The parallel tax universe that America’s most ambitious, productive people are banished to

Well, guess what? For millions of Americans, Uncle Sam is doing a head fake: Washington fully intends to take back a large chunk of that tax cut. No, we’re not talking about the much-discussed “sunset” provisions whereby Congress met its budget targets by passing cuts that phase out in a few years. We’re talking about something sneakier and much nastier: the Alternative Minimum Tax, or AMT.

The AMT isn’t new. It’s been around for decades and often gets a passing nod in newspaper and magazine articles about tax policy. It was hardly mentioned at all during the debates leading up to the latest tax cut, however, and that’s a shame. If there were ever a part of the tax code that could use some serious public discussion, this is it.

Most people don’t really know much about the AMT, other than a vague awareness that it’s a punitive and horribly complex chapter of the tax code that’s best avoided. Put simply, the AMT is a tax regime that high-income people get thrown into when they take lots of deductions or enjoy a big jump in income, such as by exercising a heap of stock options. It’s a kind of parallel tax universe that has very few deductions and forces you to pay far higher taxes in the future than you’d pay under the regular system. You lose the breaks for costs that Congress has consistently and vocally deemed break-worthy: things like property taxes, state and city income taxes, exemptions for children, the interest on home-equity loans— in fact, pretty much everything but mortgage interest and contributions to charity. You can’t even deduct the fees for tax preparation, and believe us, once you’re in the mind-bending universe of AMT, you’ll need a tax planner like you need food, shelter, and clean underwear.

Now, you may be asking, Of all the problems in our screwed-up tax code–from deep philosophical questions, such as why we always leave payroll taxes, which impose high effective tax rates on working people, out of our rate-cutting debates, to our political leaders’ increasing reliance on deficit-obscuring tricks like those sunset clauses–why focus on the AMT? Isn’t this a bit like removing one piece of bad sushi and leaving the rest of the bad sushi on the platter?

No, and here’s why. What’s most troubling and least understood about the AMT is the growth trajectory it’s now on. According to a recent study by the Urban-Brookings Tax Policy Center–class warriors, please note, this is a liberal think tank–the number of Americans exiled to AMT land is about to explode. This year the AMT will catch only 2.4 million families and individual taxpayers. By 2005 that will leap to 12.7 million, and it keeps soaring. Indeed, by 2010, 33 million taxpayers, one-third of the total, will pay the AMT if the rules aren’t changed.

The AMT is even scarier when you look at this growth in dollar terms: This year it will bring in $16 billion, around 2% of all federal income tax revenue. By 2010 the AMT will harvest $124 billion, or around 1% of the total GDP. Perhaps the most shocking way of expressing it is this: By 2010, 55% of the income generated in this country will be subject to the AMT. If Washington does nothing, the AMT is on track to supplant the existing body of rules, rates, and deductions and become the dominant tax system in the U.S.

Another thing you probably don’t know about the AMT, dear reader–especially if, as many Fortune subscribers do, you make north of $100,000 a year and live in coastal states with high taxes and high costs (and thus lots of deductions)–is that you are in the group that stands an excruciatingly high chance of getting hit by the AMT over the next few years. By Urban-Brookings’s figuring, 95% of families and individuals with incomes from $100,000 to $500,000 will fall into the AMT zone by 2010. Yes, virtually everyone in that group. And here’s the bill: You’ll be paying an extra $10,000 a year in taxes, on average. (The Congressional Budget Office has run these numbers too, and got similar results.)

Some tax cut, huh? But wait, there’s one last bitter irony. One of the things that will do the most to push you into the AMT, believe it or not, is the tax cut you thought you just got.

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A few more words about you. You account for a large portion of America’s most ambitious, productive people—you are executives, law firm partners, airline pilots, doctors. You’re not poor, of course. Even in places like New York City and San Francisco and Chicago, an income in the low to mid-six figures is hardly poor. But with high taxes and the all-around high cost of living, you certainly don’t feel rich either. Most of you are “HENRYs”: High Earners Not Rich Yet.

Bill Simmelink is a textbook HENRY who’s had a recurring real-life AMT nightmare. He’s had success both as a tech entrepreneur and as a highly paid manager in a big company. The AMT’s sneak attacks have this 54-year-old engineer and divorced father of three seething, and for good reason. The AMT first mangled Simmelink’s finances three years ago when he exercised the incentive stock options (lSOs) he’d received when the software startup he worked for was sold to Texas Instruments.

ISOs are a class of options meant to encourage recipients to keep their company’s stock, and so they get special tax treatment through a convoluted formula of prepayments and credits. But large ISO grants are also automatically taxed under the AMT. The details here are complicated; in practice what happens is that you pay the AMT when you exercise the options. If the stock plummets, you can end up paying more in tax than the entire gain— and end up with a bunch of unusable credits. That’s what happened to Simmelink: He exercised a bundle of options worth $6.5 million and paid $1.7 million in taxes upfront; he kept his shares; Tl’s stock plunged; and his gain fell to $1.8 million. And thanks to the bizarre workings of the AMT, he paid a huge tax on a phantom gain he never saw. “I paid almost as much in tax as my TI stock is worth now,” Simmelink says. He’s still shocked. “It was like paying a 100% tax on my gain.”

Now Simmelink is thriving as chief of a TI division in suburban Maryland, and AMT lurks again, for no better reason than that his six-figure pay package is growing nicely. “I’ll get sucked back into it this year just because I’m doing well,” he says. The AMT threatens to devour almost all his deductions, including a big one for property taxes on his four-bedroom Colonial. “The AMT is morally corrupt and a total rip-off,” Simmelink charges. “It doesn’t make sense to take hardworking, high-earning people and try to break them.”

“The AMT takes hardworking, high-earning people and tries to break them.”

Bill Simmelink, Maryland taxpayer

Where did this morally corrupt rip-off come from, and how does it work? Before we get into all that, we highly recommend that you sit in a comfortable chair and grip the magazine with both hands. As mentioned earlier, the AMT takes some explaining.

Like a lot of things that seemed good at the time (free love, psychedelic concept albums, Timothy Leary), the origins of the AMT can be traced back to the 1960s. In January 1969, Joseph Barr, then Lyndon Johnson’s Treasury Secretary, appeared before a taxation committee on Capitol Hill. During his testimony, in which he railed against the unfair tax system,Barr vilified a list of 21 millionaires who’d paid nothing in income taxes in 1967. Public outrage quickly ensued, and under the new President, Richard Nixon, the AMT came into being as a way of preventing the rich from using legal deductions and loopholes to squirm out of paying their fair share.

Back then, of course, there was even more reason to squirm than today. Tax rates were much higher: The top rate on earned income as well as “unearned” income like dividends and interest was 77%. That’s another world from today, where after 20 years of Republican-led tax cutting, taxes on capital and earnings from capital have plummeted. By contrast, the AMT has steadily and stealthily become more punitive— and today it ensnares millions, not just a handful of millionaires.

How did that happen? Remember “bracket creep”— the tax horror of the 1970s, when people found themselves rising into ever higher tax brackets simply by dint of inflation? Far more than cutting the top rates, getting rid of the dishonesty of bracket creep was arguably the biggest long-term achievement of Ronald Reagan’s historic 1981 tax bill. The AMT is today’s moral equivalent of bracket creep. It’s an insidious way for the government to tap into a rich vein of tax income without having to do anything or even say anything. In part, that’s because unlike the regular tax system, the AMT never got indexed, so more and more people over the years get sucked into it simply because their incomes rose with the cost of living. To make matters worse, Congress has since the 1970s gradually raised AMT tax rates, with little opposition since so few people paid it. The result is that the AMT eventually hit not just the superrich but also folks with rising incomes and lots of costs and deductions.

One of the many absurdities of the AMT is that the IRS doesn’t actually tell you when you owe it. It’s up to you to figure out whether you should be filling out Form 6251, the AMT form, which of course does not come with the standard tax packet you get in the mail. (You can, however, get it at the IRS website.) Anyway, once you scrounge up the right form, you take your regular “taxable income” before personal exemptions from line 39 of your 1040, and add back all of your deductions except for first mortgage interest and charitable contributions— property taxes, state income taxes, home-equity interest, all of it. Then, you subtract an exemption–currently set at $58,000–to arrive at your taxable AMT income, usually a far bigger number than your regular taxable income. You then apply the AMT tax rate of 26% to the first $175,000 in AMT income, and 28% to everything after that. If your liability under the AMT is higher than under your regular tax, that’s what you pay. The extra payment is your Alternative Minimum Tax.

The big tax cut enacted in late May lowers the top marginal rate from 39.6% in 2000 to 35% this year, and it reduces levies on dividends and long-term capital gains to 15%. But the legislation has the perverse effect of throwing far more people into the AMT; Urban-Brookings estimates that it will roughly double the projected number of victims to 33 million in 2010. How is that possible? Because by lowering regular tax rates and leaving the AMT brackets unchanged, Congress and the White House have ensured that millions of people who were already close to paying the AMT will now automatically fall into the trap. Once ensnared, they lose at least one-third the benefit of their tax cuts. In other words, the government is stuffing $1 in tax savings into one pocket, and yanking 33 cents out of the other.

As noted, the math of the AMT dictates that the burden falls on people earning in the $100,000 to $500,000 range. Here’s why. For families earning less than that, the current $58,000 exemption makes their taxable income under AMT so low that they would owe only a tiny AMT tax, usually far less than they’re paying under the regular system. So they avoid the AMT. This tax also tends to be a nonissue for Wall Street bonus babies, top corporate executives, and others earning $500,000 and up. These people have a big chunk of their incomes in the top 35% bracket, so their regular tax bill normally exceeds the AMT’s.

No, this particular wrecking ball is headed right for those striving hard to get rich. To see how the numbers play out, let’s visit an imaginary New Jersey family named–forgive us, but we’re trying to coin a new acronym here–the HENRYs. We’ll use scenarios developed by Michael Steiner, a financial planner with Regent-Atlantic Capital in Chatham, N.J. The HENRYs boast a nice income, two teenage kids, a yellow Lab, a Tudor on a leafy half-acre lot in a nice suburb, and love to go “down the Shore,” as Jerseyites like to say. Last year John and Joan HENRY together earned $275,000 and had $31,000 in real estate and state income taxes. They missed the AMT by a hair. But late last year they bought a beach house with an outdoor shower and heavy property taxes, and took out a $100,000 home-equity loan to help send Ginger to college. This year the couple got raises of 10%, and their real estate and state income taxes jumped to around $40,000, courtesy of their dream on the Shore and rising local tax rates.

The extra deductions and the lower rates from the new tax law will throw them straight into the AMT. Without the AMT, the HENRYs would have reaped the full benefit of the tax cut. So despite the raises, they would have paid $53,000 in taxes, $4,300 less than last year. But the AMT ruined their fun. It will add more than $8,000 to their tax bill, so they’ll pay not $53,000 but more than $61,000. Ouch.

Losing the deductions for property, state income taxes, and home-equity interest creates a double whammy. They’re two of the fastest-growing levies in America, and with local and state budget deficits soaring, they’re programmed to rise far faster than inflation for a very long time. For most taxpayers, the pain is mitigated because when property taxes or state income taxes jump, they get part of the money back by deducting the increase on their income taxes. Hence, a $1,000 rise in the levy on their home really costs them around $700.

Once you’re in the AMT, though, not only do you pay more federal tax, but you also pay 100 cents on the dollar for every increase in your rapidly rising real-estate and state income taxes. Part of the big housing subsidy that policy makers have extolled for decades will quickly evaporate. That’s a big negative for vacation homes in Nantucket, condos in SoHo, or Georgians in Lake Forest. As for the refinancings that have bolstered the economy during its post-bubble slowdown, the AMT threatens them too. If you’re in the AMT and you take out a home-equity loan, not a penny in interest is deductible.

The way the AMT treats property taxes infuriates Jim Hanny, an irrepressible 57-year-old captain for American Airlines. Hanny is a self-described “patriot” who flew 77 combat missions in Vietnam and served as a squadron commander in the Air Force Reserves. Hanny, who is married with three grown daughters, owns a home right on the shoreline in Lake Geneva, Wis., one of the most expensive towns in the Midwest. He bought it for $185,000 in 1977; the cottage is now worth more than $2 million. Last year Hanny–who earned $215,000–watched his property taxes jump 37%, from $17,900 to $24,500. But in 2001 he joined the AMT generation, so he didn’t get to deduct a dime of that $6,600 increase in his property taxes. With the big rise in deductions, he paid almost $4,000 more in federal taxes under the AMT than he would have under regular taxes.

“I’m a patriot. I played by IRS rules. Now the AMT is saying those rules are wrong.”

Jim Hanny, Wisconsin taxpayer

For Hanny, a superorganized type who logs his finances on Quicken, the AMT’s complexity is annoying. But it’s the implied message from Uncle Sam that most miffs this veteran. “I’ve always played by the rules,” says Hanny. “But the AMT is saying, ‘You are the people who otherwise wouldn’t pay their fair share. We’re going to make sure you don’t get away with anything.'”

The AMT is also surprisingly hard on capital gains. Technically they’re taxed at the same rate under AMT as under the regular tax code, now 15% for long-term gains. But in reality capital gains get stiffed by AMT in two ways. First, you no longer get to deduct the state capital gains tax. In a high-tax state like California, where the rate reached 9.3%, that deduction can bring your effective capital gains rate down by a percentage point or more. Second, a big gain can raise your income to the point where you get no help from the $58,000 AMT exemption. The exemption phases out in $0.25 increments for every dollar you earn over $150,000. So if you make $150,000, you get the full exemption; at $382,000 you get nothing. Let’s say you make $200,000— you’re in AMT country now. At that income level your exemption has dwindled to $45,500, but it’s still saving you $13,000 off your tax liability. Now let’s say you had a $250,000 capital gain this year from selling stock, pushing your income to $450,000. Here’s where the AMT smacks you upside the head. Your entire exemption has disappeared, and the tax you pay on your gain is about $51,000. That includes the $37,500 capital gains tax, plus the extra money you now pay after losing the exemption. In other words, the effective rate on your capital gain is 20%, not 15%.

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So why do we still have this tax? One word: money. The AMT is a cash cow that neither political party cares to injure, especially not at a time when the government’s future budget deficits seem likely to soar. On the revenue side, extending the latest tax cuts and credits beyond their phony sunset clauses will more than double the $350 billion pricetag Congress hung on that legislation. On the spending side neither party seems serious about cutting existing programs. Instead, we face crushing new demands for things like defense, homeland security, and rebuilding Iraq, not to mention a potentially catastrophic Medicare bill as baby-boomers retire. Meanwhile, if the AMT were abolished today, it would add almost $1 trillion to the public debt by 2012. “We can’t afford a fair tax system, so we go with an unfair one,” says Gerry Padwe, an official with the American Institute of Certified Public Accountants.

That doesn’t mean we won’t see some modest AMT reform. But it’s all too likely to be erratic, piecemeal, and aimed mainly at insulating the broad middle class from the tax. For example, Bush’s tax bill raised the A M T exemption from $49,000 to $58,000, which will spare millions of taxpayers who make less than $100,000 from the AMT trap. Well done. These are people earning between $50,000 and $100,000 who can use all the help they can get. Other stopgap measures could include indexing the exemption or restoring some of the deductions, like the one for property taxes. That will still leave millions of HENRYs facing an ugly future.

The right thing to do is to get rid of the AMT once and for all. The case for doing that doesn’t rest on arguments about equity or burden sharing, or because anyone expects a lot of sympathy for pilots or corporate VPs who live in $2 million houses and face a surprise tax hit of ten grand or so. No, it’s because of this basic principle: When it comes to their most vital tasks, such as raising revenue or securing our common defense, we should expect our political leaders to tell the truth.

Whatever we decide our tax code should be, let’s at least have an honest debate.

What’s so offensive about the AMT is that it fosters a giant lie— a lie that’s only getting bigger. Reasonable people can vigorously debate what kinds of taxes to impose, who should pay them, where rates should be set, and what behaviors we as a nation may want to subsidize or encourage. (Fortune tends toward the general view, best embodied by Reagan’s second major tax bill in 1986, that the best tax is one that eliminates the largest amount of deductions and imposes the lowest fiscally responsible rates on the largest possible tax base.)

But as it stands now, we have a tax code that is set to increasingly divide Americans into two worlds. In one world we tell citizens to work hard, give to charities, raise families. In the other we say, thanks for listening, now we’d like some of your reward back. And oh, you say we forgot to tell you about it? Too bad.

It’s not as if senior people in Washington don’t realize there’s a problem. “Unless the AMT is addressed,” Treasury Secretary John Snow says, “it would lead to a big tax increase for Americans.”

Well put, Mr. Secretary. So how about this? In the run-up to the 2004 election let’s have an honest and wide-ranging debate between Democrats and Republicans about how we can fix our gimmick-riddled tax code while continuing to allow the government to pay its bills. But let’s start by fixing the AMT. Now.

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Meet the HENRYs

2002

Last year, in this breakeven scenario, the HENRYs, our hypothetical family, avoided the AMT. By staying in the regular tax system, they got the full benefit of their $53,802 in itemized deductions, including property and state income taxes.

Salary: $275,000 (adjusted gross income: $269,814)

1040 scenario:
Deductions and exemptions: $53,802
–Mortgage interest
–Charitable donation
–State and local taxes
–Property taxes
–Child exemption
Taxable income: $216,012
Total tax: $57,417

AMT scenario:
Deductions and exemptions: $52,253
–Mortgage interest
–Charitable donation
–Other itemized deductions are replaced with an AMT exemption
Taxable income: $217,561
Total tax: $57,417

Result for 2002: Their tax bill was the one they expected, $57,417, or 21% of their adjusted growth income.

2003

This year, the Bush tax cut reduces the HENRYs’ tax bill enough to knock them into AMT land. So much for the $13,000 in additional deductions they were planning, now disallowed under the AMT.

Salary: $288,750 (adjusted gross income: $283,564)

1040 scenario:
Deductions and exemptions: $66,285
–Mortgage interest
–Charitable donation
–State and local taxes
–Property taxes
–Child exemption
–Home equity interest
Taxable income: $217,279
Total tax: $53,148

AMT scenario:
Deductions and exemptions: $51,387
–Mortgage interest
–Charitable donation
–Other itemized deductions are replaced with an AMT exemption
Taxable income: $232,177
Total tax: $61,509

Result for 2003: Instead of benefiting from the tax cut and paying $4,300 less, they’ll pay $8,361 more.

Reporter associates: Melanie Shanley and Joan Levinstein