Tax-Free Income? Myths and Partial Truths

by | Aug 8, 2011 | In The News, Tax Planning, The Economy, Weekly Column

If I had high blood pressure, I would have to give up listening to Sunday morning news shows. I’ve never figured out how politicians can so convincingly weave false information and partial truths into spin that they deliver with a straight face.

One of the more popular partial truths is that 47% of Americans don’t pay taxes. While it is true that they don’t pay federal income taxes, they do pay Social Security and Medicare taxes on their wages. They also pay sales taxes, gas taxes, property taxes, and a host of other taxes.

It is also true that the top 1% of wage earners pay 38% of all federal income taxes. Yet income taxes account for about half of the revenue raised by the federal government. A large portion of federal revenues come from Social Security, Medicare, and unemployment insurance taxes. The bottom 90% of wage earners pay the bulk of the Social Security taxes, which apply on the first $106,800 of wages.

The purpose of the Social Security program is to provide a safety net to those who did not save adequately for their retirement. It seems reasonable that those who would benefit the most from the program provide a portion of the funding. Still, many feel the wage cap on Social Security taxes should be raised or eliminated, requiring those with higher incomes to fund a greater share of Social Security.

Another partial truth underlies the many Internet and cable news stories about large corporations and hedge fund managers making billions in profits and paying no federal income taxes. These claims leave the reader or listener with the perception that the individual or corporation earned income that was tax-free. For the most part, no individual or corporation can have a taxable profit and not owe income taxes. Rarely, if ever, is income tax-free.

In some cases, however, the tax code allows the taxpayer to defer the taxes on the income into a future year. It is true they may have paid no income taxes in the current year on profits. What the media stories don’t tell you is that the tax bill comes due next year or some year in the future. Anybody who’s ever sold a house or investment property and deferred the tax liability on the gain into the future by reinvesting the proceeds into another home or investment property understands this concept.

Another charge of how the wealthy “game” the system and don’t pay income taxes was illustrated in an article published in the Portland, Oregon, Willamette Week, on April 13, 2011. The piece, written by David Cay Johnston, a columnist for tax.com, was titled “9 Things The Rich Don’t Want You To Know About Taxes.”

He gives the example of a couple who owned a sports team who went for seven years without paying a dime in income taxes while spending $45 million in one year alone. Unfair? Not when you realize the couple lived on borrowed funds during those seven years. Borrowed money is not income because you eventually must repay the loan. If the loan is secured by appreciated property and the property is sold to pay off the loan, capital gains taxes will be due at that time. In some cases, the capital gains taxes are more than the proceeds from the sale, so it’s necessary to sell other assets to pay the taxes.

The complexity of our tax code makes it difficult enough to reach accurate conclusions about who pays what on how much income. It only adds to the confusion when politicians and the media publish half-truths instead of facts.


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