Resident Scholar Alan D. Viard

If you're like most people, you've never paid much attention to the alternative minimum tax (AMT). This year, though, what you don't know about the AMT could hurt you. Depending on congressional action, or inaction, your 2007 tax return might include an unwelcome AMT liability, possibly accompanied by an IRS penalty. Fortunately, there are things you can do to protect yourself.

In 1969, the Treasury Department revealed that 155 people with incomes above $200,000 had avoided paying any income tax two years earlier. An outraged Congress promptly created the forerunner of today's AMT to ensure that everyone, especially the wealthy, paid a minimum amount of income tax. Today the AMT is a second income tax, parallel to the regular income tax, with its own tax rates and rules. At any given level of taxable income, AMT tax liability is usually lower than regular tax liability. But, taxable income is usually higher under the AMT because some common tax breaks, such as deductions for state and local taxes and personal exemptions for spouses and kids, are denied.

Each year, each of us is supposed to pay our regular income tax or our AMT, whichever is larger. A lot of Americans, though, just pay their regular tax without checking their AMT. That has generally worked, because, for nearly everyone, the regular tax has been the bigger of the two. Fewer than four million people--just 4 percent of all taxpayers--have ended up owing AMT each year.

But, this year could be different. The problem is the way that Congress has responded to the built-in expansion of the AMT. Every year, inflation pushes more people onto the AMT, because the AMT exemption amount is not adjusted for inflation. And, the 2001 and 2003 tax laws cut regular taxes without corresponding changes to the AMT, further swelling the AMT rolls.

To forestall this built-in expansion, Congress has been extending the "AMT patch" a year at a time. The patch is a relief package that hikes the AMT exemption amount and allows some tax credits to be used under the AMT. But, the patch expired at the end of 2006 and has not been extended for this year. There's a good chance that it will be extended in the end, but it's not a sure bet.

Democrats in the House of Representatives have held off on short-term relief while they pursue the worthy goal of a long-term deficit-neutral AMT reform. Unfortunately, they are likely to propose a plan that doesn't fully eliminate the AMT and that threatens economic growth by hiking top income tax rates. Congressional Republicans and the White House rightly reject that approach, but haven't put forward a reasonable alternative. In an ideal world, the parties would be working on a deficit-neutral compromise that eliminates the AMT and adjusts some features of the regular income tax, such as the state and local tax deduction. In the real world, though, they're headed inexorably toward deadlock.

What will happen after the search for a long-term solution collapses later this year? The parties might well get together and extend the patch for 2007, preferably before the IRS sends the tax forms to the printers in October. But, they might not.

If they don't, 23 million taxpayers will owe AMT this year, most for the first time. Taxpayers with incomes of $75,000 or more will be at risk, especially if they have large families or live in high-tax states. A tax originally intended to soak the rich will claim a multitude of middle-class victims.

When these taxpayers file their returns next spring, they will owe a larger tax bill than they expected. For example, according to the Urban-Brookings Tax Policy Center, a family with $75,000 would owe an extra $1,997 because of the AMT--even if the family had no itemized deductions. To add insult to injury, the affected taxpayers could face an IRS penalty for not having enough taxes withheld during the year to cover their bill.

Although this uncertainty leaves taxpayers in a precarious situation, they can take some precautions. It's fairly easy to avoid the IRS penalty. No matter how far your 2007 withholding and estimated tax payments fall short of your final tax bill, the penalty doesn't apply if your withholding was 10 percent bigger than your 2006 bill. (If your 2006 income was below $150,000, you don't need the extra 10 percent). With 2007 liability up in the air, at-risk taxpayers should ensure that their withholding meets this standard.

Tax planning also should reflect the current uncertainty. At-risk taxpayers need to learn which tax breaks are denied by the AMT and rethink any decisions that depend upon the availability of those breaks. At the same time, they must remember that they may end up keeping these tax breaks if Congress ultimately extends the patch.

For example, under the AMT, interest on most home-equity loans can't be deducted. The tax credits for child care and college costs don't apply. Although interest income from most municipal bonds (aka munis) remains exempt, that doesn't hold for munis that are issued to finance sports stadiums and other private projects. And, there's no deduction for workers who pay out-of-pocket expenses for meals and lodging while out of town on temporary job assignments. When making their plans, at-risk taxpayers should realize that they might lose these tax breaks.

The coexistence of two income tax systems, the AMT and the regular tax has caused all this uncertainty. In past years, only a small group of people were unsure about which tax system would apply to them; now, that uncertainty has spread to tens of millions more. The only way to fully eliminate this problem is to scrap the AMT. Until that happens, taxpayers need to hedge their bets.

Alan D. Viard is a resident scholar at AEI.