How to pay zero taxes

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(Money Magazine) -- You've tried staring your computer down, but it's not blinking. No matter how many times you go over the figures, you get the same answer. That number on your screen - what you're paying the IRS this year - is more than your dad earned in his five best years. You can't help thinking, Why am I such a chump when other people must be getting off scot-free?

Brace yourself. Last year 49.2 million U.S. households filed returns that obligated them to pay absolutely no federal income taxes - and they didn't necessarily do anything illegal. Before you start gnashing your teeth at the injustice, however, you should know that there are many reasons to be happy that you're not one of the tax escapees.

For starters, avoiding U.S. income taxes isn't easy. Citizens can't wriggle out of their bills by moving to another country because, almost alone among nations, the U.S. taxes all income, no matter where on earth it's earned. And although the tax code offers plenty of deductions and exemptions, if you take too many you'll be skewered by the alternative minimum tax (AMT).

Almost all the tax shelters of yesteryear disappeared when Congress closed loopholes in 1986. Even running your own business is not the shelter it was when you could deduct yourself down to zero by saddling your company with bills for luxurious travel, cars and meals out.

"Those days are over," says Charles Hayes, a C.P.A. and financial planner in Coronado, Calif. "Expenses have to be necessary and reasonable." If they aren't, the IRS will likely disallow them.

So how do the 49.2 million do it? That's what Money Magazine set out to learn. What we found offers a glimpse into the workings of the immensely complicated U.S. tax system, as well as valuable lessons in the dos and don'ts of cutting your own taxes.

Among them: Do whatever you can to shave income from your 1040 but, perhaps most important, don't cut off your tax nose to spite your financial face. You can find plenty of ways to collect tax-free income, but you'd likely find unacceptable the trade-offs it takes to get all the way to zero.

From its beginnings in 1913, the income tax system was designed to be progressive; the more you make, the more you pay. The top bracket then was 7%, and it applied only to those who earned above $500,000 a year, which is about $10.6 million in today's dollars. Congress also recognized that some were too poor to pay taxes, so it exempted the first $3,000 in income. In 1913 that exclusion liberated all but 1% of the population from taxes.

Those principles still hold today. "Our tax system still is progressive," says Len Burman, director of the Tax Policy Center in Washington, D.C. In 2005 the 10% of taxpayers with the highest incomes provided 70% of income-tax revenue, which cost them on average 25% of their income, more than any other group, according to the IRS.

That's not to say that many wealthy people don't shelter immense chunks of money, but getting to zero is difficult even for them. Fewer than 2% of earners in the top 20% (average income: $99,500) escape taxes altogether. That comes to about 400,000 filers. (Plus, even those who sidestep federal income taxes may have to pay Social Security and Medicare taxes, state and local levies, property taxes and sales tax.)

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