If economists ran the tax system, there would be virtually no exemptions or loopholes. But economists don’t run the tax system! Instead, businesses, rich people, Congressmen and attorneys spend a shockingly large amount of time lobbying for tax breaks or exploiting the ones that exist. When the modern income tax was created in 1913, the code was 27 pages long. Last year, it was 5,296 pages. What in the world does it say? After surveying 20 accountants, tax lawyers and policy wonks, we’ve boiled down their arcane knowledge to this short list of things you might want to know.
So what’s the easiest way to cheat on your taxes?
Run your own company. More specifically, as Greg Kyte, a Utah C.P.A., puts it, be the sole proprietor of a Schedule C business. Then you can buy stuff for yourself and probably write it off as a business expense. “You can look through your receipts for the year and say, ‘Here’s some stuff I bought at Home Depot,’ ” says Kyte (who, for the record, says he never does this). “The I.R.S. would have no idea if I bought that for my house or for my business.” There were more than 20 million Schedule C returns filed in 2009, with receipts of more than $1.2 trillion.
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Upstanding Schedule C filers have options, too. They can legally write off payment for office work done by family members, even if they’re in middle school. “I’ve seen people with infant children claiming that their kids are doing work,” says Howard Rosen, a St. Louis-based C.P.A. “I’m talking about a 3-year-old doing filing,” Rosen says. “He didn’t even know the alphabet.”
How often do people cheat?
For 2006, the most recent year for which data are available, the I.R.S. collected 86 percent of what it was owed in taxes. Most of this $385 billion shortfall came from underreporting income, which is often more creative than it sounds. Gambling winnings, for example, are taxable, but losses are deductible — and some people greatly exaggerate their losses. “It’s not unheard-of for gamblers to go to the track and pick up tickets for losing bets that would be thrown on the floor,” says Mark Blood, a C.P.A. in Rochester. “I had an examination once where a number of tickets the client had given me to support losses had footprints on them.” The agent disallowed the deductions.
What’s the most ridiculous loophole?
There are too many to count. Like deducting part of the cost for college football tickets. Or opening a “motorsports entertainment complex.” (Sadly for Nascar track owners, this break just expired.) Loopholes will cost the government roughly $1 trillion in lost revenue this year, which is more than it spends on defense or Medicare.
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The most surprising loopholes are the ones that are so big that they don’t even seem like loopholes. The mortgage-interest deduction, which lets people deduct the interest they pay on their mortgages, requires the government to essentially write an annual check to everyone with a mortgage. The incentive was supposed to encourage more people to buy houses, but there’s not much evidence for this, says Roberton Williams of the Tax Policy Center in Washington. It does, however, encourage people to take out even bigger mortgages. It will cost the government an estimated $84 billion this year. And it’s considered untouchable.
Who is the government’s dream taxpayer?
It’s a married, childless renter who earns a decent salary. The government didn’t set out to target these people — it’s just that married people who rent and make a decent living don’t hire lobbyists or attract activists to write op-eds. “Sometimes they’re pregnant, and I’ll say, ‘Any chance you can get that out by December?’ ” says Shayna Chapman, a C.P.A. in Gallipolis, Ohio. Or: “Do you think you can get divorced by Dec. 31?”
What’s the most ridiculous attempted deduction?
According to the accountants surveyed, here are some common, if questionable, things that people try to deduct:
1. Gym memberships
2. Country-club dues
3. Cosmetic surgery
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Less common, more questionable things:
1. A wedding (clients were invited)
2. Thongs (the buyer was an actress, who needed to avoid visible underwear lines on TV)
3. Vet bills (for pets that were listed as dependents)
What’s the biggest red flag for auditors?
“There’s an old saying in the I.R.S.,” says David Lifson, a C.P.A. in New York. “Look at T. and E. and get out by 3.” Because people are aggressive about writing off travel and entertainment expenses — and because regulations for deducting T. and E. expenses are Byzantine — this is low-hanging fruit for auditors.
Another thing that makes people more likely to be audited: being rich. Those with income of at least $1 million are 11 times as likely to be audited as the average taxpayer; those with incomes of $200,000 or more are 4 times as likely. Of the 1,000 biggest U.S. companies, more than half are being audited at any given time, says Mary B. Hevener, a partner at Morgan, Lewis and Bockius in Washington. The I.R.S. is drawn to giant corporations “for the same reason Willie Sutton robbed banks,” Hevener notes. “It’s where the money is.”
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Why is the tax code so complicated?
The answer, according to most accountants, is simple: “exceptions to the exceptions,” which, typically, are extremely complicated. John Yeutter, a C.P.A. who teaches accounting at Northeastern State University in Tahlequah, Okla., offered the following example:
RULE: When you buy a bond, you have to pay taxes on the interest payments you receive.
EXCEPTION: You don’t have to pay taxes on interest from municipal bonds (because the federal government wants to make it easy for local governments to borrow money).
EXCEPTION TO THE EXCEPTION: If a municipal bond is used to finance a professional sports arena, you have to pay taxes on the interest (the government doesn’t want to support a sports team).
Now imagine this times a thousand. “Each step along the way is great,” Yeutter says. “But after 100 years, we have a system that is very, very complex.”
Who is the greatest accountant of all time?
Many consider Luca Pacioli, a 15th-century Italian bookkeeper who hung out with Leonardo, as their standard-bearer. In his 1494 opus, “Summa de Arithmetica, Geometria, Proportioni et Proportionalita,” Pacioli described the system that Venetian merchants had begun to keep track of their far-flung businesses. That system, with some tweaks, is still in use today. “He’s the father of double-entry accounting,” Yeutter says, “the exciting world that we have.”
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Do tax cuts pay for themselves?
Politicians sometimes say that lower tax rates lead to higher economic growth, which in turn leads to higher overall tax revenue. This may have been true in the early 1960s, when the top tax rate was 91 percent, but the top tax rate today is 35 percent. For decades, lower tax rates have led to lower government revenues, says Alan Viard, an economist at the American Enterprise Institute, a conservative policy group. “The Reagan tax cuts, on the whole, reduced revenue,” he explains. “The Bush tax cuts clearly reduced revenue. There is no dispute among economists about that.”