Could you incorporate a town in such a way as to reduce income taxes?

Factual Questions
1

After reading this threadon bartering and taxation, I had an out-there idea on how people might reduce their income taxes.

In practice this will never work due to logistics, but, still, hypothetically, if one were to go ahead with this, what would be the tax implications and the IRS’ position?

First, some facts about taxation, as I understand it
[ul]
[li]The IRS taxes income, in whatever form, so even if it is from bartering, they can tax it[/li][li]Even if someone gives you a gift, that would be taxed as income[/li][li]If a place of business gave you an item or provided a service for no charge, that would be taxed as income. [/li][li]In all the above cases, I assume the “regular” price of the item would be used to assess its value and therefore your income and the resulting tax[/li][li]However, if a place of business gave you an item or provided a service for lower than its regular value, I assume that the IRS will not regard the difference as income and tax you on it. (Otherwise, how would sales work? People who buy something at 30% sale, don’t pay income tax on that 30%)[/li][li]Similarly, if a town has a cost of living that is below the national average (e.g. a massage costs 30% less than the national average, and a plumber’s services cost 25% less than the national average), then the IRS doesn’t regard that reduction in price compared to the national average as income and so it is not taxed.[/li][/ul]

Given the above, here is my main question
Can you incorporate a town where the cost of goods and services is mandated to be 50% of the national average? If you can, will the IRS tax the 50% reduction in prices as income?

[ul]
[li]I assume not[/li][li]If this is correct, then everyone in that town will be paying far fewer taxes to the IRS. Of course, they would be making much less money, but their money can buy more stuff in that town, and their taxes will be a lower percentage of their income, since they will be in a lower IRS tax bracket[/li][li]If the above is correct, how low could your town go in terms of cost of living before the IRS steps in and tries to stop you? Can the cost of living go down to 10% of the national average? 1%? If you go down to 0%, you will be engaging in bartering, and it’s not clear how the IRS would tax things, but as long as it’s not zero, who are they to say what the cost of living of any town should be?[/li][li]If a town is allowed to have a lower cost of living, what is the smallest number of people that can form a “town”? That is, can you and your two buddies form a “town” where you pay each other a very low amount of money for goods and services (essentially, you agree with your friends to barter with each other) but you interact with everyone outside your “town” as you currently do? [/li][/ul]

BTW, I understand that there are huge logistical issues (getting a large number of people to agree to any such scheme, buying goods from outside the city [which will be at full price], etc) and this will never come to be.

Hypothetically though, if enough people did agree to live in a town with such rules, and they were quite self-sufficient and not as dependent on external goods, what would be the legal position of such a town, and what would be the IRS’ position on how to tax their tiny income?

2

What you are effectively suggesting is that people should reduce their taxes by earning less.

This is perfectly legal, and perfectly effective, but the disadvantage is pretty obvious.

You’re going a bit further and trying to offset the disadvantage. OK, I will earn less by selling my work-produce for 50% less than it would fetch in the open market, but I will try to deal exclusively with like-minded others, so that I can also buy other people’s work-produce cheaply.

As you point out, the idea is impractical. There aren’t any towns anywhere in the developed world that are anything like self-sufficient, consuming only what they produce. Remember, only a tiny fraction of your income is spent on meat, vegetables, haircuts, getting your lawn mowed and other goods and services that are or can be locally produced. Think of the cars, the televisions, the power, the gas, the fuel, the pharmaceuticals, the clothing, and all the other things that are either high-value or large-cost purchases that are not locally produced. Think of books, DVDs, music and movies. Think of vacations out of town. And, even where things are locally produced, they are likely to be produced using non-local materials. How much of the bricks, mortar, timer and slate in your house were produced in your town? The beer may be brewed locally, but where to the hops, barley and malt come from?

To the extent that value is added in your town to the goods and services produced in your town then, yes, this scheme would lower prices. But my guess is that that is a pretty small extent.

The people who would do worst under this scheme are those who live by selling their labour to local consumers. They would get only 50% of the usual wage, but they would pay pretty close to 100% of the usual price for most of the things they commonly consume – not a good deal. If they’re willing to accept that deal, they would do better to go to another town, where they could get the same outcome by working only half the week, and thereby have more leisure time.

Apart from that, is there a technical problem? There may be, depending on where you establish your town. Many countries tax codes have “transfer pricing” provisions, designed to attack transactions which take place at less (or more) than market value in an attempt to locate profit where it can’t or won’t be taxed. Those provisions usually work by “interposing market value”; they tax the taxpayer on the income he would have earned in the transaction, had it taken place at market value.

Now, they’re not aimed at schemes like this; they are mainly intended to prevent multinational corporations dealing with their own foreign subsidiaries or parents. But what they do is not a thousand miles from what you suggest here, and you would want to look carefully at how transfer pricing rules would impact on a deal of the kind you are proposing.

3

I generally agree with UDS. A further impracticality is that the town would not be able to seal itself off from outsiders, and once word got out that the town’s stores sold goods at half-price, people would flock there from miles around.
A few nitpicks:

Gifts are non-taxable if they are truly gifts. If a “gift” is given by someone in exchange for some services, then it looks like income and would potentially be taxed as such.

You’re confusing income and sales taxes to some extent. Remember that when I buy something, I may pay sales tax on that purchase, but I do not pay income tax on it.

4

A couple of points:

  • Cheap cities in the US don’t seem to have a problem with outsiders coming in and buying stuff that’s more expensive back home
  • Also, on an international level, countries where stuff is cheap (like Singapore) don’t have a problem with the hoards of tourists coming in an buying stuff
  • Admittedly, these places aren’t “half-price” as our potential town would be, but I think the principle should still hold
  • Also, if there are indeed issues with this, could the stores only sell stuff to people who belong to a particular club, and membership of that club is restricted to people within a certain ZIP code?

Are you sure about this? If a father gives a $100,000 gift to his son, won’t that be taxed?

I agree, but if the store gives the item to you for free, then isn’t it like you are receiving some income, and therefore it will be taxed as income for you?
(Didn’t Tom Daschle have to pay taxes on some limo service he got for free?)

5

On the original question: some of what you suggest is a possibility. However, it could still be challenged in court under the argument that form of these transactions is artificial and not representative of the substance of those transactions. I wouldn’t try it.

To clarify for both of you: gifts are never taxable to the recipient. They may be taxable to the giver.

You are permitted up to $12,000 (currently; this is adjusted frequently) per person per year as a gift without any reporting requirements. Above $12,000 in a year, you must file a gift tax return on form 706. However, you are allowed up to $1 million per lifetime in tax-free gifts (technically, a credit of about $340,000 against gift tax). That is a unified credit that may affect your estate tax when you die. Anything above the $12,000 per year, $1 million per lifetime limit, you must pay gift tax on.