There has been a lot of hoopla since presumptive GOP presidential candidate Mitt Romney divulged his tax rate is 13.9%. Factions have lined up on both sides: some support tax breaks for the wealthy with an eye to encouraging investment while others decry the unfairness of the code that allows the ultra-rich to pay a smaller percentage of their earnings to Uncle Sam.

A recent New York Times article caught my eye when it cited data from the IRS of the highest adjusted gross income (AGI) from the top 400 individual income tax returns. The released data showed the average AGI of the 400 returns was $202 million in 2009. Many of these taxpayers paid less in taxes than Romney—in fact, six paid a rate of zero. 

Zero? No tax at all? I was shocked. How can that be? Even if these ultra-rich taxpayers suffered losses, certainly the alternative minimum tax would kick in, right?  Then I concluded that maybe total income rather than taxable income is indicated when defining $202 million. Perhaps the taxpayer sold off securities for $202 million that was purchased in an earlier year. They money is in pocket, but there is no tax liability because one is entitled to subtract basis from proceeds in order to determine taxable income. But no, the stats read that $202 million is referencing the taxpayer’s AGI--that’s the number that shows up at the bottom of page one on the tax return, line 37.

There is generally a lot of strategizing involved to reduce a taxpayer’s adjusted gross income, and the $202 million number is probably a result of thorough planning sessions. More than likely the income was closer to $400 million but by use of various entities, income splitting and other sophisticated tactics, adjusted gross income was reduced to a more manageable figure.

So in the instance of the six who paid zero in taxes, and even to the ones who paid up to 15%, the reductions to the tax liability occur on page two of the Form 1040. This involves Schedule A itemized deductions and tax credits. That’s all that’s left to play with.

Okay, so you pull down a cool $202 million and you pay nothing in taxes and it’s all 100% legitimate. I figured I should run the numbers just to see how this can be accomplished. So I fired up my tax software, and here’s what I learned:

Realizing that the lowest tax rates are applied to dividends and capital gains (15%), I allocated $202 million to dividend income to arrive at an adjusted gross income of $202 million. Once you have your AGI, you either take itemized deductions or the standard deduction. The standard deduction is obviously not going to reduce one’s liability to zero. So I went to Schedule A, Itemized Deductions-- this is the last chance for reducing income. All the other bells and whistles like capital loss carry forward and passive loss carry forward and other smoke and mirror applications are above the line and part of that tax planning strategy session to reduce AGI.

On Schedule A I donated half of my earnings - $101 million (maximum allowable) - to charitable organizations. I also deducted $12 million in state income taxes. But this did not reduce my taxable income to zero. In fact, I needed another $89 million in Schedule A deductions to accomplish this. I don’t think DMV fees and tax preparation fees would total that much. And there wasn’t much left to deduct. Just for fun I pretended that I spent the equivalent in attorney fees to protect my investments, which resulted in zero taxable income (and an extremely happy attorney). But the Alternative Minimum Tax (AMT) kicked in and I ended up owing $28,276,500. Not zero, but hey, now we know one route to the 13.9% tax rate.

The section of the tax return after itemized deductions is tax credits. This is how you get your income tax down to zero. Education credits and the retirement savings contribution credits among others are not allowed to anyone making as much money as shown on this tax return. The child and dependent care credit also won’t work because there is no earned income.

That leaves the foreign tax credit. This is a dollar-for-dollar reduction of any taxes paid during the year to another country. I often see foreign taxes paid reported on Form 1099-DIV when clients maintain foreign investments on which they pay income tax to another country.

I completed Form 1116 Foreign Tax Credit to show a foreign tax paid in the amount of the computed Alternative Minimum Tax of $28,276,500 but the tax liability didn’t change. I still owed the AMT amount. In fact the foreign tax credit disappeared, to be carried forward to future years. I didn’t lose the credit completely.

So I went back to Schedule A and removed the deduction for the legal fees I had paid to protect my investments. After all, this is one of those “preference” items that will kick in the AMT. The result was a tax liability of $31,117,282, not that much higher really than the AMT. But at least I didn’t have AMT to worry about. And a tax rate of 15.4%. By adjusting the foreign tax credit to reflect that amount, I ended up with a tax liability of zero.  

There are other roads to a zero balance owing on such a high liability. For example, interest income can be offset by interest expense without kicking in AMT.

So that’s how you do it.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook

Bonnie Lee is an enrolled agent admitted to practice and representing taxpayers in all 50 states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, Calif., and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Her new e-book Taxpertise for the Creative Mind Murder, Mayem, Romance, Comedy and Tax Tips for Artists of all Kinds is available at all major booksellers. Follow Bonnie Lee on Twitter and on Facebook.