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State and Local Taxes and the Individual AMT
Cengage
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State and Local Taxes and the Individual AMT

Contributing Author: Kristina Zvinakis

Eliminating the AMT figures prominently in various tax reform proposals and discussions of tax reform. While not as commonly proposed, some tax-reform plans also consider eliminating the state and local tax (SALT) deduction. The SALT deduction creates an adjustment for AMT purposes. Given that some taxpayers who benefit from the SALT deduction are also in AMT, it’s worthwhile to consider whether eliminating the SALT deduction and the AMT could result in a win-win scenario for these taxpayers.

Though it seems counterintuitive to suggest that losing a deduction could lead to a win-win outcome, the interaction between these two provisions should be considered in evaluating the costs and benefits of the proposed tax-reforms. Well-off taxpayers are more likely to itemize deductions and are, as a result, more likely to benefit from the SALT deduction. Generally, well-off taxpayers are also more likely to be in AMT. Thus, netting the lost benefit of the deduction with the realized benefit of no AMT liability could leave such taxpayers better off...or not.

A recent report by the Tax Policy Center suggests that well-off AMT taxpayers would pay more tax if both the SALT deduction and the AMT were eliminated. This outcome is driven by the fact that the maximum AMT rate of 28% is lower than the maximum individual income tax rate once a taxpayer enters the 33% bracket. Thus, such taxpayers would face a regular tax liability without the SALT deduction and without the AMT that was higher than their tax liability under the current income tax system (SALT deduction with AMT adjustment). In a tax-reform scenario that eliminated the AMT, without a decrease in the regular income tax rate below the current maximum AMT rate (which is not a part of most current tax-reform discussions), the loss of the SALT deduction would not be offset by the elimination of the AMT.  

Would this outcome differ for taxpayers depending on their state of residence? Most likely. Well-off taxpayers in high-tax states realize a larger regular-tax benefit from the SALT deduction than similarly situated taxpayers in low-tax states. Note that the proposal is also not automatically a win-win for taxpayers in non-income tax states. The SALT deduction allows state sales taxes to be deducted in lieu of state income taxes where the state does not levy an income tax. Thus, taxpayers, as well as their Congressional representatives, in high income and high sales tax states might be hard pressed to support tax-reform plans that included the loss of the SALT deduction.

Possible ideas for classroom discussion or assignments.

Internet research

  1. While the deduction for state and local taxes has been a part of the Internal Revenue Code since before the 1986 tax act, the provision to deduct state sales taxes in lieu of state income taxes, for taxpayers who live in a state that does not levy an income tax, was restored to the Code in 2004 (IRC Sec. 164(b)(5)). Find a popular press article that discusses the rationale for restoring the state sales-tax deduction and who the bill’s strongest supporters were.
  2. Find a popular press article that discusses how Congressional representatives in high-income-tax states feel about tax reform.

Tax policy

  1. PAYGO (“pay-as-you-go”) is a budget rule that requires tax cuts to be offset by tax increases or cuts in mandatory spending. The repeal of the AMT would likely result in the loss of significant tax revenue; some estimates put the revenue loss as high as $800 billion over a decade. An article on Bankrate.com  discusses eight tax breaks and deductions taxpayers enjoy that cost the Federal government a substantial amount of tax revenue. Is the discussion of the SALT deduction in this article consistent with the conclusions of the Tax Policy Center analysis discussed above?
  2. Many taxpayers complain about the complexity of the AMT and the requirement to calculate their tax liability under two systems (the regular income tax and the parallel AMT system). In general, reducing complexity is a goal of most tax-reform proposals (both current and past). Are there any policy justifications for keeping the current, parallel, AMT system rather than implementing tax reform that both eliminates many regular tax deductions as well as the AMT?