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About 21,000 high earners paid no federal income tax

A new report from the IRS shows that nearly 21,000 American households with incomes of $200,000 and up didn't owe federal income taxes.

If you're like me, your first question is: How can that be?

Your possible next question: Can I get that kind of tax treatment?

Tax experts say it's not that difficult to avoid owing federal income taxes. And it doesn't require giving up U.S. citizenship, a step that Facebook's co-founder took last year, reportedly to lower his tax bill.

Most likely, no single tax move by these households — among the top 3 percent of U.S. earners — allowed them to sidestep taxes. Instead, tax experts say, these filers just had the right mix of deductions and credits.

"You can't blame the people," says Jill Senso, tax education coordinator with the Wisconsin-based National Association of Tax Professionals. "It's the way our tax system is set up that allows for it."

Well, maybe it's time to overhaul a system that now allows middle-income families with several children to owe a tax originally designed only for the rich and that permits billionaire investors to pay a lower tax rate than their secretaries.

According to the IRS, 3.9 million income tax returns in 2009 — the most recent year for which firm figures are available — reported adjusted gross income of $200,000 or more. Less than 1 percent of those — 20,752 — didn't owe any federal income tax.

It's an elite group, and one that the alternative minimum tax was created in the late 1960s to eliminate. Back then, a small number of rich folks avoided taxes through the heavy use of deductions. The AMT limits deductions, although it still allows filers to deduct charitable donations, medical expenses and losses from theft or property damage.

"We have heard this pretty much every year, that the AMT isn't doing its job," says Mark Luscombe, principal tax analyst with CCH, a provider of tax information. "It's designed to make people at least pay something. It seems like every year there are still people zeroing out their income."

The irony is that the AMT wasn't adjusted for inflation, and that over time the tax began hitting even middle-income households.

Senso says that when her friends and family — who are in the 28 percent tax bracket — hear about the rich not paying taxes, they ask how they can do the same. She tells them it takes money.

"You need income to spend it on stuff that's deductible," she says.

That's partly what presidential candidate Mitt Romney has done, says Senso, who reviewed the Republican's tax returns.

The Romneys paid an effective federal tax rate of 13.9 percent for 2010. That's typically what a couple making $86,700 would pay, Luscombe says. The Romneys' income was $21.7 million.

"He had a lot of deductions, but people with a lot of money do," Senso says.

Romney donated about $3 million to charity, Senso notes.

"He had a lot of his income from investments, so a lot of it is taxed at 15 percent," she adds

The top tax rate for regular income is 35 percent.

Still, the Romneys paid some taxes. More than 20,000 high earners managed not to pay federal taxes through a combination of credits and deductions, tax professionals say.

Deductions lower the amount of income subject to tax. Credits are more valuable because they cut your bottom-line tax bill. So if your tax bill will be $20,000, a $10,000 credit would cut that in half.

Here are some of the tax breaks mostly likely taken by the fortunate 21,000:

Interest deduction This was popular among tax avoiders, with the IRS reporting that nearly 60 percent of their returns had claimed it.

You can deduct the interest paid on mortgages of up to $1 million taken out to buy a primary residence.

Charitable donations Making a big donation can cut taxable income substantially — although deductions are limited. Cash donations to charities can't exceed 50 percent of your adjusted gross income. Give more than half your income, and you can deduct excess donations in future years.

Foreign tax credit Uncle Sam taxes us on our worldwide income, so even if you're working outside the country for a year or two you will have to file an income tax return in the U.S., says Bob Scharin, senior tax analyst with Thomson Reuters. But if you paid foreign taxes on the money you earned abroad, you can get a credit for that amount on your U.S. return.

And if the foreign country has higher taxes than the United States, the credit could wipe out your tax bill here.

More than half of the households in the IRS report did pay foreign taxes, Scharin says.

AMT credit Sometimes taxpayers end up owing the alternative minimum tax because of certain situations, such as having exercised incentive stock options from an employer, Scharin says. In these cases, filers get a credit for AMT taxes paid.

Alas, households thrown into the AMT year after year because of common deductions do not get a credit.

Going green Homeowners are eligible for a credit worth 30 percent of the cost of adding solar panels to their houses. This home improvement isn't cheap, although the price has come down and more filers claim the credit, says Thomas Corley, president of the accounting firm Cerefice & Co.

"Let's say you invested $200,000 in solar panels," he says. "You get a credit of $60,000. You could wipe out your income taxes."

Business losses Some of those who didn't owe taxes had a partnership or business formed as an S Corporation, in which they reported the income on an individual tax return, says William Freeland, a tax economist with the Washington-based Tax Foundation. This allowed them to deduct business losses on their return.

And in 2009, when the economy was even weaker than it is now, lots of businesses suffered losses, Freeland says.

Business losses are deducted before adjusted gross income is calculated — so that means these filers still had at least $200,000 in AGI, Freeland says. But the losses still kept income low enough that other deductions and credits eliminated any tax bill, he says.

Some tax experts I spoke with are concerned that the IRS report will cause critics to pick on the rich for not paying their fair share. And they note that plenty of low- to-moderate income folks don't pay taxes, either.

According to Freeland, couples with two kids and income of up to $51,000 don't pay income taxes because of the earned income tax credit and other tax breaks.

And Corley, whose firm caters to high net-worth clients, says his first instinct was to feel sorry for the well-off who didn't owe taxes. That usually means something bad has happened, he says.

For example, a client's house burned down and the underinsured homeowner had to pay $200,000 out of pocket. Losses from property damage are deductible, and this helped erase 90 percent of the client's tax liability, Corley says.

That is a tragedy, but I'm not ready yet to feel sorry for all high earners who don't owe taxes.

eileen.ambrose@baltsun.com

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