second tax calculation that taxpayers are supposed to include with their tax returns. It calculates taxes owed using a different system of deductions and exemptions than the regular tax system.

Created several decades ago to prevent wealthy taxpayers from using tax avoidance schemes, it has, in recent years, been ensnaring more average taxpayers, leading critics to say it must be retooled to serve its intended purpose.

The reason for its increased use is threefold, according to David Oeth, a tax partner and managing director at RSM McGladrey Inc., in Rochester, Minn.

First, he said, people are paying higher state and local taxes, which can be used as exemptions under the regular system but not when calculating the AMT. Second, the 2003 tax rate reductions reduced each income tax bracket by about 3% -- but the AMT tax rates were not changed. That means people are paying less in regular taxes, which can affect whether the AMT is assessed. Finally, Oeth said the exemption against AMT taxable income has not been indexed for inflation, which means it has caught up with more taxpayers.

Bethea said physicians are particularly vulnerable because many have high incomes. That results in higher state and local taxes being paid, which can affect whether the AMT must be paid.

The higher-than-average incomes of physicians also can mean that they have more real estate assets, another factor that can determine whether the AMT must be paid.

Oeth said the AMT system has a broader definition of income than the regular tax system. To calculate the AMT, the taxpayer first must start with his or her taxable income under the regular system and then make several modifications. The changes are primarily in deductions and exemptions. For example, Oeth said, an individual's exemptions for self and for dependents are not allowed under the AMT, although a separate exemption is provided.

Also, deductions for real estate taxes and state and local income taxes are not allowed under the AMT. Additionally, taxpayers must forgo deductions for home equity indebtedness under the AMT, unless it was used to improve the person's home.

Differences between the AMT and the regular tax system also exist in rules about exercising incentive stock options and calculating the depreciation of business property, Oeth said.

Once the modifications are made and the alternative minimum taxable income is determined, then a flat tax rate of 26% or 28% is applied. If the AMT is greater than the tax under the regular system, that figure must be paid. If the regular tax is greater, then the AMT does not apply.

Andrew Pincus, an attorney, accountant and certified financial planner with Weiser, LLP, in Edison, N.J., said he expected the AMT system to be reformed, though probably not during an election year like 2004. Meanwhile, he said taxpayers should prepare for the possibility that they will have to pay the AMT, and should talk to their advisers about what they can do.