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Some Taxpayers Don't Owe a Penny

A law intended to close a loophole that let the wealthy avoid taxes is increasingly snaring middle-class earners.

April 15, 2003|Doug Smith | Times Staff Writer

Today, as Californians face the April 15 income tax deadline, some of the most well-to-do will feel the sting less than millions of lowly wage earners.

In fact, they will feel no sting at all. They are the 0.2% of the state's high-income filers who have worked the system so well that they don't owe a penny.

And they remain untouched even as lawmakers in Sacramento contemplate new income taxes and other ways of raising money to close a shortfall that Gov. Gray Davis has estimated at $35 billion between now and July 1, 2004.

In 2000, the last year for which records are available, 784 individuals with incomes of $200,000 or more paid no income tax, according to the state Franchise Tax Board. That was up a third from the prior year.

Although a tiny fraction of the state's overall tax roll, that group's exemption from income taxes highlights a contradiction in U.S. tax policy that has nagged lawmakers for more than 30 years -- and that continues to simmer in the debate over how California should resolve its budget shortfall:

A tax law enacted specifically to ensure that every wealthy person pay at least some taxes has never been able to achieve that, and, instead, is raising the tax bills of a growing number of middle-class Americans.

Warned of a potential taxpayer revolt during the late 1960s if the rich were not universally forced to pay taxes, Congress enacted a special system, today known as the alternative minimum tax, to catch wealthy filers who would otherwise get off free. California, known for its progressive tax structure, was one of a handful of states that followed suit.

But credits enacted to stimulate business activity are being used by sharp accountants to override the alternative tax.

Now, as the wealthy increasingly elude the snare of the alternative minimum tax, more middle-class taxpayers are being trapped in its complex and costly rules.

One estimate suggests that by the end of the decade, 36 million Americans will be paying higher taxes because of laws meant to ensure that the rich pay some.

Yet, there is little move to do away with the alternative minimum tax it because it is now responsible for a growing share of state and federal revenues, and lawmakers are not inclined to cut from any reliable revenue source in such tight times.

In California, the taxpayers who are most likely to legally avoid taxes are business owners who register their companies under the increasingly popular provisions of so-called S corporations. Those firms pay only a nominal 1.5% corporate income tax, and the profit or loss then passes to the owners' personal returns.


S Corporations Popular

Owners of profitable S corporations can reduce personal income tax by using state tax credits adopted in the 1990s to stimulate business. The Franchise Tax Board's annual report for 2001 identifies credits for manufacturing investment and doing business in enterprise zones -- together totaling about $500 million -- as the two largest factors in zero-tax returns filed by the wealthy.

Taxpayers who invest in businesses located in certain areas of Los Angeles, for instance, would be entitled to write off some expenses as deductions. That's because policymakers want to encourage the development of new businesses in areas that otherwise have trouble attracting money. Similarly, taxpayers can deduct investments in manufacturing because the state wants to protect and encourage manufacturing industries.

At the federal level, different write-offs apply. A 1998 IRS report identified tax-exempt bond interest, interest deductions, some miscellaneous itemized deductions, casualty losses and medical expenses as the major shelters reducing the tax bills of high earners.

The author of the report, economist Brian Balkovic, found that the high-income earners could avoid the alternative minimum tax by piling up deductions.

Whether nationally or in California, tax avoidance by legal means stirs deep emotions.

"It's simply outrageous that we're continuing tax credits for the wealthy when we're talking about cutting services, cutting health care, cutting education," said Carmen Balber, a consumer advocate with the Foundation for Taxpayer and Consumer Rights in Santa Monica. "We would certainly support closing a loophole that is benefiting a few individuals at the expense of the average Californian."

Some tax specialists counter, though, that society benefits from tax credits that stimulate hiring and production.

"I've got $200,000 income, I put a couple hundred thousand into one of these enterprise zone investments, that doesn't make me a bad person," said Ron Hegt, a partner in Hays and Co. of New York and a member of the tax committee of the American Institute of Certified Public Accountants.

The roots of today's debate over the alternative minimum tax date to a 1969 speech delivered by retiring Treasury Secretary Joseph W. Barr in the waning days of the Lyndon Johnson administration.

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