US Taxation Basics

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Basics

Federal government receipts by source, 2010.^[1]

A tax is imposed on net taxable income in the United States by the federal, most state, and some local governments.^[2] Income tax is imposed on individuals, corporations, estates, and trusts.^[3] 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. 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 2013 varied from 10% to 39.6%.^[4]
From 2003 through 2011, 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.
Taxable income: is defined in a comprehensive manner in the Internal Revenue Code and regulations^[5] issued by the Department of Treasury and the Internal Revenue Service. Taxable income is gross income as adjusted minus tax deductions. 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 dividends 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.

Federal receipts by source as share of total receipts (1950-2010). Individual income taxes (blue), payroll taxes/FICA (green), corporate income taxes (red), excise taxes (purple), estate and gift taxes (light blue), other receipts (orange).

 

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.
Business deductions: 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.
Personal deductions: Individuals are allowed several nonbusiness deductions. A flat amount per person is allowed as a deduction for personal exemptions. For 2014 this amount is $3,950. Taxpayers are allowed one such deduction for themselves and one for each person they support.
Standard deduction: In addition, individuals get a deduction from taxable income for certain personal expenses. Alternatively, the individual may claim a standard deduction. For 2014, the standard deduction is $6,200 for single individuals, $12,400 for a married couple, and $9,100 for a head of household. Note that the standard deduction is higher for individuals born before January 2, 1949 or who are blind.
Itemized deductions: Those who choose to claim actual itemized deductions may deduct the following, subject to many conditions and limitations:

• Medical expenses in excess of 10% 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: and qualified dividends 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.

Total U.S. Tax Revenue as a % of GDP and Income Tax Revenue as a % of GDP, 1945-2011, from Office of Management and Budget Historicals

Tax credits: 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.
Alternative Minimum Tax: 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.
Tax returns: Most individuals must file income tax returns in each year their income exceeds the standard deduction plus one personal exemption. However, some taxpayers must file an income tax return because they satisfy one of the following conditions:

• Taxpayer owes any special taxes such as the Alternative Minimum Tax
• Taxpayer received any HSA, Archer MSA, or Medicare Advantage MSA distributions
• Taxpayer had net earnings from self-employment of at least $400
• Taxpayer had wages of $108.28 or more from a church or qualified church-controlled organization that is exempt from employer social security and Medicare taxes

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.
Tax payment: Taxpayers must pay income tax due without waiting for an assessment. Many taxpayers are subject to withholding taxes when they receive income. To the extent withholding taxes do not cover all taxes due, all taxpayers must make estimated tax payments.
Tax penalties: 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 three years).