U.S. Taxation: An Overview
Tax Base and Tax Rates
The tax base is the amount to which the tax rate is applied. For example, for the Federal income tax, the tax base is taxable income. Tax rates are applied to the tax base to determine the tax liability. Tax rates may be proportional, progressive, or even regressive (e.g., social security taxes).
Tax Incidence
Tax incidence refers to the degree to which the tax burden is shared by taxpayers.
Major Types of Taxes
Major types of taxes in the U.S. include:
- Transaction taxes (e.g., excise, sales/use, transfer taxes)
- Employment taxes (e.g., FICA)
- Death and gift taxes
- Property taxes
- Income taxes
- Other taxes (e.g., customs duties, franchise taxes, occupational taxes, severance taxes)
Transaction Taxes
Excise Taxes
Excise taxes are imposed at the Federal, state, and local levels on very specific items such as gasoline, tobacco, liquor, hotel occupancy, and rental cars. These taxes are often levied on visitors who cannot vote and are used to fund special projects.
General Sales Taxes
General sales taxes are currently the jurisdiction of states and localities. States without sales or use taxes include Alaska, Delaware, Montana, New Hampshire, and Oregon.
Employment Taxes
Employment taxes, such as FICA taxes, are paid by both employees and employers. The Social Security rate is 6.2% (as of 2016) on a maximum of $118,500 of wages, while the Medicare rate is 1.45% on all wages. Self-employed individuals are subject to self-employment tax, which has rates twice that of the employee portion of FICA taxes.
Death Taxes
Federal Estate Tax
The Federal estate tax is a tax on the right to pass property to heirs. The tax is based on the value of the property included in the gross estate. Certain deductions and credits, such as the marital deduction and the unified transfer tax credit, are allowed in arriving at the taxable estate.
State Death Taxes
State death taxes may be estate taxes, inheritance taxes, or both. An inheritance tax is a tax on the right to receive property from a decedent, with the tax rate generally based on the relationship of the heir to the decedent.
Gift Tax
The Federal gift tax is a tax on the right to transfer assets during a person’s lifetime. The tax applies only to transfers that are not supported by full and adequate consideration. An annual exclusion of $14,000 per donee (as of 2016) is allowed, and the unified transfer tax credit is also available for gifts.
Property Taxes
Property taxes, also known as ad valorem taxes, are based on the value of the asset. They are essentially a tax on wealth or capital and are generally imposed on real estate or personal property. Property taxes are the exclusive jurisdiction of states and their local political subdivisions.
Other Taxes
Other taxes include Federal customs duties, franchise taxes, occupational taxes, and severance taxes.
Income Taxes
Income taxes are imposed at the Federal, most state, and some local levels of government. They are generally imposed on individuals, corporations, and certain fiduciaries (estates and trusts). The Federal income tax base is taxable income, which is income less allowable exclusions and deductions.
Income Tax Formula
The income tax formula involves several steps:
- Income – Exclusions = Gross Income
- Gross Income – Deductions for AGI = Adjusted Gross Income (AGI)
- AGI – (Itemized Deductions or Standard Deduction) – Personal and Dependency Exemptions = Taxable Income
- Federal Income Tax on Taxable Income – Tax Credits = Tax Owed (or Refund)
Individual Income Tax
For individuals, deductions are separated into two categories: deductions for AGI (generally related to business activities) and deductions from AGI (often personal in nature or related to investment activities). Individuals may choose to take a standard deduction or itemize their deductions.
Corporate Income Tax
Corporate taxable income is calculated as income minus deductions. Corporations do not have to compute AGI, nor do they have the option of taking a standard deduction or claiming personal and dependency exemptions. All allowable deductions for corporations are business expenses.
State Income Taxes
Most states impose an income tax on individuals, with the exceptions of Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Most states also impose either a corporate income tax or a franchise tax based in part on corporate income. State income taxes often have tie-ins to the Federal income tax system.
Business Entities
Various business forms exist, each with its own tax implications:
- Sole proprietorships are not separate taxable entities. The income and deductions of the proprietorship are reported on Schedule C of the owner’s Form 1040.
- C corporations are separate tax-paying entities. They report income and expenses on Form 1120. Income is taxed at the corporate level and again at the owner level when distributed as dividends.
- Partnerships are separate entities but do not pay tax. They file information returns (Form 1065) and allocate partnership income to partners, who report it on their personal tax returns.
- S corporations are like C corporations for nontax purposes but have tax treatment similar to partnerships. They are not subject to Federal income tax and file information returns (Form 1120S). Shareholders report their share of net income or loss on their own tax returns.
- Limited liability companies (LLCs) and limited liability partnerships (LLPs) exist under state laws and usually are treated as partnerships for tax purposes.
Dealings Between Individuals and Entities
Transactions between owners and their business entities have important tax ramifications. Tax planning is crucial to minimize tax liabilities and achieve desired outcomes.
Tax Planning
Tax planning strategies may include:
- Avoiding or postponing income recognition
- Maximizing deductible amounts
- Accelerating recognition of deductions
- Shifting net income from high to low-bracket years or taxpayers
- Shifting net income from high to low-tax jurisdictions
- Controlling the character of income and deductions
- Avoiding double taxation
- Maximizing tax credits
Effective tax planning requires careful consideration of the various tax laws and regulations and the specific circumstances of each taxpayer.