Income tax in the United States
Encyclopedia
In the United States
, a tax is imposed on income by the Federal, most states, and many local governments. The income tax
is determined by applying a tax rate, which may increase as income increases
, to taxable income
as defined. Individuals and corporations are directly taxable, and estates and trusts may be taxable on undistributed income. Partnerships are not taxed, but their partners are taxed on their shares of partnership income. Residents and citizens are taxed on worldwide income, while nonresidents are taxed only on income within the jurisdiction. Several types of credits reduce tax, and some types of credits may exceed tax before credits. An alternative tax applies at the Federal and some state levels.
Taxable income is total income less allowable deductions
. Income is broadly defined. Most business expenses are deductible. Individuals may also deduct a personal allowance (exemption) and certain personal expenses, including home mortgage interest, state taxes, contributions to charity, and some other items. Some deductions are subject to limits.
Capital gains
are fully taxable, and capital losses reduce taxable income only to the extent of gains. Individuals currently pay a lower rate of tax on capital gains and certain corporate dividends.
Taxpayers generally must self assess income tax by filing tax returns. Advance payments of tax are required in the form of withholding tax or estimated tax payments. Taxes are determined separately by each jurisdiction imposing tax. Due dates and other administrative procedures vary by jurisdiction. April 15 following the tax year is the due date for individual returns for Federal and many state and local returns. Tax as determined by the taxpayer may be adjusted by the taxing jurisdiction.
in the United States by the Federal, most state, and some local governments. Income tax is imposed on individuals, corporations, estates, and trusts. The definition of net taxable income for most sub-federal jurisdictions mostly follows the Federal definition.
The rate of tax at the federal level is graduated; that is, the tax rates of higher amounts of income are higher than on lower amounts. The lower rate on lower income was phased out at higher incomes prior to 2010. Some states and localities impose an income tax at a graduated rate, and some at a flat rate on all taxable income. Federal tax rates in 2009 varied from 10% to 35%. From 2003 through 2010, individuals were eligible for a reduced rate of Federal income tax on capital gains and qualifying dividends. The tax rate and some deductions are different for individuals depending on filing status. Married individuals may compute tax as a couple or separately. Single individuals may be eligible for reduced tax rates if they are head of a household in which they live with a dependent.
Federal taxable income is defined in a comprehensive manner in the Internal Revenue Code
and regulations issued by the Department of Treasury and the Internal Revenue Service. Taxable income is gross income
as adjusted less tax deduction
s. Most states and localities follow this definition at least in part, though some make adjustments to determine income taxed in that jurisdiction. Taxable income for a company or business may not be the same as its book income.
Gross income includes all income earned or received from whatever source. This includes salaries and wages, tips, pensions, fees earned for services, price of goods sold, other business income, gains on sale of other property, rents received, interest and dividend
s received, alimony received, proceeds from selling crops, and many other types of income. Some income, however, is exempt from income tax. This includes interest on municipal bonds.
Adjustments (usually reductions) to gross income of individuals are made for alimony paid, contributions to many types of retirement or health savings plans, certain student loan interest, half of self employment tax, and a few other items. The cost of goods sold
in a business is a direct reduction of gross income.
Taxable income of all taxpayers is reduced by tax deductions for expenses related to their business. These include salaries, rent, and other business expenses paid or accrued, as well as allowances for depreciation
. The deduction of expenses may result in a loss. Generally, such loss can reduce other taxable income, subject to some limits.
Individuals are allowed several nonbusiness deductions. A flat amount per person is allowed as a deduction for personal exemptions. For 2009 this amount was $3,650. Each taxpayer is allowed one such deduction for themselves and one for each person they support.
In addition, individuals get a deduction from taxable income for certain personal expenses. Alternatively, the individual may claim a standard deduction
. For 2011, the standard deduction is $5,800 for single individuals, $11,600 for a married couple, and $8,500 for a head of household. Those who choose to claim actual itemized deductions may deduct the following, subject to many conditions and limitations:
Capital gains
and qualified dividend
s may be taxed as part of taxable income. However, the tax is limited to a lower tax rate. Capital gains include gains on selling stocks and bonds, real estate, and other capital assets. The gain is the excess of the proceeds over the adjusted basis (cost less depreciation deductions allowed) of the property. This limit on tax also applies to dividends from U.S. corporations and many foreign corporations. There are limits on how much net capital loss may reduce other taxable income.
All taxpayers are allowed a tax credit
for foreign taxes and for a percentage of certain types of business expenses. Individuals are also allowed credits related to education expenses, retirement savings, child care expenses, and a credit for each child. Each of the credits is subject to specific rules and limitations. Some credits are treated as refundable payments.
All taxpayers are also subject to the Alternative Minimum Tax
if their income exceeds certain exclusion amounts. This tax applies only if it exceeds regular income tax, and is reduced by some credits.
Individuals must file income tax returns in each year their income exceeds the standard deduction plus one personal exemption, or if any tax is due. Other taxpayers must file income tax returns each year. These returns may be filed electronically. Generally, an individual's tax return covers the calendar year. Corporations may elect a different tax year. Most states and localities follow the Federal tax year, and require separate returns.
Taxpayers must pay income tax due without waiting for an assessment. Many taxpayers are subject to withholding tax
es when they receive income. To the extent withholding taxes do not cover all taxes due, all taxpayers must make estimated tax payments.
Failing to make payments on time, or failing to file returns, can result in substantial penalties
. Certain intentional failures may result in jail time.
Tax returns may be examined and adjusted by tax authorities. Taxpayers have rights to appeal any change to tax, and these rights vary by jurisdiction. Taxpayers may also go to court to contest tax changes. Tax authorities may not make changes after a certain period of time (generally 3 years).
".
An individual's marginal income tax bracket
depends upon his or her income and tax-filing classification. As of 2008, there are six tax brackets for ordinary income (ranging from 10% to 35%) and four classifications: single, married filing jointly (or qualified widow or widower), married filing separately, and head of household.
An individual pays tax at a given bracket only for each dollar within that bracket's range. For example, a single taxpayer who earned $10,000 in 2009 would be taxed 10% of each dollar earned from the 1st dollar to the 8,350th dollar (10% × $8,350 = $835.00), then 15% of each dollar earned from the 8,351st dollar to the 10,000th dollar (15% × $1,650 = $247.50), for a total of $1,082.50. Notice this amount ($1,082.50) is lower than if the individual had been taxed at 15% on the full $10,000 (for a tax of $1,500). This is because the individual's marginal rate (the percentage tax on the last dollar earned, here 15%) has no effect on the income taxed at a lower bracket (here the first $8,350 of income taxed at 10%). This ensures that every rise in a person's pre-tax salary results in an increase of their after-tax salary.
Single taxpayer, no children, under 65 and not blind, taking standard deduction;
Note that in addition to income tax, a wage earner would also have to pay Federal Insurance Contributions Act tax
(FICA) (and an equal amount of FICA tax must be paid by the employer):
less allowable tax deductions. Taxable income as determined for Federal tax purposes may be modified for state tax purposes.
states that "gross income means all income from whatever source derived," and gives specific examples. Gross income is not limited to cash received. "It includes income realized in any form, whether money, property, or services." Gross income includes wages and tips, fees for performing services, gain from sale of inventory or other property, interest, dividends, rents, royalties, pensions, alimony, and many other types of income. Items must be included in income when received or accrued. The amount included is the amount the taxpayer is entitled to receive. Gains on property are the gross proceeds less amounts returned, cost of goods sold
, or tax basis
of property sold.
Certain types of income are subject to tax exemption
. Among the more common types of exempt income are interest on municipal bonds, a portion of Social Security benefits, life insurance proceeds, gifts or inheritances, and the value of many employee benefits.
Gross income is reduced by adjustments and tax deductions. Among the more common adjustments are reductions for alimony paid and IRA
and certain other retirement plan contributions. Adjusted gross income is used in calculations relating to various deductions, credits, phase outs, and penalties.
rules. Deductions for meals and entertainment are limited to 50% of the amount incurred.
Certain deductions must be capitalized or deferred. These include:
Business losses may reduce nonbusiness income for individuals and corporations. However, losses from passive activities may reduce only income from other passive activities. Passive activities include most rental activities (except for real estate professionals) and business activities in which the taxpayer does not materially participate. In addition, losses may not, in most cases, be deducted in excess of the taxpayer's amount at risk (generally tax basis in the entity plus share of debt).
Overall net operating loss
es (business deductions in excess of gross income) may be deducted in other years by carryover or carryback of the loss.
Citizens and individuals who have U.S. tax residence
may deduct a flat amount as a standard deduction
. Alternatively, they may claim an itemized deduction
for actual amounts incurred for specific categories of nonbusiness expenses. Home owners may deduct the amount of interest and property taxes paid on their principal and second homes. Local and state income taxes are deductible, or the individual may elect to deduct state and local sales tax
. Contributions to charitable organizations are deductible by individuals and corporations, but the deduction is limited to 50% and 10% of gross income respectively. Medical expenses in excess of 7.5% of adjusted gross income
are deductible, as are uninsured casualty losses. Other income producing expenses in excess of 2% of adjusted gross income are also deductible. For years before 2010, the allowance of itemized deductions was phased out at higher incomes. The phase out expired for 2010.
(cost) of capital assets, such as corporate stock, land, buildings, etc. Capital losses (where basis is more than sales price) are deductible, but deduction for long term capital losses is limited to capital gains. An individual may exclude $250,000 ($500,000 for a married couple filing jointly) of capital gains on the sale of the individual's primary residence, subject to certain conditions and limitations.
In determining gain, it is necessary to determine which property is sold and the basis of that property. This may require identification conventions, such as first-in-first-out, for identical properties like shares of stock. Further, tax basis must be allocated among properties purchased together unless they are sold together. Original basis, usually cost paid for the asset, is reduced by deductions for depreciation
or loss.
Certain capital gains are deferred, that is, taxed at a time later than disposition. Gains on property sold for installment payments may be recognized as those payments are received. Gains on property exchanged for like kind property are not recognized, and the tax basis of the new property is based on the tax basis of the old property.
Before 1986 and from 2004 onward, individuals have been subject to a reduced rate of Federal tax on long term capital gains. This reduced rate (limited to 15%) applies for regular tax and the Alternative Minimum Tax.
). Corporate income tax is based on taxable income
, which is defined similarly to individual taxable income.
Shareholders (including other corporations) of corporations (other than S Corporations) are taxed on dividend
distributions from the corporation. They are also subject to tax on capital gains upon sale or exchange of their shares for money or property. However, certain exchanges, such as in reorganizations, are not taxable.
Multiple corporations may file a consolidated return
at the Federal and some state levels with their common parent.
Some deductions of corporations are limited at Federal or state levels. Limitations apply to items due to related parties, including interest and royalty expenses.
, and for the employer to get a deduction, the plan must meet minimum participation, vesting, funding, and operational standards.
Examples of qualified plans include:
Employees or former employees are generally taxed on distributions from retirement or stock plans. Employees are not taxed on distributions from health insurance plans to pay for medical expenses. Cafeteria plans allow employees to choose among benefits (like choosing food in a cafeteria), and distributions to pay those expenses are not taxable.
In addition, individuals may make contributions to Individual Retirement Account
s (IRAs). Those not currently covered by other retirement plans may claim a deduction for contributions to certain types of IRAs. Income earned within an IRA is not taxed until the individual withdraws it.
Businesses are also eligible for several credits. These credits are available to individuals and corporations, and can be taken by partners in business partnerships. Among the Federal credits included in a "general business credit" are:
In addition, a Federal foreign tax credit
is allowed for foreign income taxes paid. This credit is limited to the portion of Federal income tax arising due to foreign source income. The credit is available to all taxpayers.
Business credits and the foreign tax credit may be offset taxes in other years.
States and some localities offer a variety of credits that vary by jurisdiction. States typically grant a credit to resident individuals for income taxes paid to other states, generally limited in proportion to income taxed in the other state(s).
(AMT). Taxpayers who have paid AMT in prior years may claim a credit against regular tax for the prior AMT. The credit is limited so that regular tax is not reduced below current year AMT.
AMT is imposed at a nearly flat rate (20% for corporations, 26% or 28% for individuals, estates, and trusts) on taxable income as modified for AMT. Key differences between regular taxable income and AMT taxable income include:
Taxpayers must determine their taxable income based on their method of accounting
for the particular activity. Most individuals use the cash method for all activities. Under this method, income is recognized when received and deductions taken when paid. Taxpayers may choose or be required to use the accrual method for some activities. Under this method, income is recognized when the right to receive it arises, and deductions are taken when the liability to pay arises and the amount can be reasonably determined. Taxpayers recognizing cost of goods sold
on inventory must use the accrual method with respect to sales and costs of the inventory.
Methods of accounting may differ for financial reporting and tax purposes. Specific methods are specified for certain types of income or expenses. Gain on sale of property other than inventory may be recognized at the time of sale or over the period in which installment sale
payments are received. Income from long term contracts must be recognized ratably over the term of the contract, not just at completion. Other special rules also apply.
. Exempt organizations are still taxed on any business income. An organization which participates in lobbying, political campaigning, or certain other activities may lose its exempt status. Special taxes apply to prohibited transactions and activities of tax exempt entities.
Special rules apply to some or all items in the following industries:
In addition, mutual funds (regulated investment companies) are subject to special rules allowing them to be taxed only at the owner level. The company must report to each owner his/her share of ordinary income, capital gains, and creditable foreign taxes. The owners then include these items in their own tax calculation. The fund itself is not taxed, and distributions are treated as a return of capital
to the owners. Similar rules apply to real estate investment trusts and real estate mortgage investment conduits.
is limited to that part of current year tax caused by foreign source income. Determining such part involves determining the source of income and allocating and apportioning deductions to that income. States tax resident individuals and corporations on their worldwide income, but few allow a credit for foreign taxes.
Federal and state income taxes are imposed on foreign persons on their income within the jurisdiction. Federal rules tax interest, dividends, royalties, and certain other income of foreign persons at a flat rate of 30%. This rate is often reduced under tax treaties. Foreign persons are taxed on income from a U.S. business similarly to U.S. persons. Foreign persons are not subject to U.S. tax on capital gains and certain other income. The states tax non-resident individuals only on income earned within the state (wages, etc.) and tax individuals and corporations on business income apportioned to the state. Most of the states otherwise do not impose income tax on persons not resident in the state.
The United States has income tax treaties with over 65 countries. These treaties reduce the chance of double taxation by allowing each country to fully tax its citizens and residents and reducing the amount the other country can tax them. Generally the treaties provide for reduced rates of tax on investment income and limits as to which business income can be taxed. The treaties each define which taxpayers can benefit from the treaty.
. Additional backup withholding provisions apply to some payments of interest or dividends to U.S. persons. The amount of income tax withheld is treated as a payment of tax by the person receiving the payment on which tax was withheld.
, with Federal and appropriate state tax authorities. These returns vary greatly in complexity level depending on the type of filer and complexity of their affairs. On the return, the taxpayer reports income and deductions, calculates the amount of tax owed, reports payments and credits, and calculates the balance due.
Federal individual, estate, and trust income tax returns are due by April 15 for most taxpayers. Corporate returns are due two and one half months following the corporation's year end. Partnership returns are due three and one half months following the partnership's year end. Tax exempt entity returns are due four and one half months following the entity's year end. All Federal returns may be extended, with most extensions available upon merely filing a single page form. Due dates and extension provisions for state and local income tax returns vary.
Income tax returns generally consist of the basic form with attached forms and schedules. Several forms are available for individuals and corporations, depending on complexity and nature of the taxpayer's affairs. Many individuals are able to use the one page Form 1040-EZ, which requires no attachments except wage statements from employers (Forms W-2). Individuals claiming itemized deductions must complete Schedule A. Similar schedules apply for interest (B), dividends (B), business income (C), capital gains (D), farm income (F), and self employment tax (SE). All taxpayers must file those forms for credits, depreciation, AMT, and other items that apply to them.
Electronic filing of tax returns may be done for taxpayers by registered tax preparers.
If a taxpayer discovers an error on a return, or determines that tax for a year should be different, the taxpayer should file an amended return. These returns constitute claims for refund if taxes are determined to have been overpaid.
Changes to returns are subject to appeal by the taxpayer, including going to court. IRS changes are often first issued as proposed adjustments. The taxpayer may agree to the proposal, or may advise the IRS why it disagrees. Proposed adjustments are often resolved by the IRS and taxpayer agreeing to what the adjustment should be. For those adjustments to which agreement is not reached, the IRS issues a 30-day letter advising of the adjustment. The taxpayer may appeal this preliminary assessment within 30 days within the IRS. The Appeals Division reviews the IRS field team determination and taxpayer arguments, and often proposes a solution that the IRS team and the taxpayer find acceptable. Where agreement is still not reached, the IRS issues an assessment as a notice of deficiency or 90-day letter. The taxpayer then has three choices: file suit in United States Tax Court
without paying the tax, pay the tax and sue for refund in regular court, or pay the tax and be done. Recourse to court can be costly and time consuming, but is often successful.
IRS computers routinely make adjustments to correct mechanical errors in returns. In addition, the IRS conducts an extensive document matching computer program that compares taxpayer amounts of wages, interest, dividends, and other items to amounts reported by taxpayers. These programs automatically issue 30-day letters advising of proposed changes. Only a very small percentage of tax returns are actually examined. These are selected by a combination of computer analysis of return information and random sampling. The IRS has long maintained a program to identify patterns on returns most likely to require adjustment.
Procedures for examination by state and local authorities vary by jurisdiction.
Intentional failures, including tax fraud, may result in criminal penalties. These penalties may include jail time or forfeiture of property. Criminal penalties are assessed in coordination with the United States Department of Justice
.
"), specifies Congress
's power to impose "Taxes, Duties, Imposts and Excises," but Article I, Section 8 requires that, "Duties, Imposts and Excises shall be uniform throughout the United States."
The Constitution specifically limited Congress' ability to impose direct taxes, by requiring Congress to distribute direct taxes in proportion to each state's census population. It was thought that head taxes and property tax
es (slaves could be taxed as either or both) were likely to be abused, and that they bore no relation to the activities in which the Federal government had a legitimate interest. The fourth clause of section 9 therefore specifies that, "No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or enumeration herein before directed to be taken."
Taxation was also the subject of Federalist No. 33
penned secretly by the Federalist Alexander Hamilton
under the pseudonym
Publius. In it, he explains that the wording of the "Necessary and Proper" clause should serve as guidelines for the legislation of laws regarding taxation. The legislative branch is to be the judge, but any abuse of those powers of judging can be overturned by the people, whether as states or as a larger group.
The courts have generally held that direct taxes are limited to taxes on people (variously called "capitation", "poll tax" or "head tax") and property. All other taxes are commonly referred to as "indirect taxes," because they tax an event, rather than a person or property per se. What seemed to be a straightforward limitation on the power of the legislature based on the subject of the tax proved inexact and unclear when applied to an income tax, which can be arguably viewed either as a direct or an indirect tax.
In order to help pay for its war effort in the American Civil War
, Congress imposed its first personal income tax in 1861. It was part of the Revenue Act of 1861
(3% of all incomes over US $800). This tax was repealed and replaced by another income tax in 1862.
In 1894, Democrat
s in Congress passed the Wilson-Gorman tariff, which imposed the first peacetime income tax. The rate was 2% on income over $4000, which meant fewer than 10% of households would pay any. The purpose of the income tax was to make up for revenue that would be lost by tariff reductions. Also, the Panic of 1893
is said to have something to do with the passage of Wilson-Gorman.
In 1895 the United States Supreme Court, in its ruling in Pollock v. Farmers' Loan & Trust Co.
, held a tax based on receipts from the use of property to be unconstitutional. The Court held that taxes on rent
s from real estate, on interest
income from personal property and other income from personal property (which includes dividend
income) were treated as direct taxes on property, and therefore had to be apportioned. Since apportionment of income taxes is impractical, this had the effect of prohibiting a federal tax on income from property. However, the Court affirmed that the Constitution did not deny Congress the power to impose a tax on real and personal property, and it affirmed that such would be a direct tax. Due to the political difficulties of taxing individual wages without taxing income from property, a federal income tax was impractical from the time of the Pollock decision until the time of ratification of the Sixteenth Amendment (below).
(ratified by the requisite number of states in 1913), which states:
The Supreme Court
in Brushaber v. Union Pacific Railroad
, , indicated that the amendment did not expand the Federal government's existing power to tax income (meaning profit or gain from any source) but rather removed the possibility of classifying an income tax as a direct tax on the basis of the source of the income. The Amendment removed the need for the income tax to be apportioned among the states on the basis of population. Income taxes are required, however, to abide by the law of geographical uniformity.
Some tax protester
s and others opposed to income taxes cite what they contend is evidence that the Sixteenth Amendment was never properly ratified
, based in large part on materials sold by William J. Benson. In December 2007, Benson's "Defense Reliance Package
" containing his non-ratification argument which he offered for sale on the Internet, was ruled by a Federal court to be a "fraud perpetrated by Benson" that had "caused needless confusion and a waste of the customers' and the IRS' time and resources." The court stated: "Benson has failed to point to evidence that would create a genuinely disputed fact regarding whether the Sixteenth Amendment was properly ratified or whether United States Citizens are legally obligated to pay Federal taxes." See also Tax protester Sixteenth Amendment arguments
.
. In that case, a taxpayer had received an award of punitive damages from a competitor for antitrust violations and sought to avoid paying taxes on that award. The Court observed that Congress, in imposing the income tax, had defined gross income
, under the Internal Revenue Code of 1939
, to include:
(Note: The Glenshaw Glass case was an interpretation of the definition of "gross income" in section 22 of the Internal Revenue Code of 1939. The successor to section 22 of the 1939 Code is section 61 of the current Internal Revenue Code of 1986, as amended.)
The Court held that "this language was used by Congress to exert in this field the full measure of its taxing power", id., and that "the Court has given a liberal construction to this broad phraseology in recognition of the intention of Congress to tax all gains except those specifically exempted."
The Court then enunciated what is now understood by Congress and the Courts to be the definition of taxable income, "instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." Id. at 431. The defendant in that case suggested that a 1954 rewording of the tax code had limited the income that could be taxed, a position which the Court rejected, stating:
Tax statutes passed after the ratification of the Sixteenth Amendment in 1913 are sometimes referred to as the "modern" tax statutes. Hundreds of Congressional acts have been passed since 1913, as well as several codifications (i.e., topical reorganizations) of the statutes (see Codification).
In Central Illinois Public Service Co. v. United States, , the U.S. Supreme Court confirmed that wages and income are not identical as far as taxes on income are concerned, because income not only includes wages, but any other gains as well. The Court in that case noted that in enacting taxation legislation, Congress "chose not to return to the inclusive language of the Tariff Act of 1913, but, specifically, 'in the interest of simplicity and ease of administration,' confined the obligation to withhold [income taxes] to 'salaries, wages, and other forms of compensation for personal services'" and that "committee reports ... stated consistently that 'wages' meant remuneration 'if paid for services performed by an employee for his employer'".
Other courts have noted this distinction in upholding the taxation not only of wages, but also of personal gain derived from other sources, recognizing some limitation to the reach of income taxation. For example, in Conner v. United States, 303 F. Supp. 1187 (S.D. Tex. 1969), aff’d in part and rev’d in part, 439 F.2d 974 (5th Cir. 1971), a couple had lost their home to a fire, and had received compensation for their loss from the insurance company, partly in the form of hotel costs reimbursed. The court acknowledged the authority of the IRS to assess taxes on all forms of payment, but did not permit taxation on the compensation provided by the insurance company, because unlike a wage or a sale of goods at a profit, this was not a gain. As the Court noted, "Congress has taxed income, not compensation".
By contrast, other courts have interpreted the Constitution as providing even broader taxation powers for Congress. In Murphy v. IRS
, the United States Court of Appeals for the District of Columbia Circuit upheld the Federal income tax imposed on a monetary settlement recovery that the same court had previously indicated was not income, stating: "[a]lthough the 'Congress cannot make a thing income which is not so in fact,' [ . . . ] it can label a thing income and tax it, so long as it acts within its constitutional authority, which includes not only the Sixteenth Amendment but also Article I, Sections 8 and 9."
Similarly, in Penn Mutual Indemnity Co. v. Commissioner, the United States Court of Appeals for the Third Circuit indicated that Congress could properly impose the Federal income tax on a receipt of money, regardless of what that receipt of money is called:
! colspan=8 |>
Year
$10,001
$20,001
$60,001
$100,001
$250,001
1913
1%
2%
3%
5%
6%
1914
1%
2%
3%
5%
6%
1916
2%
3%
5%
7%
10%
1918
16%
21%
41%
64%
72%
1920
12%
17%
37%
60%
68%
1922
10%
16%
36%
56%
58%
1924
7%
11%
27%
43%
44%
1926
6%
10%
21%
25%
25%
1928
6%
10%
21%
25%
25%
1930
6%
10%
21%
25%
25%
1932
10%
16%
36%
56%
58%
1934
11%
19%
37%
56%
58%
1936
11%
19%
39%
62%
68%
1938
11%
19%
39%
62%
68%
1940
14%
28%
51%
62%
68%
1942
38%
55%
75%
85%
88%
1944
41%
59%
81%
92%
94%
1946
38%
56%
78%
89%
91%
1948
38%
56%
78%
89%
91%
1950
38%
56%
78%
89%
91%
1952
42%
62%
80%
90%
92%
1954
38%
56%
78%
89%
91%
1956
26%
38%
62%
75%
89%
1958
26%
38%
62%
75%
89%
1960
26%
38%
62%
75%
89%
1962
26%
38%
62%
75%
89%
1964
23%
34%
56%
66%
76%
1966 - 1976
22%
32%
53%
62%
70%
1980
18%
24%
54%
59%
70%
1982
16%
22%
49%
50%
50%
1984
14%
18%
42%
45%
50%
1986
14%
18%
38%
45%
50%
1988
15%
15%
28%
28%
28%
1990
15%
15%
28%
28%
28%
1992
15%
15%
28%
28%
31%
1994
15%
15%
28%
31%
39.6%
1996
15%
15%
28%
31%
36%
1998
15%
15%
28%
28%
36%
2000
15%
15%
28%
28%
36%
2002
10%
15%
27%
27%
35%
2004
10%
15%
25%
25%
33%
2006
10%
15%
15%
25%
33%
2008
10%
15%
15%
25%
33%
2010
10%
15%
15%
25%
33%
is a theory by one economist that postulates that in the United States, federal tax revenues will always be equal to approximately 19.5% of gross domestic product
(GDP), regardless of what the top marginal tax rate is. From fiscal year 1946 to fiscal year 2007, federal tax receipts as a percentage of GDP averaged 17.9%, with a range of 14.4% to 20.9%. During the years referred to by Hauser (FY 46 to FY 93), the actual average was 17.7%.
Where conflicts exist between various sources of tax authority, an authority in Tier 1 outweighs an authority in Tier 2 or 3. Similarly, an authority in Tier 2 outweighs an authority in Tier 3. Where conflicts exist between two authorities in the same tier, the "last-in-time rule" is applied. As the name implies, the "last-in-time rule" states that the authority that was issued later in time is controlling.
Regulations and case law serve to interpret the statutes. Additionally, various sources of law attempt to do the same thing. Revenue Rulings, for example, serves as an interpretation of how the statutes apply to a very specific set of facts. Treaties serve in an international realm.
have expressed amazement and frustration with the complexity of the U.S. income tax laws. In the article, Thomas Walter Swan, 57 Yale Law Journal
No. 2, 167, 169 (December 1947), Judge Hand wrote:
Complexity is a separate issue from flatness of rate structures. Also, in the United States, income tax laws are often used by legislatures as policy instruments for encouraging numerous undertakings deemed socially useful — including the buying of life insurance, the funding of employee health care and pensions, the raising of children, home ownership, development of alternative energy sources and increased investment in conventional energy. Special tax provisions granted for any purpose increase complexity, irrespective of the system's flatness or lack thereof.
Income tax is also be levied by most U.S. state
s and many localities on individuals, corporations, estates, and trusts. These taxes are in addition to Federal income tax and are deductible for Federal tax purposes. State and local income tax rates vary from 1% to 16% of taxable income. Some state and local income tax rates are flat (single rate) and some are graduated. State and local definitions of what income is taxable vary highly. Some states incorporate the Federal definitions by reference. Taxable income is defined separately and differently for individuals and corporations in some jurisdictions. Some states impose alternative or additional taxes based a second measure of income or capital.
States and localities tend to tax all income of residents. States and localities only tax nonresidents on income allocated or apportioned to the jurisdiction. Generally, nonresident individuals are taxed on wages earned in the state based on the portion of days worked in the state. Many states require partnerships to pay tax for nonresident partners.
Tax returns are filed separately for states and localities imposing income tax, and may be due on dates that differ from Federal due dates. Some states permit related corporations to file combined or consolidated returns. Most states and localities imposing income tax require estimated payments where tax exceeds certain thresholds, and require withholding tax
on payment of wages.
Puerto Rico
imposes a separate income tax in lieu of Federal income tax. The unincorporated territories Guam
, American Samoa
, and the Virgin Islands also impose income tax separately, under a "mirror" tax law based on Federal income tax law.
criticized the tax system as being extremely complex, requiring detailed record-keeping, lengthy instructions, and complicated schedules, worksheets, and forms. They stated that it penalizes work, discourages saving and investment
, and hinders the competitiveness of American business. "The tax code is commonly riddled with provisions that treat similarly situated taxpayers differently and create perceptions of unfairness." The panel's major reform push was for the removal of the Alternative Minimum Tax
, which is not indexed for inflation.
Several organizations and individuals are working for tax reform in the United States
including Americans for Tax Reform
, Citizens for an Alternative Tax System
, Americans For Fair Taxation
, and FreedomWorks
. Various proposals have been put forth for tax simplification in Congress including the Fair Tax Act and various Flat tax
plans.
argue that the income tax system creates perverse incentive
s by encouraging taxpayers to spend rather than save: a taxpayer is only taxed once on income spent immediately, while any interest earned on saved income is itself taxed. To the extent that this is considered unjust, it may be remedied in a variety of ways, e.g. excluding investment income from taxable income, making investments deductible and therefore only taxing them when gains are realized, or replacing the income tax by other forms of tax, such as a sales tax.
believe in a natural right
to property (money being a representation of a person's property), and that no individual, including institutions composed of individuals, can take another individual's property without their permission. Some holders of this view say that the only way government can enforce its power is through coercion; thus, such individuals may view taxation as equivalent to theft. Some believe income taxation offers the federal government a technique to diminish the power of the states, because the federal government is then able to distribute funding to states with conditions attached, often giving the states no choice but to submit to federal demands. Although many libertarians view all taxes as undesirable, the question of whether or not taxation is nevertheless necessary is up for debate among libertarians. However, in general the libertarian philosophy prefers local government over less-local government; thus a federal tax is by some viewed as the worst kind of tax.
have been raised asserting that the federal income tax is unconstitutional, including discredited claims that the Sixteenth Amendment was not properly ratified. All such claims have been repeatedly rejected by the federal courts as frivolous
.
is employed which equates to higher income earners paying a larger percentage of their income in taxes. According to the IRS, the top 1% of income earners for 2008 paid 38% of income tax revenue, while earning 20% of the income reported. The top 5% of income earners paid 59% of the total income tax revenue, while earning 35% of the income reported. The top 10% paid 70%, earning 46% and the top 25% paid 86%, earning 67%. The top 50% paid 97%, earning 87% and leaving the bottom 50% paying 3% of the taxes collected and earning 13% of the income reported.
A 2008 OECD
study ranked 24 OECD nations by progressiveness of taxes and separately by progressiveness of cash transfers, which include pensions, unemployment and other benefits. The United States had the highest concentration coefficient in income tax, a measure of progressiveness, before adjusting for income inequality. The United States was not at the top of either measure for cash transfers. Adjusting for income inequality, Ireland had the highest concentration coefficient for income taxes. Overall income tax rates for the US are below the OECD average.
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United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, a tax is imposed on income by the Federal, most states, and many local governments. The income tax
Income tax
An income tax is a tax levied on the income of individuals or businesses . Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate...
is determined by applying a tax rate, which may increase as income increases
Progressive tax
A progressive tax is a tax by which the tax rate increases as the taxable base amount increases. "Progressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from low to high, where the average tax rate is less than the marginal tax rate...
, to taxable income
Taxable income
Taxable income refers to the base upon which an income tax system imposes tax. Generally, it includes some or all items of income and is reduced by expenses and other deductions. The amounts included as income, expenses, and other deductions vary by country or system. Many systems provide that...
as defined. Individuals and corporations are directly taxable, and estates and trusts may be taxable on undistributed income. Partnerships are not taxed, but their partners are taxed on their shares of partnership income. Residents and citizens are taxed on worldwide income, while nonresidents are taxed only on income within the jurisdiction. Several types of credits reduce tax, and some types of credits may exceed tax before credits. An alternative tax applies at the Federal and some state levels.
Taxable income is total income less allowable deductions
Tax deduction
Income tax systems generally allow a tax deduction, i.e., a reduction of the income subject to tax, for various items, especially expenses incurred to produce income. Often these deductions are subject to limitations or conditions...
. Income is broadly defined. Most business expenses are deductible. Individuals may also deduct a personal allowance (exemption) and certain personal expenses, including home mortgage interest, state taxes, contributions to charity, and some other items. Some deductions are subject to limits.
Capital gains
Capital gains tax in the United States
In the United States, individuals and corporations pay income tax on the net total of all their capital gains just as they do on other sorts of income. Capital gains are generally taxed at a preferential rate in comparison to ordinary income...
are fully taxable, and capital losses reduce taxable income only to the extent of gains. Individuals currently pay a lower rate of tax on capital gains and certain corporate dividends.
Taxpayers generally must self assess income tax by filing tax returns. Advance payments of tax are required in the form of withholding tax or estimated tax payments. Taxes are determined separately by each jurisdiction imposing tax. Due dates and other administrative procedures vary by jurisdiction. April 15 following the tax year is the due date for individual returns for Federal and many state and local returns. Tax as determined by the taxpayer may be adjusted by the taxing jurisdiction.
Basics
A tax is imposed on net taxable incomeTaxable income
Taxable income refers to the base upon which an income tax system imposes tax. Generally, it includes some or all items of income and is reduced by expenses and other deductions. The amounts included as income, expenses, and other deductions vary by country or system. Many systems provide that...
in the United States by the Federal, most state, and some local governments. Income tax is imposed on individuals, corporations, estates, and trusts. The definition of net taxable income for most sub-federal jurisdictions mostly follows the Federal definition.
The rate of tax at the federal level is graduated; that is, the tax rates of higher amounts of income are higher than on lower amounts. The lower rate on lower income was phased out at higher incomes prior to 2010. Some states and localities impose an income tax at a graduated rate, and some at a flat rate on all taxable income. Federal tax rates in 2009 varied from 10% to 35%. From 2003 through 2010, individuals were eligible for a reduced rate of Federal income tax on capital gains and qualifying dividends. The tax rate and some deductions are different for individuals depending on filing status. Married individuals may compute tax as a couple or separately. Single individuals may be eligible for reduced tax rates if they are head of a household in which they live with a dependent.
Federal taxable income is defined in a comprehensive manner in the Internal Revenue Code
Internal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
and regulations issued by the Department of Treasury and the Internal Revenue Service. Taxable income is gross income
Gross income
Gross income in United States tax law is receipts and gains from all sources less cost of goods sold. Gross income is the starting point for determining Federal and state income tax of individuals, corporations, estates and trusts, whether resident or nonresident."Except as otherwise provided" by...
as adjusted less tax deduction
Tax deduction
Income tax systems generally allow a tax deduction, i.e., a reduction of the income subject to tax, for various items, especially expenses incurred to produce income. Often these deductions are subject to limitations or conditions...
s. Most states and localities follow this definition at least in part, though some make adjustments to determine income taxed in that jurisdiction. Taxable income for a company or business may not be the same as its book income.
Gross income includes all income earned or received from whatever source. This includes salaries and wages, tips, pensions, fees earned for services, price of goods sold, other business income, gains on sale of other property, rents received, interest and dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
s received, alimony received, proceeds from selling crops, and many other types of income. Some income, however, is exempt from income tax. This includes interest on municipal bonds.
Adjustments (usually reductions) to gross income of individuals are made for alimony paid, contributions to many types of retirement or health savings plans, certain student loan interest, half of self employment tax, and a few other items. The cost of goods sold
Cost of goods sold
Cost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...
in a business is a direct reduction of gross income.
Taxable income of all taxpayers is reduced by tax deductions for expenses related to their business. These include salaries, rent, and other business expenses paid or accrued, as well as allowances for depreciation
MACRS
The Modified Accelerated Cost Recovery System is the current tax depreciation system in the United States. Under this system, the capitalized cost of tangible property is recovered over a specified life by annual deductions for depreciation. The lives are specified broadly in the Internal...
. The deduction of expenses may result in a loss. Generally, such loss can reduce other taxable income, subject to some limits.
Individuals are allowed several nonbusiness deductions. A flat amount per person is allowed as a deduction for personal exemptions. For 2009 this amount was $3,650. Each taxpayer is allowed one such deduction for themselves and one for each person they support.
In addition, individuals get a deduction from taxable income for certain personal expenses. Alternatively, the individual may claim a standard deduction
Standard deduction
The standard deduction, as defined under United States tax law, is a dollar amount that non-itemizers may subtract from their income and is based upon filing status. It is available to US citizens and resident aliens who are individuals, married persons, and heads of household and increases every...
. For 2011, the standard deduction is $5,800 for single individuals, $11,600 for a married couple, and $8,500 for a head of household. Those who choose to claim actual itemized deductions may deduct the following, subject to many conditions and limitations:
- Medical expenses in excess of 7.5% of adjusted gross income,
- State, local, and foreign taxes,
- Home mortgage interest,
- Contributions to charities,
- Losses on nonbusiness property due to casualty, and
- Deductions for expenses incurred in the production of income in excess of 2% of adjusted gross income.
Capital gains
Capital gains tax in the United States
In the United States, individuals and corporations pay income tax on the net total of all their capital gains just as they do on other sorts of income. Capital gains are generally taxed at a preferential rate in comparison to ordinary income...
and qualified dividend
Qualified dividend
Qualified dividends, as defined by the United States Internal Revenue Code, are ordinary dividends that meet specific criteria to be taxed at the lower long-term capital gains tax rate rather than at higher tax rate for an individual's ordinary income...
s may be taxed as part of taxable income. However, the tax is limited to a lower tax rate. Capital gains include gains on selling stocks and bonds, real estate, and other capital assets. The gain is the excess of the proceeds over the adjusted basis (cost less depreciation deductions allowed) of the property. This limit on tax also applies to dividends from U.S. corporations and many foreign corporations. There are limits on how much net capital loss may reduce other taxable income.
All taxpayers are allowed a tax credit
Tax credit
A tax credit is a sum deducted from the total amount a taxpayer owes to the state. A tax credit may be granted for various types of taxes, such as an income tax, property tax, or VAT. It may be granted in recognition of taxes already paid, as a subsidy, or to encourage investment or other behaviors...
for foreign taxes and for a percentage of certain types of business expenses. Individuals are also allowed credits related to education expenses, retirement savings, child care expenses, and a credit for each child. Each of the credits is subject to specific rules and limitations. Some credits are treated as refundable payments.
All taxpayers are also subject to the Alternative Minimum Tax
Alternative Minimum Tax
The Alternative Minimum Tax is an income tax imposed by the United States federal government on individuals, corporations, estates, and trusts. AMT is imposed at a nearly flat rate on an adjusted amount of taxable income above a certain threshold . This exemption is substantially higher than the...
if their income exceeds certain exclusion amounts. This tax applies only if it exceeds regular income tax, and is reduced by some credits.
Individuals must file income tax returns in each year their income exceeds the standard deduction plus one personal exemption, or if any tax is due. Other taxpayers must file income tax returns each year. These returns may be filed electronically. Generally, an individual's tax return covers the calendar year. Corporations may elect a different tax year. Most states and localities follow the Federal tax year, and require separate returns.
Taxpayers must pay income tax due without waiting for an assessment. Many taxpayers are subject to withholding tax
Withholding tax
Withholding tax, also called retention tax, is a government requirement for the payer of an item of income to withhold or deduct tax from the payment, and pay that tax to the government. In most jurisdictions, withholding tax applies to employment income. Many jurisdictions also require...
es when they receive income. To the extent withholding taxes do not cover all taxes due, all taxpayers must make estimated tax payments.
Failing to make payments on time, or failing to file returns, can result in substantial penalties
IRS penalties
Taxpayers in the United States may face various penalties for failures related to Federal, state, and local tax matters. The Internal Revenue Service is primarily responsible for initiating these penalties at the Federal level. The IRS can impose only those penalties specified in Federal tax law...
. Certain intentional failures may result in jail time.
Tax returns may be examined and adjusted by tax authorities. Taxpayers have rights to appeal any change to tax, and these rights vary by jurisdiction. Taxpayers may also go to court to contest tax changes. Tax authorities may not make changes after a certain period of time (generally 3 years).
Federal income tax rates
Recent Federal income brackets and tax rates are published annually by the IRS as "Tax Rate SchedulesRate schedule (federal income tax)
A rate schedule is a chart that helps United States taxpayers determine their federal income tax burden for a particular year. Another name for “rate schedule” is “rate table.”- Origin :...
".
Marginal rate vs. income
Year 2009 income brackets and tax rates
| Marginal Tax Rate | Single | Married Filing Jointly or Qualified Widow(er) | Married Filing Separately | Head of Household |
|---|---|---|---|---|
| 10% | $0 – $8,350 | $0 – $16,700 | $0 – $8,350 | $0 – $11,950 |
| 15% | $8,351 – $33,950 | $16,701 – $67,900 | $8,351 – $33,950 | $11,951 – $45,500 |
| 25% | $33,951 – $82,250 | $67,901 – $137,050 | $33,951 – $68,525 | $45,501 – $117,450 |
| 28% | $82,251 – $171,550 | $137,051 – $208,850 | $68,526 – $104,425 | $117,451 – $190,200 |
| 33% | $171,551 – $372,950 | $208,851 – $372,950 | $104,426 – $186,475 | $190,201 – $372,950 |
| 35% | $372,951+ | $372,951+ | $186,476+ | $372,951+ |
Year 2010 income brackets and tax rates
| Marginal Tax Rate | Single | Married Filing Jointly or Qualified Widow(er) | Married Filing Separately | Head of Household |
|---|---|---|---|---|
| 10% | $0 – $8,375 | $0 – $16,750 | $0 – $8,375 | $0 – $11,950 |
| 15% | $8,376 – $34,000 | $16,751 – $68,000 | $8,376 – $34,000 | $11,951 – $45,550 |
| 25% | $34,001 – $82,400 | $68,001 – $137,300 | $34,001 – $68,650 | $45,551 – $117,650 |
| 28% | $82,401 – $171,850 | $137,301 – $209,250 | $68,651 – $104,625 | $117,651 – $190,550 |
| 33% | $171,851 – $373,650 | $209,251 – $373,650 | $104,626 – $186,825 | $190,551 – $373,650 |
| 35% | $373,651+ | $373,651+ | $186,826+ | $373,651+ |
Year 2011 income brackets and tax rates
| Marginal Tax Rate | Single | Married Filing Jointly or Qualified Widow(er) | Married Filing Separately | Head of Household |
|---|---|---|---|---|
| 10% | $0 – $8,500 | $0 – $17,000 | $0 – $8,500 | $0 – $12,150 |
| 15% | $8,501 – $34,500 | $17,001 – $69,000 | $8,501 – $34,500 | $12,150 – $46,250 |
| 25% | $34,501 – $83,600 | $69,001 – $139,350 | $34,501 – $69,675 | $46,251 – $119,400 |
| 28% | $83,601 – $174,400 | $139,351 – $212,300 | $69,676 – $106,150 | $119,401 – $193,350 |
| 33% | $174,401 – $379,150 | $212,301 – $379,150 | $106,151 – $189,575 | $193,351 – $379,150 |
| 35% | $379,151+ | $379,151+ | $189,576+ | $379,151+ |
An individual's marginal income tax bracket
Tax bracket
Tax brackets are the divisions at which tax rates change in a progressive tax system . Essentially, they are the cutoff values for taxable income — income past a certain point will be taxed at a higher rate.-Example:Imagine that there are three tax brackets: 10%, 20%, and 30%...
depends upon his or her income and tax-filing classification. As of 2008, there are six tax brackets for ordinary income (ranging from 10% to 35%) and four classifications: single, married filing jointly (or qualified widow or widower), married filing separately, and head of household.
An individual pays tax at a given bracket only for each dollar within that bracket's range. For example, a single taxpayer who earned $10,000 in 2009 would be taxed 10% of each dollar earned from the 1st dollar to the 8,350th dollar (10% × $8,350 = $835.00), then 15% of each dollar earned from the 8,351st dollar to the 10,000th dollar (15% × $1,650 = $247.50), for a total of $1,082.50. Notice this amount ($1,082.50) is lower than if the individual had been taxed at 15% on the full $10,000 (for a tax of $1,500). This is because the individual's marginal rate (the percentage tax on the last dollar earned, here 15%) has no effect on the income taxed at a lower bracket (here the first $8,350 of income taxed at 10%). This ensures that every rise in a person's pre-tax salary results in an increase of their after-tax salary.
Example of a tax computation
Income tax for year 2011:Single taxpayer, no children, under 65 and not blind, taking standard deduction;
- $40,000 gross income – $5,800 standard deductionStandard deductionThe standard deduction, as defined under United States tax law, is a dollar amount that non-itemizers may subtract from their income and is based upon filing status. It is available to US citizens and resident aliens who are individuals, married persons, and heads of household and increases every...
– $3,700 personal exemption = $30,500 taxable income- $8,500 × 10% = $850.00 (taxation of the first income bracket)
- $30,500 – $8,500 = $22,000.00 (amount in the second income bracket)
- $22,000.00 × 15% = $3,300.00 (taxation of the amount in the second income bracket)
- Total income tax is $850.00 + $3,300.00 = $4,150.00 (10.375% effective tax)
Note that in addition to income tax, a wage earner would also have to pay Federal Insurance Contributions Act tax
Federal Insurance Contributions Act tax
Federal Insurance Contributions Act tax is a United States payroll tax imposed by the federal government on both employees and employers to fund Social Security and Medicare —federal programs that provide benefits for retirees, the disabled, and children of deceased workers...
(FICA) (and an equal amount of FICA tax must be paid by the employer):
- $40,000 (adjusted gross income)
- $40,000 × 4.2% = $1,680 (Social Security portion)
- $40,000 × 1.45% = $580 (Medicare portion)
- Total FICA tax = $2,260 (5.65% of income)
- Total Federal tax of individual = $6,410.00 (16.025% of income)
Taxable income
Income tax is imposed as a tax rate times taxable income, less applicable tax credits. Taxable income is gross incomeGross income
Gross income in United States tax law is receipts and gains from all sources less cost of goods sold. Gross income is the starting point for determining Federal and state income tax of individuals, corporations, estates and trusts, whether resident or nonresident."Except as otherwise provided" by...
less allowable tax deductions. Taxable income as determined for Federal tax purposes may be modified for state tax purposes.
Gross income
The Internal Revenue CodeInternal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
states that "gross income means all income from whatever source derived," and gives specific examples. Gross income is not limited to cash received. "It includes income realized in any form, whether money, property, or services." Gross income includes wages and tips, fees for performing services, gain from sale of inventory or other property, interest, dividends, rents, royalties, pensions, alimony, and many other types of income. Items must be included in income when received or accrued. The amount included is the amount the taxpayer is entitled to receive. Gains on property are the gross proceeds less amounts returned, cost of goods sold
Cost of goods sold
Cost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...
, or tax basis
Tax basis
The tax basis of an asset is generally its cost. Determining such cost may require allocations where multiple assets are acquired together. Tax basis may be reduced by allowances for depreciation. Such reduced basis is referred to as the adjusted tax basis. Adjusted tax basis is used in...
of property sold.
Certain types of income are subject to tax exemption
Tax exemption
Various tax systems grant a tax exemption to certain organizations, persons, income, property or other items taxable under the system. Tax exemption may also refer to a personal allowance or specific monetary exemption which may be claimed by an individual to reduce taxable income under some...
. Among the more common types of exempt income are interest on municipal bonds, a portion of Social Security benefits, life insurance proceeds, gifts or inheritances, and the value of many employee benefits.
Gross income is reduced by adjustments and tax deductions. Among the more common adjustments are reductions for alimony paid and IRA
Individual Retirement Account
An individual retirement arrangement is the blanket term for a form of retirement plan that provides tax advantages for retirement savings in the United States...
and certain other retirement plan contributions. Adjusted gross income is used in calculations relating to various deductions, credits, phase outs, and penalties.
Business deductions
Deductions are permitted for most business expenses of entities and individuals. There are limits on some types of these deductions. The deduction for depreciation expense must be computed under MACRSMACRS
The Modified Accelerated Cost Recovery System is the current tax depreciation system in the United States. Under this system, the capitalized cost of tangible property is recovered over a specified life by annual deductions for depreciation. The lives are specified broadly in the Internal...
rules. Deductions for meals and entertainment are limited to 50% of the amount incurred.
Certain deductions must be capitalized or deferred. These include:
- Cost of goods soldCost of goods soldCost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...
, including costs required to be capitalized under tax rules that differ from financial accounting rules, - Personal, living, and family expenses,
- Items producing future benefits,
- Political contributions,
- Expenses not properly documented under tax rules, and
- Other items.
Business losses may reduce nonbusiness income for individuals and corporations. However, losses from passive activities may reduce only income from other passive activities. Passive activities include most rental activities (except for real estate professionals) and business activities in which the taxpayer does not materially participate. In addition, losses may not, in most cases, be deducted in excess of the taxpayer's amount at risk (generally tax basis in the entity plus share of debt).
Overall net operating loss
Net operating loss
Under U.S. Federal income tax law, a net operating loss occurs when certain tax-deductible expenses exceed taxable revenues for a taxable year. If a taxpayer is taxed during profitable periods without receiving any tax relief during periods of NOLs, an unbalanced tax burden results...
es (business deductions in excess of gross income) may be deducted in other years by carryover or carryback of the loss.
Personal deductions
Individuals are allowed a special deduction called a personal exemption for dependents. This is a fixed amount allowed each taxpayer, plus an additional fixed amount for each child or other dependent the taxpayer supports. The amount of this deduction for 2009 and 2010 is $3,650. The amount is indexed annually for inflation. The amount of exemption is phased out at higher incomes through 2009; the phase out expired for 2010.Citizens and individuals who have U.S. tax residence
Tax residence
Definitions of residence for tax purposes vary considerably from state to state. For individuals, physical presence in a state is an important factor. Some states also determine residency of an individual by reference to a variety of other factors, such as the ownership of a home or availability...
may deduct a flat amount as a standard deduction
Standard deduction
The standard deduction, as defined under United States tax law, is a dollar amount that non-itemizers may subtract from their income and is based upon filing status. It is available to US citizens and resident aliens who are individuals, married persons, and heads of household and increases every...
. Alternatively, they may claim an itemized deduction
Itemized deduction
An itemized deduction is an eligible expense that individual taxpayers in the United States can report on their federal income tax returns in order to decrease their taxable income....
for actual amounts incurred for specific categories of nonbusiness expenses. Home owners may deduct the amount of interest and property taxes paid on their principal and second homes. Local and state income taxes are deductible, or the individual may elect to deduct state and local sales tax
Sales tax
A sales tax is a tax, usually paid by the consumer at the point of purchase, itemized separately from the base price, for certain goods and services. The tax amount is usually calculated by applying a percentage rate to the taxable price of a sale....
. Contributions to charitable organizations are deductible by individuals and corporations, but the deduction is limited to 50% and 10% of gross income respectively. Medical expenses in excess of 7.5% of adjusted gross income
Adjusted Gross Income
For United States individual income tax, taxable income is adjusted gross income less allowances for personal exemptions and itemized deductions. Adjusted gross income is total gross income minus specific items laid out in the tax code...
are deductible, as are uninsured casualty losses. Other income producing expenses in excess of 2% of adjusted gross income are also deductible. For years before 2010, the allowance of itemized deductions was phased out at higher incomes. The phase out expired for 2010.
Capital gains
Taxable income includes capital gains. These are the excess of the sales price over tax basisTax basis
The tax basis of an asset is generally its cost. Determining such cost may require allocations where multiple assets are acquired together. Tax basis may be reduced by allowances for depreciation. Such reduced basis is referred to as the adjusted tax basis. Adjusted tax basis is used in...
(cost) of capital assets, such as corporate stock, land, buildings, etc. Capital losses (where basis is more than sales price) are deductible, but deduction for long term capital losses is limited to capital gains. An individual may exclude $250,000 ($500,000 for a married couple filing jointly) of capital gains on the sale of the individual's primary residence, subject to certain conditions and limitations.
In determining gain, it is necessary to determine which property is sold and the basis of that property. This may require identification conventions, such as first-in-first-out, for identical properties like shares of stock. Further, tax basis must be allocated among properties purchased together unless they are sold together. Original basis, usually cost paid for the asset, is reduced by deductions for depreciation
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
or loss.
Certain capital gains are deferred, that is, taxed at a time later than disposition. Gains on property sold for installment payments may be recognized as those payments are received. Gains on property exchanged for like kind property are not recognized, and the tax basis of the new property is based on the tax basis of the old property.
Before 1986 and from 2004 onward, individuals have been subject to a reduced rate of Federal tax on long term capital gains. This reduced rate (limited to 15%) applies for regular tax and the Alternative Minimum Tax.
| Ordinary Income Rate | Long-term Capital Gain Rate | Short-term Capital Gain Rate | Long-term Gain on Real Estate* | Long-term Gain on Collectibles | Long-term Gain on Certain Small Business Stock |
|---|---|---|---|---|---|
| 10% | 0% | 10% | 10% | 10% | 10% |
| 15% | 0% | 15% | 15% | 15% | 15% |
| 25% | 15% | 25% | 25% | 25% | 25% |
| 28% | 15% | 28% | 25% | 28% | 28% |
| 33% | 15% | 33% | 25% | 28% | 28% |
| 35% | 15% | 35% | 25% | 28% | 28% |
* Capital gains up to $250,000 ($500,000 if filed jointly) on real estate used as primary residence are exempt.
Partnerships and LLCs
Business entities treated as partnerships are not subject to income tax at the entity level. Instead, their members include their shares of income, deductions, and credits in computing their own tax. The character of the partner's share of income (such as capital gains) is determined at the partnership level. Many types of business entities, including limited liability companies (LLCs), may elect to be treated as a corporation or as a partnership. Distributions from partnerships are not taxed as dividends.Corporate tax
Corporate tax is imposed in the United States at the Federal, most state, and some local levels on the income of entities treated for tax purposes as corporations. Shareholders of a corporation wholly owned by U.S. citizens and resident individuals may elect for the corporation to be taxed similarly to partnerships (see S CorporationS Corporation
An S corporation, for United States federal income tax purposes, is a corporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code....
). Corporate income tax is based on taxable income
Taxable income
Taxable income refers to the base upon which an income tax system imposes tax. Generally, it includes some or all items of income and is reduced by expenses and other deductions. The amounts included as income, expenses, and other deductions vary by country or system. Many systems provide that...
, which is defined similarly to individual taxable income.
Shareholders (including other corporations) of corporations (other than S Corporations) are taxed on dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
distributions from the corporation. They are also subject to tax on capital gains upon sale or exchange of their shares for money or property. However, certain exchanges, such as in reorganizations, are not taxable.
Multiple corporations may file a consolidated return
Combined Reporting
Some jurisdictions permit or require combined reporting or combined or consolidated filing of income tax returns. Such returns include income, deductions, and other items of multiple related corporations, and may compute tax as if such multiple entities were a single taxpayer. Most rules require...
at the Federal and some state levels with their common parent.
Corporate tax rates
Federal corporate income tax is imposed at graduated rates from 15% to 35%. The lower rate brackets are phased out at higher rates of income, with all income subject to tax at 34% to 35% where taxable income exceeds $335,000. All income is taxed at the same rate. Additional tax rates imposed below the federal level vary widely by jurisdiction, from under 1% to over 16%. State and local income taxes are allowed as tax deductions in computing Federal taxable income.Deductions for corporations
Corporations are not allowed the personal deductions allowed to individuals, such as deductions for exemptions and the standard deduction. However, most other deductions are allowed. In addition, corporations are allowed certain deductions unique to corporate status. These include a partial deduction for dividends received from other corporations, deductions related to organization costs, and certain other items.Some deductions of corporations are limited at Federal or state levels. Limitations apply to items due to related parties, including interest and royalty expenses.
Estates and trusts
Estates and trusts may be subject to income tax at the estate or trust level, or the beneficiaries may be subject to income tax on their share of income. Where the all income must be distributed, the beneficiaries are taxed similarly to partners in a partnership. Where income may be retained, the estate or trust is taxed. It may get a deduction for later distributions of income. Estates and trusts are allowed only those deductions related to producing income, plus $1,000. They are taxed at graduated rates that increase rapidly to the maximum rate for individuals. The tax rate for trust and estate income in excess of $11,500 was 35% for 2009. Estates and trusts are eligible for the reduced rate of tax on dividends and capital gains through 2010.Retirement savings and fringe benefit plans
Employers get a deduction for amounts contributed to a qualified employee retirement plan or benefit plan. The employee does not recognize income with respect to the plan until he or she receives a distribution from the plan. The plan itself is organized as a trust and is considered a separate entity. For the plan to qualify for tax exemptionTax exemption
Various tax systems grant a tax exemption to certain organizations, persons, income, property or other items taxable under the system. Tax exemption may also refer to a personal allowance or specific monetary exemption which may be claimed by an individual to reduce taxable income under some...
, and for the employer to get a deduction, the plan must meet minimum participation, vesting, funding, and operational standards.
Examples of qualified plans include:
- pension plans (Defined benefit pension planDefined benefit pension planIn economics, a defined benefit pension plan is a major type of pension plan in which an employer promises a specified monthly benefit on retirement that is predetermined by a formula based on the employee's earnings history, tenure of service and age, rather than depending on investment returns...
), - profit sharing plans (defined contribution planDefined contribution planIn economics, a defined contribution plan is a type of retirement plan in which the amount of the employer's annual contribution is specified. Individual accounts are set up for participants and benefits are based on the amounts credited to these accounts plus any investment earnings on the money...
), - Employee Stock Ownership Plan (ESOPs),
- stock purchase plans,
- health insurance plans,
- employee benefit plans,
- Cafeteria planCafeteria planA cafeteria plan is a type of employee benefit plan offered in the United States pursuant to Section 125 of the Internal Revenue Code. Its name comes from the earliest such plans that allowed employees to choose between different types of benefits, similar to the ability of a customer to choose...
s.
Employees or former employees are generally taxed on distributions from retirement or stock plans. Employees are not taxed on distributions from health insurance plans to pay for medical expenses. Cafeteria plans allow employees to choose among benefits (like choosing food in a cafeteria), and distributions to pay those expenses are not taxable.
In addition, individuals may make contributions to Individual Retirement Account
Individual Retirement Account
An individual retirement arrangement is the blanket term for a form of retirement plan that provides tax advantages for retirement savings in the United States...
s (IRAs). Those not currently covered by other retirement plans may claim a deduction for contributions to certain types of IRAs. Income earned within an IRA is not taxed until the individual withdraws it.
Credits
The Federal and state systems offer numerous tax credits for individuals and businesses. Among the key Federal credits for individuals are:- child creditChild tax creditA child tax credit is the name for tax credits issued in some countries that depends on the number of dependent children in a family. The credit may depend on other factors as well: typically it depends on income level. For example, in the United States, only families making less than $110K per...
: a credit up to $1,000 per qualifying child. - Child and dependent care creditChild and Dependent Care CreditThe Household and Dependent Care Credit is a nonrefundable tax credit available to United States taxpayers. Taxpayers that care for a qualifying individual are eligible. The purpose of the credit is to allow the taxpayer to be gainfully employed. This credit is created by 26 U.S.C...
: a credit up to $6,000, phased out at incomes above $15,000. - Earned Income Tax CreditEarned income tax creditThe United States federal earned income tax credit or earned income credit is a refundable tax credit primarily for individuals and families who have low to moderate earned income. Greater tax credit is given to those who also have qualifying children...
: this refundable credit is granted for a percentage of income earned by a low income individual. The credit is calculated and capped based on the number of qualifying children, if any. This credit is indexed for inflation and phased out for incomes above a certain amount. For 2009, the maximum credit was $5,657. - Credit for the elderly and disabled: A nonrefundable credit up to $1,125
- Two mutually exclusive credits for college expenses.
Businesses are also eligible for several credits. These credits are available to individuals and corporations, and can be taken by partners in business partnerships. Among the Federal credits included in a "general business credit" are:
- Credit for increasing research expensesResearch & Experimentation Tax CreditInternal Revenue Code §41 known as the Research & Experimentation Tax Credit or the R&D Tax Credit is a general business tax credit for companies that are incurring R&D expenses in the United States. The R&D Tax Credit was originally introduced in the Economic Recovery Tax Act of 1981 sponsored by...
. - Work Incentive Credit or credit for hiring people in certain enterprise zones or on welfare.
- A variety of industry specific credits.
In addition, a Federal foreign tax credit
Foreign tax credit
Income tax systems that tax residents on worldwide income generally offer a foreign tax credit to mitigate the potential for double taxation. The credit may also be granted in those systems taxing residents on income that may have been taxed in another jurisdiction...
is allowed for foreign income taxes paid. This credit is limited to the portion of Federal income tax arising due to foreign source income. The credit is available to all taxpayers.
Business credits and the foreign tax credit may be offset taxes in other years.
States and some localities offer a variety of credits that vary by jurisdiction. States typically grant a credit to resident individuals for income taxes paid to other states, generally limited in proportion to income taxed in the other state(s).
Alternative Minimum Tax
Taxpayers must pay the higher of the regular income tax or the Alternative Minimum TaxAlternative Minimum Tax
The Alternative Minimum Tax is an income tax imposed by the United States federal government on individuals, corporations, estates, and trusts. AMT is imposed at a nearly flat rate on an adjusted amount of taxable income above a certain threshold . This exemption is substantially higher than the...
(AMT). Taxpayers who have paid AMT in prior years may claim a credit against regular tax for the prior AMT. The credit is limited so that regular tax is not reduced below current year AMT.
AMT is imposed at a nearly flat rate (20% for corporations, 26% or 28% for individuals, estates, and trusts) on taxable income as modified for AMT. Key differences between regular taxable income and AMT taxable income include:
- The standard deduction and personal exemptions are replaced by a single deduction, which is phased out at higher income levels,
- No deduction is allowed individuals for state taxes,
- Most miscellaneous itemized deductions are not allowed for individuals,
- Depreciation deductions are computed differently, and
- Corporations must make a complex adjustment to more closely reflect economic income.
Accounting periods and methods
The United States tax system allows individuals and entities to choose their tax year. Most individuals choose the calendar year. There are restrictions on choice of tax year for some closely held entities. Taxpayers may change their tax year in certain circumstances, and such change may require IRS approval.Taxpayers must determine their taxable income based on their method of accounting
Comparison of Cash Method and Accrual Method of accounting
The two primary accounting methods of the cash and the accruals basis are used to calculate US public debt, as well as taxable income for U.S. federal income taxes and other income taxes...
for the particular activity. Most individuals use the cash method for all activities. Under this method, income is recognized when received and deductions taken when paid. Taxpayers may choose or be required to use the accrual method for some activities. Under this method, income is recognized when the right to receive it arises, and deductions are taken when the liability to pay arises and the amount can be reasonably determined. Taxpayers recognizing cost of goods sold
Cost of goods sold
Cost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...
on inventory must use the accrual method with respect to sales and costs of the inventory.
Methods of accounting may differ for financial reporting and tax purposes. Specific methods are specified for certain types of income or expenses. Gain on sale of property other than inventory may be recognized at the time of sale or over the period in which installment sale
Installment sale
In United States income tax law, an installment sale is generally a "disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs." The term "installment sale" does not include, however, a "dealer disposition" or, generally,...
payments are received. Income from long term contracts must be recognized ratably over the term of the contract, not just at completion. Other special rules also apply.
Tax exempt entities
U.S. tax law exempts certain types of entities from income and some other taxes. These provisions arose during the late 19th century. Charitable organizations and cooperatives may apply to the IRS for tax exemptionTax exemption
Various tax systems grant a tax exemption to certain organizations, persons, income, property or other items taxable under the system. Tax exemption may also refer to a personal allowance or specific monetary exemption which may be claimed by an individual to reduce taxable income under some...
. Exempt organizations are still taxed on any business income. An organization which participates in lobbying, political campaigning, or certain other activities may lose its exempt status. Special taxes apply to prohibited transactions and activities of tax exempt entities.
Special taxes
There are many Federal tax rules designed to prevent people from abusing the tax system. Provisions related to these taxes are often complex. Such rules include:- Accumulated earnings tax on corporation accumulations in excess of business needs,
- Personal holding company taxes,
- Passive foreign investment companyPassive foreign investment companyFor purposes of income tax in the U.S., U.S. persons owning shares of a passive foreign investment company may choose between current taxation on the income of the PFIC or deferral of such income subject to a deemed tax and interest regime...
rules, and - Controlled Foreign CorporationControlled Foreign CorporationControlled foreign corporation rules are features of an income tax system designed to limit artificial deferral of tax by using offshore low taxed entities. The rules are needed only with respect to income of entities that is not currently taxed to the owners of the entity. The basic mechanism and...
provisions.
Special industries
Tax rules recognize that some types of businesses do not earn income in the traditional manner and thus require special provisions. For example, Insurance companies must ultimately pay claims to some policy holders from the amounts received as premiums. These claims may happen years after the premium payment. Computing the future amount of claims requires actuarial estimates until claims are actually paid. Thus, recognizing premium income as received and claims expenses as paid would seriously distort an insurance company's income.Special rules apply to some or all items in the following industries:
- Insurance companies (rules related to recognition of income and expense; different rules apply to life insurance and to property and casualty insurance)
- Shipping (rules related to the revenue recognition cycle)
- Extractive industries (rules related to expenses for exploration and development and for recovery of capitalized costs)
In addition, mutual funds (regulated investment companies) are subject to special rules allowing them to be taxed only at the owner level. The company must report to each owner his/her share of ordinary income, capital gains, and creditable foreign taxes. The owners then include these items in their own tax calculation. The fund itself is not taxed, and distributions are treated as a return of capital
Return of capital
Return of capital refers to payments back to "capital owners" that exceed the growth of a business. It should not be confused with return on capital which measures a 'rate of return'....
to the owners. Similar rules apply to real estate investment trusts and real estate mortgage investment conduits.
International aspects
Federal income tax is imposed on citizens, residents, and U.S. corporations based on their worldwide income. To mitigate double taxation, a credit is allowed for foreign income taxes. This foreign tax creditForeign tax credit
Income tax systems that tax residents on worldwide income generally offer a foreign tax credit to mitigate the potential for double taxation. The credit may also be granted in those systems taxing residents on income that may have been taxed in another jurisdiction...
is limited to that part of current year tax caused by foreign source income. Determining such part involves determining the source of income and allocating and apportioning deductions to that income. States tax resident individuals and corporations on their worldwide income, but few allow a credit for foreign taxes.
Federal and state income taxes are imposed on foreign persons on their income within the jurisdiction. Federal rules tax interest, dividends, royalties, and certain other income of foreign persons at a flat rate of 30%. This rate is often reduced under tax treaties. Foreign persons are taxed on income from a U.S. business similarly to U.S. persons. Foreign persons are not subject to U.S. tax on capital gains and certain other income. The states tax non-resident individuals only on income earned within the state (wages, etc.) and tax individuals and corporations on business income apportioned to the state. Most of the states otherwise do not impose income tax on persons not resident in the state.
The United States has income tax treaties with over 65 countries. These treaties reduce the chance of double taxation by allowing each country to fully tax its citizens and residents and reducing the amount the other country can tax them. Generally the treaties provide for reduced rates of tax on investment income and limits as to which business income can be taxed. The treaties each define which taxpayers can benefit from the treaty.
Social Security tax
The United States social insurance system is funded by a tax similar to an income tax. Social Security tax of 6.2% is imposed on wages paid to employees. The tax is imposed on both the employer and the employee. For 2011 and 2012, the employee tax is reduced by 2% to 4.2%. The maximum amount of wages subject to the tax for 2009, 2010, and 2011 was/is $106,800. This amount is indexed for inflation. A companion Medicare Tax of 1.45% of wages is imposed on employers and employees, with no limitation. A self employment tax in like amounts (totaling 15.3%, 13.3% for 2011 and 2012) is imposed on self employed persons.Withholding of tax
Persons paying wages or making certain payments to foreign persons are required to withhold income tax from such payments. The Social Security tax is one type of withholding tax. Withholding of income tax is also required. Income tax withholding on wages is based on declarations by employees and tables provided by the IRS. Persons paying interest, dividends, royalties, and certain other amounts to foreign persons must also withhold income tax at a flat rate of 30%. This rate may be reduced by a tax treatyTax treaty
Many countries have agreed with other countries in treaties to mitigate the effects of double taxation . Tax treaties may cover income taxes, inheritance taxes, value added taxes, or other taxes...
. Additional backup withholding provisions apply to some payments of interest or dividends to U.S. persons. The amount of income tax withheld is treated as a payment of tax by the person receiving the payment on which tax was withheld.
Tax returns
Individuals, corporations, partnerships, estates, and trusts must file annual reports, called tax returnsTax return (United States)
Tax returns in the United States are reports filed with the Internal Revenue Service or with the state or local tax collection agency containing information used to calculate income tax or other taxes...
, with Federal and appropriate state tax authorities. These returns vary greatly in complexity level depending on the type of filer and complexity of their affairs. On the return, the taxpayer reports income and deductions, calculates the amount of tax owed, reports payments and credits, and calculates the balance due.
Federal individual, estate, and trust income tax returns are due by April 15 for most taxpayers. Corporate returns are due two and one half months following the corporation's year end. Partnership returns are due three and one half months following the partnership's year end. Tax exempt entity returns are due four and one half months following the entity's year end. All Federal returns may be extended, with most extensions available upon merely filing a single page form. Due dates and extension provisions for state and local income tax returns vary.
Income tax returns generally consist of the basic form with attached forms and schedules. Several forms are available for individuals and corporations, depending on complexity and nature of the taxpayer's affairs. Many individuals are able to use the one page Form 1040-EZ, which requires no attachments except wage statements from employers (Forms W-2). Individuals claiming itemized deductions must complete Schedule A. Similar schedules apply for interest (B), dividends (B), business income (C), capital gains (D), farm income (F), and self employment tax (SE). All taxpayers must file those forms for credits, depreciation, AMT, and other items that apply to them.
Electronic filing of tax returns may be done for taxpayers by registered tax preparers.
If a taxpayer discovers an error on a return, or determines that tax for a year should be different, the taxpayer should file an amended return. These returns constitute claims for refund if taxes are determined to have been overpaid.
Tax examinations
The IRS and state, and local tax authorities may examine a tax return and propose changes. Changes to tax returns may be made with minimal advance involvement by taxpayers, such as changes to wage or dividend income to correct errors. Other examination of returns may require extensive taxpayer involvement, such as an audit by the IRS. These audits often require that taxpayers provide the IRS or other tax authority access to records of income and deductions. Audits of businesses are usually conducted by IRS personnel at the business location.Changes to returns are subject to appeal by the taxpayer, including going to court. IRS changes are often first issued as proposed adjustments. The taxpayer may agree to the proposal, or may advise the IRS why it disagrees. Proposed adjustments are often resolved by the IRS and taxpayer agreeing to what the adjustment should be. For those adjustments to which agreement is not reached, the IRS issues a 30-day letter advising of the adjustment. The taxpayer may appeal this preliminary assessment within 30 days within the IRS. The Appeals Division reviews the IRS field team determination and taxpayer arguments, and often proposes a solution that the IRS team and the taxpayer find acceptable. Where agreement is still not reached, the IRS issues an assessment as a notice of deficiency or 90-day letter. The taxpayer then has three choices: file suit in United States Tax Court
United States Tax Court
The United States Tax Court is a federal trial court of record established by Congress under Article I of the U.S. Constitution, section 8 of which provides that the Congress has the power to "constitute Tribunals inferior to the supreme Court"...
without paying the tax, pay the tax and sue for refund in regular court, or pay the tax and be done. Recourse to court can be costly and time consuming, but is often successful.
IRS computers routinely make adjustments to correct mechanical errors in returns. In addition, the IRS conducts an extensive document matching computer program that compares taxpayer amounts of wages, interest, dividends, and other items to amounts reported by taxpayers. These programs automatically issue 30-day letters advising of proposed changes. Only a very small percentage of tax returns are actually examined. These are selected by a combination of computer analysis of return information and random sampling. The IRS has long maintained a program to identify patterns on returns most likely to require adjustment.
Procedures for examination by state and local authorities vary by jurisdiction.
Tax collection
Taxpayers are required to voluntarily pay all taxes owed based on the self-assessed tax returns, as adjusted. The IRS allows taxpayers to extent payment in certain circumstances, and provides time payment plans that include interest and a "penalty" that is merely added interest. Where taxpayers do not pay tax owed, the IRS has strong means to enforce collection. These include the ability to levy bank accounts and seize property. Generally, significant advance notice is given before levy or seizure. However, in certain rarely used jeopardy assessments the IRS may immediately seize money and property. The IRS Collection Divisions are responsible for most collection activities.Statute of limitations
Taxpayers and the IRS are both precluded from changing tax after a certain period of time. Generally, this period is three years from the later of the due date of the original tax return or the date the original return was filed. The IRS has an additional three more years to make changes if the taxpayer has substantially understated gross income. The period under which the IRS may make changes is unlimited in the case of fraud by the taxpayer.Penalties
Taxpayers who fail to file returns, file late, or file returns that are wrong, may be subject to penalties. These penalties vary based on the type of failure. Some penalties are computed like interest, some are fixed amounts, and some are based on other measures. Penalties for filing or paying late are generally based on the amount of tax that should have been paid and the degree of lateness. Penalties for failures related to certain forms are fixed amounts, and vary by form from very small to huge.Intentional failures, including tax fraud, may result in criminal penalties. These penalties may include jail time or forfeiture of property. Criminal penalties are assessed in coordination with the United States Department of Justice
United States Department of Justice
The United States Department of Justice , is the United States federal executive department responsible for the enforcement of the law and administration of justice, equivalent to the justice or interior ministries of other countries.The Department is led by the Attorney General, who is nominated...
.
Constitutional
Article I, Section 8, Clause 1 of the United States Constitution (the "Taxing and Spending ClauseTaxing and Spending Clause
Article I, Section 8, Clause 1 of the United States Constitution, is known as the Taxing and Spending Clause. It is the clause that gives the federal government of the United States its power of taxation...
"), specifies Congress
United States Congress
The United States Congress is the bicameral legislature of the federal government of the United States, consisting of the Senate and the House of Representatives. The Congress meets in the United States Capitol in Washington, D.C....
's power to impose "Taxes, Duties, Imposts and Excises," but Article I, Section 8 requires that, "Duties, Imposts and Excises shall be uniform throughout the United States."
The Constitution specifically limited Congress' ability to impose direct taxes, by requiring Congress to distribute direct taxes in proportion to each state's census population. It was thought that head taxes and property tax
Property tax
A property tax is an ad valorem levy on the value of property that the owner is required to pay. The tax is levied by the governing authority of the jurisdiction in which the property is located; it may be paid to a national government, a federated state or a municipality...
es (slaves could be taxed as either or both) were likely to be abused, and that they bore no relation to the activities in which the Federal government had a legitimate interest. The fourth clause of section 9 therefore specifies that, "No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or enumeration herein before directed to be taken."
Taxation was also the subject of Federalist No. 33
Federalist No. 33
Federalist No. 33 is an essay by Alexander Hamilton, the thirty-third of the Federalist Papers. It was published on January 2, 1788 under the pseudonym Publius, the name under which all the Federalist Papers were published. This is the fourth of seven essays by Hamilton on the then-controversial...
penned secretly by the Federalist Alexander Hamilton
Alexander Hamilton
Alexander Hamilton was a Founding Father, soldier, economist, political philosopher, one of America's first constitutional lawyers and the first United States Secretary of the Treasury...
under the pseudonym
Pseudonym
A pseudonym is a name that a person assumes for a particular purpose and that differs from his or her original orthonym...
Publius. In it, he explains that the wording of the "Necessary and Proper" clause should serve as guidelines for the legislation of laws regarding taxation. The legislative branch is to be the judge, but any abuse of those powers of judging can be overturned by the people, whether as states or as a larger group.
The courts have generally held that direct taxes are limited to taxes on people (variously called "capitation", "poll tax" or "head tax") and property. All other taxes are commonly referred to as "indirect taxes," because they tax an event, rather than a person or property per se. What seemed to be a straightforward limitation on the power of the legislature based on the subject of the tax proved inexact and unclear when applied to an income tax, which can be arguably viewed either as a direct or an indirect tax.
Early Federal income taxes
The first income tax suggested in the United States was during the War of 1812. The idea for the tax was based on the British Tax Act of 1798. The British tax law applied progressive rates to income. The British tax rates were 0.08% on income above £60 and 10% on income above £200. The tax proposal was developed in 1814. Because the treaty of Ghent was signed in 1815, ending hostilities and the need for additional revenue, the tax was never imposed in the United States.In order to help pay for its war effort in the American Civil War
American Civil War
The American Civil War was a civil war fought in the United States of America. In response to the election of Abraham Lincoln as President of the United States, 11 southern slave states declared their secession from the United States and formed the Confederate States of America ; the other 25...
, Congress imposed its first personal income tax in 1861. It was part of the Revenue Act of 1861
Revenue Act of 1861
The Revenue Act of 1861, formally cited as , included the first U.S. Federal income tax statute . The Act, motivated by the need to fund the Civil War , imposed an income tax to be "levied, collected, and paid, upon the annual income of every person residing in the United States, whether such...
(3% of all incomes over US $800). This tax was repealed and replaced by another income tax in 1862.
In 1894, Democrat
History of the United States Democratic Party
The history of the Democratic Party of the United States is an account of the oldest political party in the United States and arguably the oldest democratic party in the world....
s in Congress passed the Wilson-Gorman tariff, which imposed the first peacetime income tax. The rate was 2% on income over $4000, which meant fewer than 10% of households would pay any. The purpose of the income tax was to make up for revenue that would be lost by tariff reductions. Also, the Panic of 1893
Panic of 1893
The Panic of 1893 was a serious economic depression in the United States that began in 1893. Similar to the Panic of 1873, this panic was marked by the collapse of railroad overbuilding and shaky railroad financing which set off a series of bank failures...
is said to have something to do with the passage of Wilson-Gorman.
In 1895 the United States Supreme Court, in its ruling in Pollock v. Farmers' Loan & Trust Co.
Pollock v. Farmers' Loan & Trust Co.
Pollock v. Farmers' Loan & Trust Company, , aff'd on reh'g, , with a ruling of 5–4, was a landmark case in which the Supreme Court of the United States ruled that the unapportioned income taxes on interest, dividends and rents imposed by the Income Tax Act of 1894 were, in effect, direct taxes, and...
, held a tax based on receipts from the use of property to be unconstitutional. The Court held that taxes on rent
Economic rent
Economic rent is typically defined by economists as payment for goods and services beyond the amount needed to bring the required factors of production into a production process and sustain supply. A recipient of economic rent is a rentier....
s from real estate, on interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
income from personal property and other income from personal property (which includes dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
income) were treated as direct taxes on property, and therefore had to be apportioned. Since apportionment of income taxes is impractical, this had the effect of prohibiting a federal tax on income from property. However, the Court affirmed that the Constitution did not deny Congress the power to impose a tax on real and personal property, and it affirmed that such would be a direct tax. Due to the political difficulties of taxing individual wages without taxing income from property, a federal income tax was impractical from the time of the Pollock decision until the time of ratification of the Sixteenth Amendment (below).
Ratification of the Sixteenth Amendment
In response, Congress proposed the Sixteenth AmendmentSixteenth Amendment to the United States Constitution
The Sixteenth Amendment to the United States Constitution allows the Congress to levy an income tax without apportioning it among the states or basing it on Census results...
(ratified by the requisite number of states in 1913), which states:
The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.
The Supreme Court
Supreme Court of the United States
The Supreme Court of the United States is the highest court in the United States. It has ultimate appellate jurisdiction over all state and federal courts, and original jurisdiction over a small range of cases...
in Brushaber v. Union Pacific Railroad
Brushaber v. Union Pacific Railroad
Brushaber v. Union Pacific Railroad, 240 U.S. 1 , was a landmark United States Supreme Court case in which the Court upheld the validity of a tax statute called the Revenue Act of 1913, also known as the Tariff Act, Ch. 16, 38 Stat. 166 Brushaber v. Union Pacific Railroad, 240 U.S. 1 (1916), was a...
, , indicated that the amendment did not expand the Federal government's existing power to tax income (meaning profit or gain from any source) but rather removed the possibility of classifying an income tax as a direct tax on the basis of the source of the income. The Amendment removed the need for the income tax to be apportioned among the states on the basis of population. Income taxes are required, however, to abide by the law of geographical uniformity.
Some tax protester
Tax protester (United States)
A tax protester is someone who refuses to pay a tax on constitutional or legal grounds, typically because he or she believes that the tax laws are unconstitutional or otherwise invalid...
s and others opposed to income taxes cite what they contend is evidence that the Sixteenth Amendment was never properly ratified
Ratification
Ratification is a principal's approval of an act of its agent where the agent lacked authority to legally bind the principal. The term applies to private contract law, international treaties, and constitutionals in federations such as the United States and Canada.- Private law :In contract law, the...
, based in large part on materials sold by William J. Benson. In December 2007, Benson's "Defense Reliance Package
The Law that Never Was
The Law That Never Was: The Fraud of the 16th Amendment and Personal Income Tax is a 1985 book by William J. Benson and Martin J. "Red" Beckman which claims that the Sixteenth Amendment to the United States Constitution, commonly known as the income tax amendment, was never properly ratified...
" containing his non-ratification argument which he offered for sale on the Internet, was ruled by a Federal court to be a "fraud perpetrated by Benson" that had "caused needless confusion and a waste of the customers' and the IRS' time and resources." The court stated: "Benson has failed to point to evidence that would create a genuinely disputed fact regarding whether the Sixteenth Amendment was properly ratified or whether United States Citizens are legally obligated to pay Federal taxes." See also Tax protester Sixteenth Amendment arguments
Tax protester Sixteenth Amendment arguments
Tax protester Sixteenth Amendment arguments are assertions that the imposition of the U.S. federal income tax is illegal because the Sixteenth Amendment to the United States Constitution, which reads "The Congress shall have power to lay and collect taxes on incomes, from whatever source derived,...
.
Modern interpretation of the power to tax incomes
The modern interpretation of the Sixteenth Amendment taxation power can be found in Commissioner v. Glenshaw Glass Co.Commissioner v. Glenshaw Glass Co.
Commissioner v. Glenshaw Glass Co., , was an important income tax case before the United States Supreme Court. The Court held as follows:...
. In that case, a taxpayer had received an award of punitive damages from a competitor for antitrust violations and sought to avoid paying taxes on that award. The Court observed that Congress, in imposing the income tax, had defined gross income
Gross income
Gross income in United States tax law is receipts and gains from all sources less cost of goods sold. Gross income is the starting point for determining Federal and state income tax of individuals, corporations, estates and trusts, whether resident or nonresident."Except as otherwise provided" by...
, under the Internal Revenue Code of 1939
Internal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
, to include:
gains, profits, and income derived from salaries, wages or compensation for personal service . . . of whatever kind and in whatever form paid, or from professions, vocations, trades, businesses, commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property; also from interest, rent, dividends, securities, or the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatever.
(Note: The Glenshaw Glass case was an interpretation of the definition of "gross income" in section 22 of the Internal Revenue Code of 1939. The successor to section 22 of the 1939 Code is section 61 of the current Internal Revenue Code of 1986, as amended.)
The Court held that "this language was used by Congress to exert in this field the full measure of its taxing power", id., and that "the Court has given a liberal construction to this broad phraseology in recognition of the intention of Congress to tax all gains except those specifically exempted."
The Court then enunciated what is now understood by Congress and the Courts to be the definition of taxable income, "instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." Id. at 431. The defendant in that case suggested that a 1954 rewording of the tax code had limited the income that could be taxed, a position which the Court rejected, stating:
The definition of gross income has been simplified, but no effect upon its present broad scope was intended. Certainly punitive damages cannot reasonably be classified as gifts, nor do they come under any other exemption provision in the Code. We would do violence to the plain meaning of the statute and restrict a clear legislative attempt to bring the taxing power to bear upon all receipts constitutionally taxable were we to say that the payments in question here are not gross income.
Tax statutes passed after the ratification of the Sixteenth Amendment in 1913 are sometimes referred to as the "modern" tax statutes. Hundreds of Congressional acts have been passed since 1913, as well as several codifications (i.e., topical reorganizations) of the statutes (see Codification).
In Central Illinois Public Service Co. v. United States, , the U.S. Supreme Court confirmed that wages and income are not identical as far as taxes on income are concerned, because income not only includes wages, but any other gains as well. The Court in that case noted that in enacting taxation legislation, Congress "chose not to return to the inclusive language of the Tariff Act of 1913, but, specifically, 'in the interest of simplicity and ease of administration,' confined the obligation to withhold [income taxes] to 'salaries, wages, and other forms of compensation for personal services'" and that "committee reports ... stated consistently that 'wages' meant remuneration 'if paid for services performed by an employee for his employer'".
Other courts have noted this distinction in upholding the taxation not only of wages, but also of personal gain derived from other sources, recognizing some limitation to the reach of income taxation. For example, in Conner v. United States, 303 F. Supp. 1187 (S.D. Tex. 1969), aff’d in part and rev’d in part, 439 F.2d 974 (5th Cir. 1971), a couple had lost their home to a fire, and had received compensation for their loss from the insurance company, partly in the form of hotel costs reimbursed. The court acknowledged the authority of the IRS to assess taxes on all forms of payment, but did not permit taxation on the compensation provided by the insurance company, because unlike a wage or a sale of goods at a profit, this was not a gain. As the Court noted, "Congress has taxed income, not compensation".
By contrast, other courts have interpreted the Constitution as providing even broader taxation powers for Congress. In Murphy v. IRS
Murphy v. IRS
Marrita Murphy and Daniel J. Leveille, Appellants v. Internal Revenue Service and United States of America, Appellees , is a controversial tax case in which the United States Court of Appeals for the District of Columbia Circuit originally held that the taxation of emotional distress awards by the...
, the United States Court of Appeals for the District of Columbia Circuit upheld the Federal income tax imposed on a monetary settlement recovery that the same court had previously indicated was not income, stating: "[a]lthough the 'Congress cannot make a thing income which is not so in fact,' [ . . . ] it can label a thing income and tax it, so long as it acts within its constitutional authority, which includes not only the Sixteenth Amendment but also Article I, Sections 8 and 9."
Similarly, in Penn Mutual Indemnity Co. v. Commissioner, the United States Court of Appeals for the Third Circuit indicated that Congress could properly impose the Federal income tax on a receipt of money, regardless of what that receipt of money is called:
It could well be argued that the tax involved here [an income tax] is an "excise tax" based upon the receipt of money by the taxpayer. It certainly is not a tax on property and it certainly is not a capitation tax; therefore, it need not be apportioned. [ . . . ] Congress has the power to impose taxes generally, and if the particular imposition does not run afoul of any constitutional restrictions then the tax is lawful, call it what you will.
History of top rates
- In 1913, the top tax rate was 7% on incomes above $500,000 ($10 million 2007 dollars).
- During World War IWorld War IWorld War I , which was predominantly called the World War or the Great War from its occurrence until 1939, and the First World War or World War I thereafter, was a major war centred in Europe that began on 28 July 1914 and lasted until 11 November 1918...
, the top rate rose to 77% and the income threshold to be in this top bracket increased to $1,000,000 ($16 million 2007 dollars); after the war, the top rate was scaled down to a low of 24% and the income threshold for paying this rate fell to a low of $100,000 ($1 million 2007 dollars). - During the Great DepressionGreat DepressionThe Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
and World War IIWorld War IIWorld War II, or the Second World War , was a global conflict lasting from 1939 to 1945, involving most of the world's nations—including all of the great powers—eventually forming two opposing military alliances: the Allies and the Axis...
, the top income tax rate rose from pre-war levels. In 1939, the top rate was 75% applied to incomes above $5,000,000 ($75 million 2007 dollars). During 1944 and 1945, the top rate was its all-time high at 94% applied to income above $200,000. - Since 1964, the threshold for paying top income tax rate has generally been between $200,000 and $400,000. The one exception is the period from 1982–1992 when the top income tax brackets were removed and incomes above around $100,000 (varies by year) paid the top rate. From 1981 until 1986 the top marginal rate was lowered to 50%. From 1988–1990, the threshold for paying the top rate was even lower, with incomes above $29,750 to $32,450 ($51,000 in 2007 dollars) paying the top rate of 28% in those years.
Federal income tax rates
The federal income tax rates have varied widely since 1913. For example, in 1954, the Congress imposed federal income tax on individuals, with the tax imposed in layers of 24 income brackets at tax rates ranging from 20% to 91% (for a chart, see Internal Revenue Code of 1954). The chart on the right shows changes in the federal marginal income tax rate, for the top tax bracket, since 1913.
|
Historical income tax rates (1913–2010)
Historical marginal income tax rates for Married Filing Jointly at stated income levels (not adjusted for inflation). Note that these income levels are not amounts used in the tax laws at the time.! colspan=8 |>
Hauser's Law
Hauser's LawHauser's Law
Hauser's law is the proposition that, in the United States, federal tax revenues since World War II have always been approximately equal to 19.5% of GDP, regardless of wide fluctuations in the marginal tax rate.- Historic tax revenues :...
is a theory by one economist that postulates that in the United States, federal tax revenues will always be equal to approximately 19.5% of gross domestic product
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
(GDP), regardless of what the top marginal tax rate is. From fiscal year 1946 to fiscal year 2007, federal tax receipts as a percentage of GDP averaged 17.9%, with a range of 14.4% to 20.9%. During the years referred to by Hauser (FY 46 to FY 93), the actual average was 17.7%.
Sources of U.S. income tax laws
United States income tax law comes from a number of sources. These sources have been divided into three tiers as follows:- Tier 1
- United States ConstitutionUnited States ConstitutionThe Constitution of the United States is the supreme law of the United States of America. It is the framework for the organization of the United States government and for the relationship of the federal government with the states, citizens, and all people within the United States.The first three...
- Internal Revenue CodeInternal Revenue CodeThe Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
(IRC) (legislative authority, written by the United States CongressUnited States CongressThe United States Congress is the bicameral legislature of the federal government of the United States, consisting of the Senate and the House of Representatives. The Congress meets in the United States Capitol in Washington, D.C....
through legislationLegislationLegislation is law which has been promulgated by a legislature or other governing body, or the process of making it...
) - Treasury regulationsTreasury regulationsTreasury Regulations are the tax regulations issued by the United States Internal Revenue Service , a bureau of the United States Department of the Treasury. These regulations are the Treasury Department’s official interpretations of the Internal Revenue Code and are one source of U.S...
- Federal courtUnited States federal courtsThe United States federal courts make up the judiciary branch of federal government of the United States organized under the United States Constitution and laws of the federal government.-Categories:...
opinions (judicial authority, written by courts as interpretation of legislation) - Treaties (executive authority, written in conjunction with other countries)
- United States Constitution
- Tier 2
- Agency interpretative regulations (executive authority, written by the Internal Revenue ServiceInternal Revenue ServiceThe Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
(IRS) and Department of the TreasuryUnited States Department of the TreasuryThe Department of the Treasury is an executive department and the treasury of the United States federal government. It was established by an Act of Congress in 1789 to manage government revenue...
), including:- Final, Temporary and Proposed Regulations promulgated under IRC § 7805;
- Treasury Notices and Announcements;
- Public Administrative Rulings (IRS Revenue Rulings, which provide informal guidance on specific questions and are binding on all taxpayers)
- Agency interpretative regulations (executive authority, written by the Internal Revenue Service
- Tier 3
- Legislative History
- Private Administrative Rulings (private parties may approach the IRS directly and ask for a Private Letter Ruling on a specific issue – these rulings are binding only on the requesting taxpayer).
Where conflicts exist between various sources of tax authority, an authority in Tier 1 outweighs an authority in Tier 2 or 3. Similarly, an authority in Tier 2 outweighs an authority in Tier 3. Where conflicts exist between two authorities in the same tier, the "last-in-time rule" is applied. As the name implies, the "last-in-time rule" states that the authority that was issued later in time is controlling.
Regulations and case law serve to interpret the statutes. Additionally, various sources of law attempt to do the same thing. Revenue Rulings, for example, serves as an interpretation of how the statutes apply to a very specific set of facts. Treaties serve in an international realm.
The complexity of the U.S. income tax laws
United States tax law attempts to define a comprehensive system of measuring income in a complex economy. Many provisions defining income or granting or removing benefits require significant definition of terms. Further, many state income tax laws do not conform with Federal tax law in material respects. These factors and others have resulted in substantial complexity. Even venerable legal scholars like Judge Learned HandLearned Hand
Billings Learned Hand was a United States judge and judicial philosopher. He served on the United States District Court for the Southern District of New York and later the United States Court of Appeals for the Second Circuit...
have expressed amazement and frustration with the complexity of the U.S. income tax laws. In the article, Thomas Walter Swan, 57 Yale Law Journal
Yale Law Journal
The Yale Law Journal is a student-run law review affiliated with the Yale Law School. Published continuously since 1891, it is the most widely known of the eight law reviews published by students at Yale Law School...
No. 2, 167, 169 (December 1947), Judge Hand wrote:
In my own case the words of such an act as the Income Tax… merely dance before my eyes in a meaningless procession: cross-reference to cross-reference, exception upon exception—couched in abstract terms that offer [me] no handle to seize hold of [and that] leave in my mind only a confused sense of some vitally important, but successfully concealed, purport, which it is my duty to extract, but which is within my power, if at all, only after the most inordinate expenditure of time. I know that these monsters are the result of fabulous industry and ingenuity, plugging up this hole and casting out that net, against all possible evasion; yet at times I cannot help recalling a saying of William James about certain passages of Hegel: that they were no doubt written with a passion of rationality; but that one cannot help wondering whether to the reader they have any significance save that the words are strung together with syntactical correctness.
Complexity is a separate issue from flatness of rate structures. Also, in the United States, income tax laws are often used by legislatures as policy instruments for encouraging numerous undertakings deemed socially useful — including the buying of life insurance, the funding of employee health care and pensions, the raising of children, home ownership, development of alternative energy sources and increased investment in conventional energy. Special tax provisions granted for any purpose increase complexity, irrespective of the system's flatness or lack thereof.
State, local and territorial income taxes
U.S. state
A U.S. state is any one of the 50 federated states of the United States of America that share sovereignty with the federal government. Because of this shared sovereignty, an American is a citizen both of the federal entity and of his or her state of domicile. Four states use the official title of...
s and many localities on individuals, corporations, estates, and trusts. These taxes are in addition to Federal income tax and are deductible for Federal tax purposes. State and local income tax rates vary from 1% to 16% of taxable income. Some state and local income tax rates are flat (single rate) and some are graduated. State and local definitions of what income is taxable vary highly. Some states incorporate the Federal definitions by reference. Taxable income is defined separately and differently for individuals and corporations in some jurisdictions. Some states impose alternative or additional taxes based a second measure of income or capital.
States and localities tend to tax all income of residents. States and localities only tax nonresidents on income allocated or apportioned to the jurisdiction. Generally, nonresident individuals are taxed on wages earned in the state based on the portion of days worked in the state. Many states require partnerships to pay tax for nonresident partners.
Tax returns are filed separately for states and localities imposing income tax, and may be due on dates that differ from Federal due dates. Some states permit related corporations to file combined or consolidated returns. Most states and localities imposing income tax require estimated payments where tax exceeds certain thresholds, and require withholding tax
Withholding tax
Withholding tax, also called retention tax, is a government requirement for the payer of an item of income to withhold or deduct tax from the payment, and pay that tax to the government. In most jurisdictions, withholding tax applies to employment income. Many jurisdictions also require...
on payment of wages.
Puerto Rico
Puerto Rico
Puerto Rico , officially the Commonwealth of Puerto Rico , is an unincorporated territory of the United States, located in the northeastern Caribbean, east of the Dominican Republic and west of both the United States Virgin Islands and the British Virgin Islands.Puerto Rico comprises an...
imposes a separate income tax in lieu of Federal income tax. The unincorporated territories Guam
Guam
Guam is an organized, unincorporated territory of the United States located in the western Pacific Ocean. It is one of five U.S. territories with an established civilian government. Guam is listed as one of 16 Non-Self-Governing Territories by the Special Committee on Decolonization of the United...
, American Samoa
American Samoa
American Samoa is an unincorporated territory of the United States located in the South Pacific Ocean, southeast of the sovereign state of Samoa...
, and the Virgin Islands also impose income tax separately, under a "mirror" tax law based on Federal income tax law.
Simplification movement in the 2000s
In 2005, the President's Advisory Panel for Federal Tax ReformPresident's Advisory Panel for Federal Tax Reform
On January 7, 2005, President George W. Bush announced the establishment of the President's Advisory Panel for Tax Reform, a bipartisan panel to advise on options to reform the United States income tax code to make it simpler, fairer, and more pro-growth to benefit all Americans.On November 1,...
criticized the tax system as being extremely complex, requiring detailed record-keeping, lengthy instructions, and complicated schedules, worksheets, and forms. They stated that it penalizes work, discourages saving and investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
, and hinders the competitiveness of American business. "The tax code is commonly riddled with provisions that treat similarly situated taxpayers differently and create perceptions of unfairness." The panel's major reform push was for the removal of the Alternative Minimum Tax
Alternative Minimum Tax
The Alternative Minimum Tax is an income tax imposed by the United States federal government on individuals, corporations, estates, and trusts. AMT is imposed at a nearly flat rate on an adjusted amount of taxable income above a certain threshold . This exemption is substantially higher than the...
, which is not indexed for inflation.
Several organizations and individuals are working for tax reform in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
including Americans for Tax Reform
Americans for Tax Reform
Americans for Tax Reform is an advocacy group and taxpayer group whose stated goal is "a system in which taxes are simpler, flatter, more visible, and lower than they are today. The government's power to control one's life derives from its power to tax...
, Citizens for an Alternative Tax System
Citizens for an Alternative Tax System
Citizens for an Alternative Tax System is a national tax reform public interest group in the United States. Their Las Vegas chapter proposes, "...that Congress should eliminate the IRS and all income taxes, corporate and personal; estate, gift and inheritance taxes, plus many excise taxes;...
, Americans For Fair Taxation
Americans For Fair Taxation
Americans For Fair Taxation , also known as FairTax.org, states it is the United States' largest, single-issue grassroots organization and taxpayers union dedicated to fundamental tax code replacement...
, and FreedomWorks
FreedomWorks
FreedomWorks is a conservative non-profit organization based in Washington D.C., United States. FreedomWorks trains volunteers, assists in campaigns, and encourages them to mobilize, interacting with both fellow citizens and their political representatives....
. Various proposals have been put forth for tax simplification in Congress including the Fair Tax Act and various Flat tax
Flat tax
A flat tax is a tax system with a constant marginal tax rate. Typically the term flat tax is applied in the context of an individual or corporate income that will be taxed at one marginal rate...
plans.
Alternatives
Proponents of a consumption taxConsumption tax
A consumption tax is a tax on spending on goods and services. The tax base of such a tax is the money spent on consumption. Consumption taxes are usually indirect, such as a sales tax or a value added tax...
argue that the income tax system creates perverse incentive
Perverse incentive
A perverse incentive is an incentive that has an unintended and undesirable result which is contrary to the interests of the incentive makers. Perverse incentives are a type of unintended consequences.- Examples :...
s by encouraging taxpayers to spend rather than save: a taxpayer is only taxed once on income spent immediately, while any interest earned on saved income is itself taxed. To the extent that this is considered unjust, it may be remedied in a variety of ways, e.g. excluding investment income from taxable income, making investments deductible and therefore only taxing them when gains are realized, or replacing the income tax by other forms of tax, such as a sales tax.
Tax as theft
Strict libertariansLibertarianism
Libertarianism, in the strictest sense, is the political philosophy that holds individual liberty as the basic moral principle of society. In the broadest sense, it is any political philosophy which approximates this view...
believe in a natural right
Human rights
Human rights are "commonly understood as inalienable fundamental rights to which a person is inherently entitled simply because she or he is a human being." Human rights are thus conceived as universal and egalitarian . These rights may exist as natural rights or as legal rights, in both national...
to property (money being a representation of a person's property), and that no individual, including institutions composed of individuals, can take another individual's property without their permission. Some holders of this view say that the only way government can enforce its power is through coercion; thus, such individuals may view taxation as equivalent to theft. Some believe income taxation offers the federal government a technique to diminish the power of the states, because the federal government is then able to distribute funding to states with conditions attached, often giving the states no choice but to submit to federal demands. Although many libertarians view all taxes as undesirable, the question of whether or not taxation is nevertheless necessary is up for debate among libertarians. However, in general the libertarian philosophy prefers local government over less-local government; thus a federal tax is by some viewed as the worst kind of tax.
Tax protestors
Numerous tax protester argumentsTax protester arguments
Tax protester arguments are a number of objections raised by individuals who deny that a person has a legal obligation to pay a tax for which the United States government has determined that person is liable....
have been raised asserting that the federal income tax is unconstitutional, including discredited claims that the Sixteenth Amendment was not properly ratified. All such claims have been repeatedly rejected by the federal courts as frivolous
Frivolous litigation
In law, frivolous litigation is the practice of starting or carrying on law suits that, due to their lack of legal merit, have little to no chance of being won. The term does not include cases that may be lost due to other matters not related to legal merit...
.
Distribution
In the United States, a progressive tax systemProgressive tax
A progressive tax is a tax by which the tax rate increases as the taxable base amount increases. "Progressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from low to high, where the average tax rate is less than the marginal tax rate...
is employed which equates to higher income earners paying a larger percentage of their income in taxes. According to the IRS, the top 1% of income earners for 2008 paid 38% of income tax revenue, while earning 20% of the income reported. The top 5% of income earners paid 59% of the total income tax revenue, while earning 35% of the income reported. The top 10% paid 70%, earning 46% and the top 25% paid 86%, earning 67%. The top 50% paid 97%, earning 87% and leaving the bottom 50% paying 3% of the taxes collected and earning 13% of the income reported.
A 2008 OECD
Organisation for Economic Co-operation and Development
The Organisation for Economic Co-operation and Development is an international economic organisation of 34 countries founded in 1961 to stimulate economic progress and world trade...
study ranked 24 OECD nations by progressiveness of taxes and separately by progressiveness of cash transfers, which include pensions, unemployment and other benefits. The United States had the highest concentration coefficient in income tax, a measure of progressiveness, before adjusting for income inequality. The United States was not at the top of either measure for cash transfers. Adjusting for income inequality, Ireland had the highest concentration coefficient for income taxes. Overall income tax rates for the US are below the OECD average.
See also
- Capital gains tax in the United StatesCapital gains tax in the United StatesIn the United States, individuals and corporations pay income tax on the net total of all their capital gains just as they do on other sorts of income. Capital gains are generally taxed at a preferential rate in comparison to ordinary income...
- Corporate tax in the United StatesCorporate tax in the United StatesCorporate tax is imposed in the United States at the Federal, most state, and some local levels on the income of entities treated for tax purposes as corporations. Federal tax rates on corporate taxable income vary from 15% to 35%. State and local taxes and rules vary by jurisdiction, though many...
- FairTaxFairTaxThe FairTax is a tax reform proposal for the federal government of the United States that would replace all federal taxes on personal and corporate income with a single broad national consumption tax on retail sales. The Fair Tax Act would apply a tax once at the point of purchase on all new goods...
- Federal tax revenue by stateFederal tax revenue by stateThis is a table of the total federal tax revenue by state collected by the U.S. Internal Revenue Service in 2007.Gross collections indicates the total federal tax revenue collected by the IRS from each U.S. state, the District of Columbia, and Puerto Rico. The figure includes all individual and...
- Flat TaxFlat taxA flat tax is a tax system with a constant marginal tax rate. Typically the term flat tax is applied in the context of an individual or corporate income that will be taxed at one marginal rate...
- Internal Revenue Code § 212 – tax deductibility of investment expenses.
- Payroll taxes in the United States
- Progressive taxProgressive taxA progressive tax is a tax by which the tax rate increases as the taxable base amount increases. "Progressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from low to high, where the average tax rate is less than the marginal tax rate...
- Sales taxes in the United StatesSales taxes in the United StatesThere is no federal sales or use tax in the United States. 45 states and the District of Columbia impose sales and use taxes on the retail sale, lease and rental of many goods, as well as some services. Many cities, counties, transit authorities and special purpose districts impose additional local...
- State income taxState income taxState and local income taxes are imposed in addition to Federal income tax. State income tax is allowed as a deduction in computing Federal income tax, subject to limitations for individuals. Some localities impose an income tax, often based on state income tax calculations. Forty-three states...
- State tax levelsState tax levelsState tax levels indicate both the tax burden and the services a state can afford to provide residents.States use a different combination of sales, income, excise taxes, and user fees, some imposed directly on residents and other imposed indirectly...
- Tax DayTax DayIn the United States, Tax Day is a colloquial term for the day on which individual income tax returns are due to the federal government. The term may also refer to the same day for states, even where the tax return due date is a different day....
- Tax preparationTax preparationTax preparation is the process of preparing tax returns, often income tax returns, often for a person other than the taxpayer, and generally for compensation. Tax preparation may be done by the taxpayer with or without the help of tax preparation software and online services...
- Tax protesterTax protester (United States)A tax protester is someone who refuses to pay a tax on constitutional or legal grounds, typically because he or she believes that the tax laws are unconstitutional or otherwise invalid...
- Taxation in the United StatesTaxation in the United StatesThe United States is a federal republic with autonomous state and local governments. Taxes are imposed in the United States at each of these levels. These include taxes on income, property, sales, imports, payroll, estates and gifts, as well as various fees.Taxes are imposed on net income of...
- Taxation of illegal income in the United StatesTaxation of illegal income in the United StatesIn the United States, the Internal Revenue Code was enacted by the U.S. Congress in part for the purpose of taxing net income. The Code is not a mechanism for enforcing other codes of law, for example, criminal law...
- Tax resister
- US State NonResident Withholding Tax
Additional reading
Government sources:- IRS Publication 17, Your Federal Income Tax
- IRS Publication 334, Tax Guide for Small Business
- IRS Publication 509, Tax Calendar
- IRS Publication 541, Partnerships
- IRS Publication 542, Corporations
- IRS Publicatoin 544, Sales and Other Dispositions of Assets
- IRS Publication 556 Examination of Returns, Appeal Rights, and Claims for Refund
- IRS Publications by topic
IRS videos on tax topics
Law & regulations:
Standard texts (updated annually):
- Pratt, James W.; Kulsrud, William N.; et al, Federal Taxation", updated periodically. 2010 edition ISBN 978-1424069866 (cited above as Pratt & Kulsrud 2005).
- Whittenberg, Gerald; and Altus-Buller, Martha, Income Tax Fundamentals 2010, ISBN 9781439044094
- Willis, Eugene; Hoffman, William H. Jr.; et al, South-Western Federal Taxation, published annually. 2009 edition included ISBN 973-0-324-66060-0 (student) and ISBN 978-0-324-66208-5 (instructor).
Reference works (annual):
- CCH U.S. Master Tax Guide, 2010 ISBN 978-0808021698
- RIA Federal Tax Handbook 2010 ISBN 978-0781104173
Popular publications (annual):
- J.K. Lasser's Your Income Tax for 2010 ISBN 978-0470447116