Overview of our income tax system

 

The federal tax system

Hi I'm David Luhman and welcome to "Income Tax Planning for Everyone". In this tape I'd like to tell you how to prepare your taxes and how to save money doing it.

But before we look at the details of our federal income tax system, let's take a quick look at some of the principles behind it.

The first thing to notice is that there weren't any federal income taxes until the twentieth century. In fact, until the 16th Amendment was passed in 1913, federal income taxes were unconstitutional.

It's easy to see why people went along with the income tax back then. Initially, less than half a million people paid the tax, and the highest rate was only 7 percent.

However, to help pay for two world wars, income tax rates rose dramatically until top marginal rates were over 90 percent from the 1940s to the 1960s. The number of people subject to the income tax also rose dramatically, so by the 1940s the majority of Americans had to pay income taxes.

The progressive income tax

The federal government uses a graduated income tax where higher-income people face progressively higher rates. The richest Americans face a top marginal rate of about 40 percent, while the average American loses 28 cents of each new dollar to the IRS.

Despite all the hot air you might hear about the so-called rich not paying their fair share, when you look at the numbers, you'd have to say the rich are "contributing" plenty.

According to studies, 5 percent of Americans pay about 50 percent of total federal income taxes. And the top 25 percent of US taxpayers pay 80 percent of income taxes.

Although most people would agree that well-off people should pay more in taxes, the multi-bracket, graduated nature of the current tax code has it's problems.

Tax arbitrage

First, with the existence of different levels of taxation, there's an incentive to shift income from a high bracket to a low bracket. This can be done by shifting expenses or income in time, or by shifting income and expenses to a person or corporation in a lower bracket.

This income shifting is something I call tax arbitrage. To prevent tax arbitrage the tax code is full of complicated rules and regulations. So in the name of so-called tax fairness, we get a complicated system that even the IRS doesn't understand.

A flat tax with large exemptions reduces or eliminates some of the problems with the current tax system. With no chances for tax arbitrage because everyone faces the same flat rate, people won't game the system to cut their taxes.

Most people don't know about taxes

But let's leave the mythical land of the flat tax and return to the system we've got today. Although the current tax code is a mess, you can gain a lot by learning about the system.

And if your knowledge of taxes is less than expansive, don't worry. You're not alone. Even though taxes will continue to be a source of confusion for the foreseeable future, I hope this tape will help you cut through the fog.

Loopholes have gotten smaller

Once you understand the tax code a little better, you'll understand that you don't need to do anything fancy to cut your taxes by hundreds or even thousands of dollars. In fact, using sophisticated tax shelters can get you in a lot of trouble.

Although there are stories of the rich using tax shelters, this game has become difficult to play. The Tax Reform Act of 1986 and other legislation closed most of the old shelters, and the IRS is pursuing aggressively those who misuse shelters.

In fact, this is what happened to Willie Nelson. If you've ever wondered how someone can end up owing the government over $16 million, like Willie did, here's how.

The case of Willie Nelson

Willie was making plenty of money as a popular singer, but to avoid taxes, he put a lot of his money into tax shelters. He thought these shelters would give him losses that he could use to offset his income.

His accountants thought this would work, but the IRS said otherwise. During an audit, the IRS went back and looked over his old tax returns.

They said that many of the losses weren't allowable, and they sent Willie a bill for the taxes due for all those previous years. To pay off his tax bill, the IRS seized and sold off about $4 million worth of his property. Willie filed for bankruptcy, and eventually agreed to pay a total of $9 million over five years to the IRS.

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