Version 7.01 |
Click here to return to Bill Wood's Blog Pages.Tax MadnessThis may be good business for the folks who make a living doing tax preparation, but it isn't good for democracy. Paying your taxes, like voting, is an important obligation of citizenship. Moreover, the way income taxes are levied has a huge effect on the distribution of wealth and the economic well being of the citizenry. As citizens and taxpayers, each of us needs to understand how our tax liability is computed. If we can't understand how our tax system works, we will be unable to petition our political leaders to redress errors and inefficiencies in the system. It is hard to defend the fairness of a system few people can understand. And without the perception of fairness, it becomes harder to insure the widespread voluntary compliance with the tax code upon which our democracy depends. Nowhere is the complexity of the modern personal income tax system more overwhelming for average taxpayers than in matters involving the alternative minimum tax (“AMT”). Created in 1969 to insure that very high income taxpayers would pay some minimum level of taxes, the AMT, which has not been effectively adjusted either for inflation or for changes in the regular tax code, now touches some five million taxpayers (and is projected to affect between 20 and 30 million taxpayers by 2010 if left unchanged). The complexity introduced by the AMT has helped to make average taxpayers and their accountants ever more reliant on complex computer software to prepare their tax returns. Unfortunately, some of the rules relating to the AMT are simply too complicated for today's popular tax programs to handle. The example I have come to know involves how to determine what portion of the refund of state income taxes should be reported as income on line 10 of Form 1040. A year ago I discovered that the software my tax attorney had used for my 2004 tax return had failed to properly handle this issue because it was beyond its analytical capabilities. The result was that my entire refund had been included in income. This had increased my taxable income and the Federal tax I paid. This caught my eye because in 2003 I had been subject to the AMT which meant that I had been unable to deduct my state taxes from the income used to determine my tax liability. I found it hard to imagine that I should have paid taxes in 2004 on a refund of state taxes which had not been available to reduce my Federal tax liability at the time I paid them. It turns out that I was my right and that both my attorney and his tax program had been wrong. Twenty-five years ago, the rule of whether or not to include a refund of state income tax in income was almost as simple as “did you itemize deductions last year or not”? The actual rule today for filers subject to the AMT is far more complicated. The instructions for line 10 on the Form 1040 direct you to Publication 525 (“Taxable and Nontaxable Income”) if you were subject to AMT. It is there, buried under the heading “Miscellaneous Income,” that one finds the relevant instructions for determining whether or not a refund of state income taxes should be included in income: If you were subject to the alternative minimum tax in the year of the deduction, you will have to recompute your tax for the earlier year to determine if the recovery must be included in your income. This will require a recomputation of your regular tax ... and a recomputation of your alternative minimum tax [for that prior year]. If inclusion of the recovery does not change your total tax, you do not include the recovery in your income. However, if your total tax increases by any amount, you received a tax benefit from the deduction and you must include the recovery in your income up to the amount of the deduction that reduced your tax in the earlier year. This rule is completely fair-- the refund is only taxed to the extent that it conferred a benefit in the year the original deduction was claimed. However, it is also horrifically onerous: In order to complete this one line on the tax form, a taxpayer is forced to recompute his entire regular and AMT tax returns for the year the deduction was taken at least once and perhaps several times in order to determine how much of the refund should be taxed. I recently filed my tax return for 2006 using another popular tax program. I had a large refund of state tax taxes in 2006 and I was subject to the AMT in 2005. If I hadn't discovered Publication 525 and if I had simply relied on the tax software I am using, I'd be overstating my income for 2006 by the amount of that refund. I challenge you to review your tax returns going back to 2004 (you have until April 15, 2008 to amend your 2004 return). In any year in which you included the full refund of your state income taxes in income on your Form 1040, if you were also subject to the AMT in the year in which those taxes were paid, you probably overpaid your taxes. Go back and check your tax returns. Then, write your lawmakers in Washington and tell them you object to a tax system so complicated that a smart and responsible taxpayer is forced into overpaying the taxes he rightfully owes because even the folks who write the computer software can't do the calculations the IRS requires. Tell them it’s time for a fairer and simpler income tax system, one that starts with the complete elimination of the alternative minimum tax as we know it today. |
