How our Federal Income Tax System Really Works

We Americans are hearing more and more about the American tax system and what’s allegedly wrong with it. And I’m sure there are more than a few positive changes that can be made to make it better. Let’s not forget, although it was originally devised solely to collect revenue necessary to fund the operation of our government and the various programs it provides its citizens… somewhere along the way, it occurred to economists that they could also use it as a tool to manipulate and regulate the economy. So it is indeed an imperfect system – and I suspect it always will be, because it attempts, as best as possible, to address the numerous and specific needs and circumstances of 313 million Americans, plus the foreigners who work with us.

My experience is that even though most Americans have to file an income tax return every year during their entire adult lives, they know painfully little about how our individual tax system actually works. They hear about loopholes being closed and tax brackets being lowered, and they believe that doing so is definitely a good thing – when most of the time it actually isn’t. They are hearing about the notion of flat tax – and they don’t understand that the ramifications of converting to that system, would actually increase most people’s tax liabilities. Many Americans prepare their own tax returns, either by hand or with the aid of tax software such as Turbo Tax. They don’t realize that a conceptual understanding of how our individual tax system works is a different dynamic than understanding which numbers go on which lines of which forms.

Our clients don’t experience these feelings. It’s been a good couple of decades since a client of ours got angry because he owed more than he thought he would or got less of a refund than he hoped he would. They may feel disappointment – but they don’t feel anger. The reason for this: I educate my clients. Folks… if you continue to earn money… you’re going to be filing tax returns for a really long time. Particularly if you want to criticize the process… shouldn’t you have at least a basic idea of how our tax system actually works ? I think you should. A lot of accountants don’t feel this way. They attempt to maintain a mystique around the process so you won’t leave them for another accountant, or worse still, Turbo Tax. Our practice takes a different approach… an educated client, is a happy and proactive client.

So I’m going to tell you a story this morning that illustrates the basic concepts of how the American individual tax system actually works. It’s not a true story – it’s one I made up. This story, is not the way it was. But, I’m telling it because it is, the way it is.

The first thing I’m going to tell you, however, actually is true. And that is in the year of our lord 1913, the individual income tax return was introduced into American culture. It was three pages long with one page of instructions and it basically said: folks… tell us how much you earned and we’ll tell you how much to pay. It was very simple. It required no risk taking on the part of the taxpayer, no effort, no energy. Just give us basic information and we’ll tell you how much to hand over.

And this went on for a while. But somewhere along the line, a group of people approached the government and said “Government, we understand what you are doing here. This is the United States of America. We have social programs, diplomatic programs and security programs to implement and maintain, and to pay for these services, our government needs to earn income, or in government lingo, collect taxes. But, there’s a group of people over here, that we feel deserve a break on their taxes that the general population doesn’t deserve. And the government said, “tell us what’s on your mind.” And the group said “the general population takes on no discernable positive risk, and puts out little if any effort or energy to make America a better place. But, there’s a group of people over here who take on a low amount of positive risk, and put out some positive energy and effort to make America a better place, and we feel these low risk, low energy and low effort people, deserve a break on their taxes over what the no risk, no energy and no effort people get. And the government said, “tell us more.”

“Well,” they said, “in their own way, these people are investing in America by building community. They are starting and raising families and that requires a bigger roof to put over their heads. So they’re going out and buying homes which requires builders to build them and banks to lend on them. They are paying banks mortgage interest and tax authorities property taxes. Sometimes their parents move in as well and become their dependents. These people are incurring medical, dental, orthodontia and long term care expenses on behalf of themselves and their families. They are contributing to their local churches, Red Cross, Girl Scouts and Goodwill. Some of them are police officers and firefighters who actually have to spend their own money to maintain their uniforms and skills in order to do a better job on the job. Some are in outside sales and they incur auto, telephone, travel and marketing expenses to do a better job on the job, and they aren’t reimbursed by their employers. Some are teachers who spend their own hard earned money on books and supplies for their classroom, to supplement what their underfunded schools lack, in an effort to provide our children a higher quality learning experience.

These people are taking on a low amount of positive risk, and putting out a low amount of positive energy and effort, at a grassroots community level, to make America a better place. And because of that, we feel these low risk, low energy and effort people should get a break on their taxes over the no risk, energy and effort people.”

And the government agreed and invented what we tax accountants call itemized deductions and what many taxpayers affectionately refer to as “the long form”, giving them credit for the positive risk they take on and the positive energy and effort they expend while building America at the grassroots community level, by allowing them to deduct a portion of their mortgage interest, property taxes, charitable donations, medical expenses and employee business expenses from their income before calculating their tax liability.

And this went on for many years. Meanwhile, there was a group of people sitting way up on a hill looking down and jealously eyeing these people getting a break. When they could stand it no more, they jumped down off the hill and said to the government, “government: we understand what you are doing with these people. They absolutely deserve a break on their taxes for their contribution to society and the economy. But, there are two other groups of people that we believe deserve even bigger breaks on their taxes.” And the government said “We’re listening. Tell us what’s on your mind.”

“Well” they said, ”In life, there comes a time when you have to take a hard assessment of where you are, versus where you want to be. And in order to get from where you are, to where you want to be, you have to take a giant leap of faith across that proverbial line in the sand. And there are two groups of people who have done just that. The first group of people are investors. These people take money out of their own pockets and put it into IRA’s and SEPs. They have their employers put some of their earnings into 401ks or 403bs. Some of them actually take even more of their money and purchase investment properties that they rent out to families and businesses. Others buy stock in American corporations and loan money to the government. Each of these people take on a moderate amount of positive risk and put out a moderate amount of positive energy and effort to make America a better place. Consequently, we think these moderate risk, energy and effort people deserve a bigger tax break over the low risk, energy and effort people, who deserve a break over the no risk, energy and effort people.” And the government agreed.

So, if you’re a high but positive risk taker and own your own business, every expense you legitimately incur on behalf of that business is a deduction, with only three exceptions. Country club dues, are not a deduction. Business gifts are limited to no more than $ 25 per person, and meals and entertainment expenses are only 50% deductible. But every other expense that is legitimately related to your business, is a deduction. You can even incur a loss two out of five years… but not more than that. The government’s position is that when a business incurs more than two out of five years of loss, the prospect of profit potential appears diminished, so its level of risk taking is no longer construed to be positive. And they only reward positive risk taking.

If you’re a moderate but positive risk taker and invest money in a rental property, you can deduct up to $ 25,000 of loss per year. But once your income exceeds $ 100,000, this deductible loss is limited and when it exceeds $ 150,000 your deduction doesn’t get lost or marginalized, but gets deferred to a future year when either your income drops below $ 150,000, or you dispose of the property.

In this story, you heard how the investors and business people crossed that proverbial line in the sand. In the tax world, we accountants refer to that line as adjusted gross income or AGI, which is the last line on the first page of the Form 1040 tax return. Investors and business people live most of their financial lives above this line. The low and no risk people live most of their lives below this line.

And why are the tax benefits for low risk people less than the moderate or high risk people ? Schedule A, the form that accommodates itemized deductions is what we accountants refer to as the land of: yes-buts. Are medical expenses a deduction ? Yes… but… only to the extent that they exceed 10% of AGI. So if your income is $ 100,000, the first 10% of your $ 100,000 income or $ 10,000 of medical is thrown out and if your medical expenses are $ 12,000, you only get to deduct the remaining $ 2,000. Is mortgage interest deductible ? Yes… but… only interest on the first one million dollars of home acquisition debt and the first one hundred thousand dollars of equity. Are charitable deductions deductible ? Yes… but… only up to 50% of your income. Are theft losses deductible ? Yes… but… only to the extent that they exceed 10% of AGI. Are employee business expenses deductible ? Yes… but… only to the extent that they exceed 2% of AGI. And after passing the 2% test, their deductibility, as well as that of state taxes and property taxes can be further limited by alternative minimum tax, also known as AMT.

So… now that you’ve heard this story, reasonably, you can’t really feel angry that you owed more than you thought or got less of a refund than you hoped. You can feel disappointment, but not anger. You can complain about it… but legitimately, only to your Congressperson. Because now that you’ve heard this story, you understand that how much you pay in taxes under our current system, is a lifestyle choice. How much you pay in taxes directly correlates to the extent that you are willing to take on positive risk and put out positive energy and effort, to make America, a better place. You understand that from the perspective of the United States federal income tax code, if you want to be, the best American you can be, you are living your life in all three of these areas. You own your own business, you are putting away money for retirement and investing in corporate America and the government, you are raising a family, putting down roots by owning a home and contributing to local charities and by doing so, building community. One of the wonderful things about being an American, is that you can do all of these things, some of these things or none of these things. The choice is yours. Perhaps you have no plans to own your own business; you’re fulfilled as an employee. But you put money into retirement and own a home. Perhaps you own a home and a business but don’t have the resources to fund retirement. The choices and challenges are yours to choose from and contend with, based on your choice of lifestyle. But from the perspective of the tax code, they indicate the level of your tolerance for positive risk taking, as well as the amount of energy and effort you are willing to put out, and this directly correlates to the size of your tax liability.

And for better or for worse, this is how our current federal income tax system works.

“I didn’t sign up for this” you say ! This must be the fault our current president and Congress!

Actually, that is barely true.

The first federal tax code was written under Democratic president Woodrow Wilson in 1913. That code was put aside in 1934 by Democratic president Franklin Roosevelt. That code was once again put aside in 1954 by Republican president Dwight Eisenhower. And finally, that code was put aside once more in 1986 by Republican president Ronald Reagan. Presidents Bush one and two, Clinton and Obama and their Congresses have certainly made modifications to it, but the bulk of the current tax code is the Income Tax Code of 1986 written by President Reagan and his Congress.