Rolling back misconceptions on income tax

The U.S. tax code is massive and complicated — the perfect fodder for mythmaking.

Perhaps the most well-worn fallacy — shot down by many courts despite the best efforts of tightfisted taxpayers — is that federal taxes are actually illegal.

It's an argument often used by people who have turned to Tax Masters, which helps filers in trouble with the Internal Revenue Service (IRS), says company president Patrick Cox. Some clients have claimed they don't owe U.S. taxes because they are "citizens of the world." If that were the case, maybe they should be paying taxes to the United Nations, Cox jokes.

Many myths involve audits. That's understandable, given that the IRS doesn't dish details on what triggers an audit, leaving us to speculate. Some tax legends maintain that the IRS will give your return an extra hard look if you call the agency to ask a question.

"Not true," says IRS spokesman Jim Dupree. "If someone asks a general tax question, we aren't going to ask who they are."

To help separate fact from fiction, here are some common myths:

• Income taxes are unconstitutional

Pick an amendment — from the right to free speech to protections against self-incrimination and involuntary servitude — and tax protesters have used it to justify not paying taxes. In particular, the 97-year-old 16th Amendment, which authorized Congress to enact our current tax system, has long been under attack.

"There are some people in jail who argued that the 16th Amendment was never ratified," says Eddy Quijano, an instructor at California Polytechnic State University and a former IRS lawyer.

Actor Wesley Snipes, who argued he wasn't legally required to pay taxes, may soon join other so-called tax deniers in jail. He was convicted in 2008 of failing to file tax returns but remains free while appealing his three-year prison sentence.

Similarly, some argue that because we have a "voluntary" system, taxes are optional. But voluntary only "means the government is trusting you to self-report how much tax you owe," instead of the government telling you what you owe, says George Willis, an associate clinical professor at Chapman University School of Law.

• Bartering is tax-free

Bartering has blossomed in the recession, particularly online. But while no money changes hands, the value of the swaps is taxable income for both sides, Quijano says.

• Internet revenue isn't taxable

Online entrepreneurs who believe this are in for a rude shock next year, says Barbara Weltman, author of "J.K. Lasser's 1001 Deductions & Tax Breaks." That's when credit-card companies and groups like PayPal must start reporting merchant sales to the IRS, she says.

• Ill-gotten gains aren't taxable

Even if your line of work is theft, embezzlement, prostitution, drug dealing or some other illegal enterprise, that income is still taxable.

Take bribing a senator. "The senator should report the bribe," Willis says. He quickly adds: "The bribe is not deductible to the payer."

• Cash isn't taxed

Tips, gambling winnings, extra bucks you earn under the table and money you find on the street must be reported to the IRS and is subject to tax.

"The law requires reporting all your income, even if it's not on a Form 1099 or W-2," says Zack Goff, a senior tax analyst with The Tax Institute at H&R Block.

The IRS has the tools to uncover unreported cash. "They can get access to bank-account information and other third-party sources to, in a roundabout way, verify income," Goff says.

• My dog is my dependent

"People think they can claim anyone living with them as dependents," Willis says. "The joke was, before the IRS required Social Security numbers (for dependents), people claimed their dogs and cats."

There are exceptions, but dependents usually are children or other relatives who get more than half their financial support from you and live with you for more than half the year.

• Home-office deduction triggers audit

This used to be true when anyone with a desk in a basement corner claimed it as a home office. Teachers were big offenders, saying they graded papers at home even though their principal place of business was the school, Weltman says. The rules were clarified in the 1990s, so people are less likely to mistakenly claim the deduction, and it's not the red flag to the IRS that it once was, she says.

Still, filers shy away from the deduction for fear of an audit, she says. "If you're entitled to take it, you should take it."

• Extensions lead to audits

Filers suspect that if they request more time to file a return, the IRS will get suspicious and might pull them in for an audit. But extensions are routine and don't raise an eyebrow.

What prompts an audit "is a guarded secret," says Dennis Raible, an accounting professor at Saint Joseph's University and a former IRS agent. However, flags are raised when income listed on a return doesn't match what the employer reported or your claims seem way out of line compared with others in your locale, he says.

• If you get a refund, you won't be audited

A refund doesn't mean you're in the clear, Quijano says. The IRS generally can audit returns filed within the past three years, but there's no limit to its reach if fraud is involved.

• Kids and retirees don't have to file returns

It's not your age that determines whether you have to file, but your income. For instance, singles under age 65 with $9,350 in gross income last year must file a return, as well as those 65 and older with income of $10,750 or more. The self-employed with income of $400 or more also must file.

• The rich don't pay taxes

"People don't understand how progressive the income tax is," says Len Burman, a public-policy professor at Syracuse University. "Middle-income people think they are paying more than they are."

Sure, the rich can afford to hire accountants and lawyers to help shelter income from taxes, he says. But figures from the Tax Policy Center show the top fifth of earners pay 67 percent of the federal income taxes. The bottom fifth of earners actually get more back from income taxes than they paid in because of refundable credits and other tax breaks.

• Most will pay the federal estate tax

This tax disappeared this year but will be back in 2011. Still, last year 99.8 percent of deaths didn't set off the estate tax, according to the Tax Policy Center.

Estate-tax opponents often don't realize the millions — $3.5 million per person last year — that can be sheltered from this tax, Burman says. Others are against the tax because they dream of being rich someday. "But you have to be really rich to be subject to the estate tax," he says.