How to Pay $0 Taxes Despite tax reform, it's still possible to beat the IRS -- legally. Consider three who did.
(MONEY Magazine) – There is hope for the human race. There are still honest and patriotic taxpayers who manage to pay zero taxes legally. They are the surprising survivors of the Tax Reform Act of 1986, a kind of superbomb launched, according to the politicians who designed it, to obliterate unfairness in the tax world. Let all pay their share, and let no sheltered megamillionaire ever again escape taxes altogether. In 1986, the year before reform, 26,557 Americans with income of more than $40,000 for that year paid absolutely nothing, according to the Internal Revenue Service. A year later, that figure was supposed to drop to -- well, zero. Did it? The IRS hasn't gotten around to reporting on that yet, but you'd think that the new law had covered all loopholes. After all, hadn't it eliminated the value of write-offs from those notorious tax shelters and reduced or wiped out such beloved deductions as those for personal interest, sales tax and IRAs? And hadn't tax reform expanded the existing alternative minimum tax so that even if some rich sharpie somehow managed to salvage massive write-offs, he or she would get slapped with the AMT's flat 21% rate? Despite the politicians' rhetoric and the seeming odds, MONEY correspondents across the country asked dozens of tax professionals and financial planners: Is it still possible to cut taxes to zero? Within a week, we had tracked down seven tax-free souls. Four, out of fear of an IRS audit, or to protect their privacy, declined to be interviewed. But the other three agreed to talk: a dentist in Oregon, a couple in California who run a financial planning and real estate brokerage practice, and a retired engineer in the Boston area. They would not let us divulge their identities, but they allowed us to interview their tax professionals at length and submitted their tax returns for 1987 for our expert to examine. A key lesson we learned from these three cases was that being tax-free today does not necessarily mean being carefree. ''Contrary to what most people think,'' says Michael Dreyer, the Los Angeles C.P.A. who is the adviser to the California couple, ''zero is generally not so desirable these days because usually it means you haven't earned a great deal of money, or you've suffered real losses.'' While that is true to some extent in our cases -- our Oregon dentist, for example, sustained huge medical expenses -- that is hardly the whole story. As Dreyer added: ''Today, to hit zero taxes, you have to use strategies, not loopholes.'' Many of those strategies are fairly simple, such as taking full advantage of the $25,000 write-off still permitted from rental property losses. Our Oregon dentist put $23,459 worth of those losses, plus a rich lode of itemized deductions, against $80,000 of income and was home free. And our financial planner couple zapped $57,000 in income with an amazing wink of business write-offs. ''Getting to zero may be simple for some people today, but it sure doesn't happen by luck,'' echoes C.P.A. Kevin Greig of Eugene, Ore., who shepherded our dentist to zerohood. ''Most taxpayers don't have any idea how much they can control their taxable income and therefore their taxes.'' Our Boston retiree is one of those few who do know. ''It's me against the government,'' he says, ''and I'm happy to say, I win.'' His strategy: he squeezed down to the zero-tax level by living largely on tax-free income from Social Security and the interest on tax-free munis, while carefully monitoring and controlling his taxable income, which is largely the sum he decides to draw out of his IRA. Tax-free munis are nothing new. Dreyer put $2 million of one client's money into them when she declared that she had paid enough taxes for a lifetime and that she didn't trust the stock market, real estate or the IRS. She wanted tax-free income, about $250,000 a year, no worries and no problems. She got it. Out of these cases, there are a number of substantial tax moves that you might well adapt -- even if they don't fly you all the way to zero. After all, the best to hope for is high income with moderate taxes. Even our retired taxpayer, who has made a virtue of his lack of taxes, shares that sentiment: ''How would I feel if I had to pay $100,000 in income taxes? It should only happen to me.'' Now see if any of these could happen to you.
DR. ZERO: THE OREGON DENTIST This is a tale of how to turn adversity -- in the form of high unexpected medical expenses -- into tax heaven. In 1987, after Dr. Zero, as we'll call him, had spent $250,000 for dental equipment and office improvements to expand his practice, he and his family ran up horrendous medical bills, largely for reconstructive surgery. The tab: $13,400 that was not covered by his family's major-medical policy. Dr. Zero envisioned disaster. But his C.P.A., Kevin Greig of Barkman Gibbs & Greig in Eugene, saw deliverance. Greig, an amiable 33-year-old who had been doing Dr. Zero's taxes since 1985, explained: ''The average taxpayer would have let the year just happen. 'Tough luck,' he would have said, and paid a lot of taxes without realizing how much control he has over the amount he owes.''
What Greig saw taking shape was a tax-free scenario of heavy deductions and limited income. First there was the looming medical write-off, which eventually amounted to $9,161 after subtracting the 7.5% of adjusted gross income (AGI) from the $13,400 in medical bills, as provided for under tax reform (reflected in the table on page 163). Then there were additional itemized deductions totaling $41,641, as well as a paper loss of $23,459 from one real estate investment and the rental property Dr. Zero owned, an apartment building with four rental units. In the end, the deductions amounted to some $74,000. The real trick: juggling the timing of income and expenses so they balance, and the deductions wipe out a maximum amount of income. There is such a thing as too many deductions -- the amount that exceeds income is lost. Too much income could be a problem as well. In 1987, for example, extra income would have pushed Dr. Zero's AGI over $100,000, and that would have endangered the $23,459 deductible loss tossed off by his rental properties. Over $100,000 AGI, the amount Dr. Zero could deduct would be phased out, a dollar lost for every two dollars in AGI income that exceeds $100,000. With an AGI of $110,000, for example, he would lose $5,000. Also, substantial income when married to the wrong write-offs, such as charitable contributions for appreciated property, could trigger the alternative minimum tax. To control Dr. Zero's income, Greig conceived two pieces of strategy. First, because his client was self-employed -- employed by his own professional corporation, technically -- he had the dentist pay himself zero salary for 1987. Normally, such a move would invite IRS scrutiny. The law calls for no ''unreasonable compensation'' for any taxpayer, a term regularly debated in tax court but which the IRS roughly translates to mean neither too much salary * nor too little. For 1987, however, with Dr. Zero's corporation spending so heavily for new equipment, the resulting depreciation reduced the corporation's taxable earnings even further, and there were other expenses as well. Therefore, Greig felt he could defend his client's zero salary if the IRS challenged him. The second piece of fine-tuning actually went back to the end of the previous year, 1986, and vividly illustrates the meaning of year-end planning. ''I always try to look at two or three tax years at the same time,'' says Greig. As he was doing that toward the end of 1986, he discovered two intriguing elements. First, being familiar with all of Dr. Zero's investments, he knew that the dentist owned 2,750 shares of a stock that was going nowhere. He also knew at that time, as C.P.A. to the dentist's professional corporation, that Dr. Zero was thinking seriously about buying that expensive equipment in 1987. He formed an elegant plan that he presented this way: Why not sell the stock? But -- and here comes the timing strategy -- let's give ourselves the option of receiving the gain from the sale in 1986 or 1987, Greig explained. We do that by getting an extension on the filing date of our 1986 return, from April 15 to Aug. 15 of 1987. That will give us until Aug. 15 to see how 1987 is shaping up. If, as I suspect, it's a year where your corporation has heavy expenses and not much income, then 1987 could be the year it does not pay you -- in fact cannot pay you -- any salary. If that's the case, then you're going to elect to make an ''installment sale'' -- selling the stock in 1986 but receiving the gain from the stock in 1987. With no salary that year, you will need the money from the sale to live on, and with other deductions -- losses from the rental investments, for example -- we might be able to wipe out a big chunk of the taxes you would otherwise have to pay on that stock gain. Greig's plan worked. Dr. Zero elected the installment sale -- which Congress has since wiped out for marketable securities, though not for real estate -- and he took a long-term capital gain of $53,589 in 1987. That sum was more than erased by his heavy deductions, and on line 53 of his return for 1987, next to where it says, ''This is your total tax,'' Greig was able to put a big 0. Like an alchemist, he had transformed adversity into tax heaven, leaving behind four fiscal homilies for us all to consider: -- Never forget the tax-cutting effect of adjusting the balance between your income and your expenses. For example, ''If you see yourself moving into a higher bracket in 1990,'' Greig says, ''you could start right now deferring expenses into that year, when they are going to be worth so much more to you. Similarly, maybe you could drain off income into this year.'' -- Good tax planning requires a perspective of more than one year -- for example, whether to sell a stock at the end of a year to take the income in that year; whether to accelerate interest payments for a given year; and whether to make repairs and incur expenses on a rental property to increase the expenses and therefore the deduction on the property. To extend your overview, it might help to obtain an automatic extension on the filing date of your return from April to Aug. 15. -- Your planning is most flexible when you are able to control your income flow. Unfortunately, if you are a salaried employee and all or nearly all of your earnings comes from that job, there isn't much you can do. But if you supplement that salary with freelance income, or even better if you can work in a self-employed status or through your own corporation, you are in a good position to minimize your take. -- Schedule not one but three meetings with your adviser each year. The first, early in the year, should be devoted to doing your tax return itself; then have a session in the spring immediately after you file your return, when everything is fresh in both your minds, to start planning for the next year; and then get together again for a review late in the year, especially if you're considering a year-end stock sale. Such a high level of attention -- higher than most taxpayers normally require of themselves and their preparers -- does not have to become overly expensive. Greig charges $90 an hour. His bill to Dr. Zero for 1987 for three meetings, regular telephone consultations and, of course, that masterpiece of a return: $1,369. A reasonable investment, considering that some preparers charge twice as much for simply doing your taxes, not to mention Greig's beauteous bottom line: 0.
THE COMERS: CALIFORNIA PLANNERS The Comers -- he's 40 and she's 38 -- started their own financial planning and real estate brokerage business three years ago and are building it with a combination of their hard work and a tax system that still indulges small business. With their office in their home, for example, they can deduct heavy business expenses from their personal income -- and become no-tax winners. Says Michael Dreyer, 37, their tax professional and managing partner in the Los Angeles accounting firm Dreyer Edmonds & McGlone: ''Most people have trouble proving that they meet clients in their home office, as the law requires. This couple is safe -- they have a fully dedicated space.''
Here's how they got away tax-free: They cut their taxable income to $46,300 with an $11,575 contribution to their corporate pension plan. They trimmed it further with $36,993 worth of itemized deductions, including almost $15,000 in home-mortgage interest, $3,291 in credit-card interest and a somewhat unusual $7,962 for the business use of their car. (Knowing that the IRS looks suspiciously at this last expense, they carefully documented the 23,000 miles they traveled from their home office to clients as far as 60 miles away.)
The Comers' zero-tax year probably won't happen again. They expect to pay -- happily -- $4,000 in 1988 federal income taxes and, as their planning business prospers, they will melt into the mass of normal taxpayers.
MR. GOLDEN: BOSTON RETIREE Since he's 71, we can call him Mr. Golden, short for golden ager. But there's another reason the name fits: His zero-tax status came not through illness or struggle but from a zest for winning what he calls his ''game of wits'' with the tax man. In the five years since he retired, he has done his own taxes and not paid a dollar to the IRS for the last four. An engineer with an analytic eye, Mr. Golden started by carefully estimating his and his 67-year-old wife's retirement income needs. For 1987, he figured they would require about $29,000 after taxes. He also knew that if he could get his AGI below $10,000 -- a magic number for a couple age 65 or older filing jointly -- he and Mrs. Golden would owe no tax, nor would they even have to file a return. Mr. Golden says anyone can do it. His theory: first ''save like hell'' in the years between the time your last child finishes college and when you retire. Then invest that nest egg with care -- ''Nothing too fancy, and don't get greedy,'' he warns. He favors municipal bonds. Result: you will have income, largely tax-free, that combined with your Social Security benefits and pension will allow you to live comfortably. Applying his own theory, he took his nearly $55,000 nest egg in the early '80s and bought tax-free municipal bond trusts and individual munis yielding 12.5% to 13%. In 1987 the munis paid $6,059 tax-free. In addition, the couple got $13,910 in Social Security benefits, also tax-free. For the additional $9,000 or so they needed, they used taxable income on CDs, a capital gain from the sale of a stock, and a withdrawal from his IRA as well as his corporate pension. With that $10,000 tax-free cap in mind, Mr. Golden pulled just $1,000 out of his IRA. (His AGI cap rises slightly for 1988 to $10,100. Mr. Golden will lift his income accordingly and again be untaxed.) ''I must confess that I really enjoy not paying the government more in taxes than I have to,'' Mr. Golden notes. He has yet to be audited, and furthermore he doesn't expect to be. ''I don't use chicanery,'' he says. ''If the IRS comes knocking at my door, I can defend every single number on my returns.'' Although he fills out those returns himself, Mr. Golden does get some help from Harry Kluger, his certified financial planner. They usually meet in Kluger's Lexington, Mass. office for a couple of hours once a month to talk about investment and tax news. Says Kluger, who may check out a technical point for his client in the tax code once in a while: ''He doesn't really need me for his taxes.'' At bottom, Mr. Golden is a zealous believer in the inspirational wisdom of Judge Learned Hand, who wrote in a 1934 decision: ''Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes.''
CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: An Oregon dentist.
CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: Two California planners.
CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: A Boston retiree.