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Popular Tax Myths

Definition. Myth: a fictitious or imaginary story; a false belief. [Source: The American Heritage Dictionary.]

Myths about US tax system.
Myths about "tax breaks" and reducing your tax.
Myths about filing or not filing annual tax returns.
Myths about tax cheating.
Myths about IRS audits and collection.
Myths about corresponding with the IRS.

 

Myths about US tax system

Myth: Taxes are illegal and/or anti-constitutional.

This is a popular topic on the Internet and in high-school debate clubs. Groups of so-called "tax protesters" keep promoting various theories about illegal nature of income taxes. To date, none of them won in court. The moment they win, I will stop paying taxes myself. You think I enjoy paying myself? Meanwhile, we must pay taxes, and this is a federal law. In other words, not paying taxes is against the law with all the usual consequences.

Myth: The rich pay less tax than the poor.

The following quote is from the Money magazine [Jan. 1996]: "While pro a flat tax, 64% say the rich ought to pay more." Whether they ought to or not is debatable, but it helps to know what they are paying now. According to Taxes for Dummies, the wealthiest 1% of the American population pay 25% of all income taxes.

Myth: US taxpayers pay more than other nations.

From Parade magazine [4.13.97]: "The U.S. ranks 11th in the percentage of federal revenues derived from individual income taxes (39%) and 70th in the percentage from corporate taxes (10%)."

Myth: The IRS is the source of all our tax problems.

In fact, tax laws are created and constantly changed by the Congress. The IRS simply serves as the administrator of the law, just like any other law enforcement agency. The IRS's "contribution" to the tax nightmare is that they interpret and sometimes arbitrarily apply the laws - but they do not create them.

 

Myths about "tax breaks" and reducing taxes

Myth: Many things don't cost you anything because they are "tax deductible."

Sorry, but "deductible" does not mean "free." If you spend $100 on something "deductible", you do not recover your $100 in taxes. In reality, $100 is deducted not from your taxes but rather from your taxable income. The result is that you will only recover $15 or $28 (depending on your income level), not $100. It's still better than $0, but not enough to justify purchasing something that you don't need otherwise.

Myth: You must keep records of all "tax deductible" expenses.

Before you do this, make sure that you're entitled to deducting any expenses. You are entitled to deductions if any one of the below conditions is true (there are some other situations, too). Otherwise, you may be out of luck, and there is no need to bother with records.

• You run a business, rent out property, or practice an occupation as an independent contractor (not regular employee!) and the expense is business-related.
• You choose to itemize deductions instead of using the standard deduction. The choice only makes sense when you have large mortgage interest payments and property taxes, huge medical expenses, or enormous casualty loss. For many people, itemizing is not an option.
• You had to move because of job change and you satisfy some additional requirements and the expense is directly related to the move and it is recognized by the IRS as a legitimate moving expense.

Myth: It's smart to chase all possible deductions and "loopholes."

First, most of the deductions only apply to people who choose to itemize rather than use the no-nonsense standard deduction. Many people cannot itemize at all. Even if you do itemize, "chasing" deductions will cost you time, money, or both. Compare the benefits with the costs. If you need to spend 4 more hours of your time and pay your accountant an extra $200 to save $300 on taxes - it may not be worth the trouble. As an extra bonus, your hard work can be rewarded with additional scrutiny from the IRS. But if you feel that the game is worth it - and often it is - then go for it!

Myth: Whatever you spend for business purposes, you can later deduct from taxes.

This statement contains 2 mistakes:

1. You deduct business expenses from your business income, and not from taxes directly. As a result, you can recover only between 15% and 28% of what you spent. The rest - and it is the bulk of the expense! - still goes out of your pocket.
2. Not all business expenses are allowed as deductible, and some are only partially deductible. The rules are very complex here. Professional help is strongly recommended.

Myth: Most personal expenses can be "converted" into deductible business expenses.

This is the single most popular topic for "how-to-pay-no-taxes" books and seminars. They feed you some very tempting suggestions and claim that "the rich people do it all the time." Unfortunately, they usually suggest making up a bogus (non-existent) "business" and then falsely claiming your personal, travel, and entertainment expenses as related to this "business." In plain English, it is called illegal. In courts, it is called fraud. Just like any other illegal activity, it can go unnoticed for a while, maybe even forever. In most cases, however, your "smart strategies" can result in rewards ranging from money penalties to jail terms.

Bonus tip: the IRS agents also read these books and attend these seminars.

Myth: Owning a home is a tax paradise.

Do not buy a house because of taxes. Buy it when you are ready and want to. While it is true that many expenses of a homeowner, such as mortgage interest and property taxes, are tax-deductible, it is also true that you have to itemize deductions to take advantage of it. Itemizing may or may not make sense in your particular case. If all your allowable deductions combined do not exceed the standard deduction, you're not saving any taxes - even if you own a home. Bottom line: owning a house can be a smart financial move and a significant tax saver too, but do your math carefully to avoid nasty surprises down the road!

Myth: Owning a business is a tax paradise.

Owning a business can be very rewarding - both emotionally and financially - or very devastating. In first case, you're paying taxes on your profits. In second case, you don't pay taxes but you're losing money on the business itself. One way or another, "tax paradise" is hardly the right term. Sadly, what many promoters mean by "tax paradise" is lying that you're operating a business while you are actually not, and then claiming that all your personal expenses are part of "running the business." This type of "business" is supposed to show big losses, thus reducing or even eliminating your taxes. What the promoters don't tell you is that they won't help you when the IRS goes after you for these clearly illegal activities.

Myth: Renting out your house is a tax paradise.

Do not buy a rental property to save on taxes. Buy it to make money from renting and/or from reselling. Buy only when you understand real estate investing. When you rent property to somebody, it's a business. Like in any business, you can make money or lose money. If you're making money, your profit is taxable income, just like salary or interest on savings. If you are losing money, your loss sometimes may reduce your taxes. This is how it works (provided you are eligible). You made $35,000 at your job and lost $3,000 on renting. Your tax is calculated on $32,000 ($35,000 minus $3,000), not on $35,000. Do you recover your $3,000 loss? No! Do you recover at least part of it? Yes. Is it worth the trouble? Depends. You have to weight potential long-time gain (if your property price goes up and you sell it at a profit) against current rental losses, combined with typical landlord's headaches and risk of the property price going down. Besides, not all rental losses can be deducted from your income. Consult your tax advisor.

Myth: [ fill in the blank ] is a tax paradise.

Let me know when you find one, and I'll burst your bubble at no charge. To my knowledge, the only sure way to pay zero taxes is to make zero money.

 

Myths about filing annual tax returns

Myth: Don't file if you don't owe tax.

Not everyone needs to file (submit) annual income tax paperwork. There are very specific requirements regarding who has to file and who doesn't. You can find them in IRS booklets, tax books, or on the IRS Home Page. "Owning no tax" is not one of the exceptions. Attention: Even if you discover that you do not have to file, it may be helpful if you do. You actually may be entitled to a refund! How can this happen?

1. If you overpaid your taxes during the year
2. If your employer overpaid them for you (with your money!)
3. If you made very little money and became eligible for a special break called Earned Income Credit
4. For a number of other reasons

If they owe you money, you have to apply for it by filing your income tax. Otherwise, you may never see the money.

Myth: Don't file if you don't have money to pay the tax.

This is a very frequent and a very serious mistake. Filing and paying are two different actions. You pay taxes throughout the year and file tax return by April 15th next year. By the same deadline, you must pay the difference between what you had paid and what you calculated on the return. If you don't pay (don't have the money), there is a penalty plus interest. If you also don't file - there is an additional non-filing penalty, which can be 10 times (!) as high as the non-payment penalty. You can, in fact you should, file timely, even if you can't pay. This way you will avoid the non-filing penalty and show your good faith. Most people who don't have money for taxes decide not to file fearing that the IRS will go after them. The truth is, they will go after non-payers either way - whether they file or not. Not filing only makes the matter worse. There are several options to consider when you can't pay, but not filing a return will never help.

Myth: You need a CPA to do your taxes right.

Hiring a CPA (Certified Public Accountant) to do your taxes is a popular and expensive choice. Most people are intimidated with taxes. In fact, more often than not you can do it yourself. Unfortunately, most of the IRS publications and "how-to" books are way too thick and complicated for an average person. The only book I can recommend is Taxes for Dummies by Eric Tyson & David J. Silverman. If you still decide to hire somebody, keep in mind that you may choose from different kinds of tax professionals - CPAs are only one group of several.

Myth: Getting a refund is a good thing.

Receiving a refund check from the IRS definitely feels good. Until you realize that this is your money that you previously overpaid, now being returned back to you. Worse, they are not paying you any interest for the time they held your money. In effect, you gave a free loan to the government! Of course, discovering that you owe them is not great either. The solution would be to do your math and accurately estimate your future taxes and then pay exactly what you have to pay, no more and no less. If this is too much trouble for you or if you really prefer to receive a big refund check each spring, here is another idea. Have your payroll department deduct less taxes from your paychecks, take the difference and put it in a separate savings account or, better yet, Money Market mutual fund. Next year, you will see a nice "refund" waiting for you and, unlike the IRS refund, this money will earn interest for you. Catch: you are not allowed to tap this account!

Myth: Getting a "refund anticipation loan" is a good deal.

Refund anticipation loans are normally issued by tax preparation firms that provide you a "quick refund" immediately after you file your return. This is not a refund. This is a loan! You get the cash and pay what seems to be a very reasonable fee for the service. Ironically, you're borrowing your own money! Now, take your calculator and figure out the interest rate you're being charged. You may discover that it's as high as 40%! So, first you overpay, thus giving the government a free loan. Then somebody loans you your own money back at a horrible rate. What a deal!

Myth: You can postpone payment of taxes for 4 months.

Many people misunderstand the automatic 4-month extension that anybody can request by April 15th. Unfortunately, it's only extension of time to file the return. There is no time extension to pay the tax. Late-payment penalty and interest will start accumulating immediately after the April 15th deadline, regardless of the extension. Extension only protects you from late-filing penalty.

 

Myths about tax cheating

Myth: It's easy to cheat on taxes.

It used to be. As computer technology and information sharing advance, it's becoming increasingly more difficult to cheat. For instance, information about your earnings, investments, real estate, and dependent relatives is very easy to verify by computers. On the other hand, there are still areas where automatic computer verification is impossible, like cash earnings and tips, business expenses, certain investments. In these and similar areas, it is easy to underreport income and overclaim expenses. To be sure, the IRS perfectly realizes that. Their weapon of choice is an audit. During an audit, you're supposed to prove your numbers using bank statements, receipts, bills, and whatever evidence you can provide. If you fail to prove that you're right, they automatically decide that you're wrong. The usual results are disallowed deductions, additional taxes and penalties, and doctor bills. The good news: returns with "typical and reasonable" numbers rarely get audited. Conclusion: moral considerations aside, tax cheating is relatively easy. But mild cheating is not saving you much, while bold cheating may get you in trouble.

Myth: They won't catch you.

Maybe. Not all thieves are caught either. But many are. The IRS is getting better every year at this. They are pressured by Congress to do so, and they take advantage of the technology. For example, they now use the Internet to access public records of many state and local agencies. You can take your chances - if this is your idea of fun. Beware: the IRS has a different idea of fun, and they may have it at your expense (literally).

Myth: The IRS has only 3 years to go after you.

This is only half-true. Indeed, the IRS has 3 years after the filing deadline to audit and amend your returns, provided that you do file and do not intentionally give false or fraudulent information. Then, there is no time limit. They have 6 years is there was "substantial" understatement of income. If your case is being audited around the 3-year deadline, they can force you to sign a waiver of Statute of Limitation. To collect delinquent taxes, they have 10 years.

 

Myths about IRS audits and collection

Myth: Smart people can avoid an IRS audit.

Nobody can. There is more than one way a return can be selected for an audit. Most of the time, returns are flagged by a computer when an error is found or some numbers are suspicious. These audits are relatively easy, since they are usually limited to a few specific areas on the return. These are the audits that, at least in theory, can be avoided. Unfortunately, not every audit is initiated this way. You may be audited as a member of a specially targeted group, even if your return is fine. Target groups can be based on a certain occupation, geographical area, or any number of other criteria that change all the time. You may be audited in connection with somebody else's return, such as your employer's, ex-spouse's, or even housekeeper's. Finally, every year hundreds of returns are selected for an audit absolutely at random, as part of the IRS "compliance" program. Quite unfairly, this last case can be the worst of all, because those are comprehensive examinations - everything on your return gets checked. As you see, you can reduce - but not eliminate - your chances of an audit.

Myth: An audit is a nightmare.

I'm not going to lie that audits are pleasant. But they can go very smoothly if you're organized (have all the requested documentation available) and cooperative (flexible and open to compromises). Most of the time, you are going to end up paying more money - this is exactly why they spend time on your case. Some lucky people do leave an audit paying nothing extra or even getting a refund. It happens. Good luck! Hint: the IRS is motivated to close your case quickly, collect the money, and move to the next one. Therefore, the auditors are instructed to be reasonable and avoid confrontation. The same is expected from you. However, sometimes emotions and attitudes surface on either side of the table, and this is when the things may turn ugly. Try to stay calm. Request another auditor when the situation goes out of control. It's also a good idea to have a qualified tax professional represent you.

Myth: The IRS penalties and interest can be cancelled.

Sadly, this is not true. Some penalties can be abated (cancelled), some can be compromised (reduced), and some cannot be changed at all. Penalties adjustment is always at the discretion of the IRS, never automatic. By law, interest on unpaid tax cannot be waived or reduced. The only exception is when the IRS made a mistake and no tax was in fact due.

Myth: The IRS is going to jail me for non-payment.

Not paying taxes by itself is not a crime. To be criminally prosecuted, you need to intentionally and willfully avoid paying taxes. For instance, a crime is committed if someone fraudulently conceals or transfers assets to evade tax. The fraud needs to be serious enough to warrant the case. Even when there is enough evidence to support a criminal case, the government is more interested in getting paid than sending someone behind the bars. Unless you're a criminal figure, a celebrity, or an extremely uncooperative person, your chances of being jailed by the IRS are about zero.

Myth: The IRS may not take and sell your home.

They are discouraged, but not prohibited from doing it. Such an extreme action has to be justified financially and politically and requires an approval at a very high level within the IRS. But it will be taken if the IRS exhausted other options of collecting money from you and decides that the action is appropriate.

 

Myths about corresponding with the IRS

Myth: A letter from the IRS spells trouble.

A written notice from the IRS does not mean you are being audited. It may not even mean that you've done something wrong. Read before screaming! Quite often, the letter will simply request some additional informaion or inform you about current status of your case. You should know that typically the matter is settled by letters, and you never have to talk to an IRS person, even if the notice says that you made a mistake. Go ahead, correct the mistake if it's yours or write back to them if it's theirs. Warning: under no circumstances should you ignore correspondence from the IRS - this will get you in trouble.

Myth: You can ignore correspondence from the IRS.

You can, at your own risk. Unlike other creditors, they are not going to "forget" about you if you ignore them. Because, unlike other creditors, they have tremendous power to collect money. They can seize your paychecks, your bank accounts and investments, even your car, safe deposit box, and house. They can ruin your career, your business, and your entire life - sometimes many years after the incident! They won't do any of that, though, if you respond to their letters and phone calls and work on a mutually acceptable solution. Cooperation is the key to solving any IRS problem.

Myth: The IRS does not make mistakes.

Even by their own admission (the official 1040 booklets), in 1996 they "achieved an accuracy rate of 93% in answering tax law and account questions." It means that 1 out of every 14 questions they answered wrong. Personally, I think the actual numbers are worse. Moral: double-check everything they say or write to you, especially when they claim that you owe them. If unsure, get professional help.