Don’t Envy Those 779 Wealthy Non-Taxpayers

You might have been among many people who were angry and disgusted when they heard that a record number of high-income individuals and couples--average income of $436,000--paid no federal tax, according to newly released Internal Revenue Service data.

But if you are tempted to give these rich folks a piece of your mind, it might be better to give them a piece of advice.

A close examination of the data for 1989--the latest year available--shows that these 779 non-taxpayers gave up a lot, lost a lot or did something thoroughly unadvisable with their money to avoid tax, experts say. A few, despite earning bushels of cash, could even be on the brink of insolvency.

“If you’re more allergic to taxes than anything else, you can avoid them,” says Philip J. Holthouse, partner at Holthouse Carlin & Van Trigt in Los Angeles. “But it doesn’t make a lot of financial sense.”

Adds Harvey Gettleson, a partner at the national accounting firm of Ernst & Young, “I think this is more indicative of the impact of the recession than tax avoidance.”

How could someone earning $436,000 be strapped or stupid? That does require some explanation.

Thanks to the Tax Reform Act of 1986, which slashed most tax shelters, there are only a handful of ways you can report income without being liable for federal tax.

To wit:

* You could invest in two remaining tax shelters: municipal bonds or low-income housing projects.

* You could invest--or lose--a fortune in a business venture that you are actively involved in.

* You could have unusually high “allowable deductions”--the type that don’t trigger an onerous alternate federal tax called the AMT. These allowable deductions mainly include mortgage interest, casualty and theft losses, medical expenses and charitable contributions.

* Or you could combine some or all of the above, the most common scenario.

According to IRS statistics, about 30% of the non-taxpaying group reported losses from partnerships and Subchapter S corporations. A Subchapter S corporation is a company that gets taxed like an individual. It’s a popular corporate structure for small business owners. The average loss amounted to $500,000--or $64,000 more than what these individuals earned from other sources.

Could their tax losses have been higher than their real cash losses? In one year, yes. Over the long haul, no. Gettleson speculates that some laid-off executives may have tapped savings accounts to equip small businesses. They could, then, have claimed depreciation deductions in excess of their income. But they had to use up their savings to do it.

Some may have invested in low-income housing deals too. These are commonly set up as partnerships. This is one of the last remaining tax shelters, but it’s not necessarily a great investment. To get the tax breaks, you give up access to your money for more than a decade--and even then there’s no guarantee you’ll ever get your principal back. Indeed, some maintain that principal loss is likely.

Meanwhile, nearly two-thirds of the rich non-taxpayers invested in municipal bonds, the IRS says. Average interest earned: $392,000. That means the average member of the group earned just $44,000 in cash wages and $392,000 in interest on municipal bonds. Most likely that would be a retired couple with Social Security, a small pension and every dollar they’ve every saved in municipal bonds.

What’s wrong with that? Two things. They probably could have earned a better after-tax rate of return by investing elsewhere. And nearly all advisers caution against putting all your eggs in a single investment. With state governments everywhere facing serious financial crises, default risks are rising. But municipal bond yields are not. They are now averaging about 5%.

What about deductions? Only about half these high-income people claimed itemized deductions. Of those, 69 had casualty losses amounting to $436,000. Another 47 claimed medical expenses averaging $196,000.

However, to claim the deductions, these individuals had to have far greater losses than what’s noted here. That’s because you can only deduct a personal casualty loss that’s greater than 10% of your income plus $100. In other words, to have a casualty deduction of $436,000, the average high-income filer would have an uninsured loss worth $479,700. (The restrictions are somewhat less onerous for business losses, but you generally can’t deduct every dollar.)

Medical expense deductions, which averaged $196,000, are subject to similar limitations. To claim this deduction, the average high-income filer would actually have had to pay out more than $228,000. And then, of course, since the highest federal tax rate is 31%, the deductions are only worth about one-third the cost. In other words, you get a tax break worth $62,000 for every $200,000 you spend. Not exactly a great deal.

The bottom line: Some of these people may still be living high on the hog, but they could have been living substantially better if they were subject to federal tax.

Sensible Ways to Cut Your Taxes

Some tax-avoidance techniques make good economic sense. But experts warn against using them to excess. That’s because, in some instances, you would be spending a dollar to save 15 cents.

That said, here are a few financially savvy ways to cut your tax bill.

* Contribute to an IRA, 401(k) or Keogh. Each of these tax-favored plans is slightly different, but the concept is the same. You put money in savings for your own retirement and the government doesn’t tax you on the contribution or earnings until you pull the money out. But if you withdraw retirement savings before you’re 59 1/2, you may be subject to tax penalties.

* Consolidate debts with a home equity loan. If you have substantial home equity but also have consumer debts, consider paying off the other debts with the proceeds from a home equity loan. These loans are typically cheaper than auto and credit card loans, and the interest you pay on loans of $100,000 or less is tax-deductible--regardless of how you use the money.

* Give to charity. It costs you nothing to clean out your closets and give away unused clothing, toys and housewares. But you can deduct their current value--approximately what you would get for the items at a garage sale--on your taxes as a charitable contribution.

* Invest in municipal bonds. If you’re in the highest tax bracket, consider putting money in tax-free municipal bonds. Interest earned on most municipal bonds is exempt from federal taxes, and sometimes from state and local taxes as well.