Federal Income Tax

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In the United States both, individuals and businesses are taxed by the U.S. federal government at varying rates depending on their income levels. The United States government, like many governments around the world, depends on federal income taxes to pay for the services that it provides for its constituents such as roads, schools and defense, in addition to funding its basic operations. During its 2007 fiscal year, the federal government collected 1.5 trillion dollars in corporate and individual income taxes (excluding social security and Medicare and other payroll taxes. [1]

Personal Income Tax

The federal government taxes individuals based on their total income for the year. Sources of taxable income include wages, dividends from stocks, gains from the sale of stock and unearned income (gifts over a certain amount). The filer adds up all of his sources of income to determine his or her gross income. He or she then applies any relevant tax deductions in order to come up with his taxable income (the actual amount that he or she pays taxes on).

Alternative Minimum Tax

The alternative minimum tax (AMT) was established in 1969 with the goal of ensuring that the wealthy would not be able to avoid paying taxes by claiming excessive tax deductions. The AMT, however, was not indexed for inflation and as American incomes have risen with inflation, the AMT has expanded to include millions of middle class families over the last 2 decades. If a filer makes over $75,000 per year, then he or she may be subject to the AMT. The AMT uses a different formula than the regular tax code to determine how much an individual owes in taxes. This formula uses a stricter interpretation of taxable income and allows for far fewer deductions. If the tax owed, as calculated by the AMT, is higher than than the tax liability calculated using that standard tax formula, then the filer must pay the AMT instead. The AMT is 26% for the first 87,500 in taxable income and 28% on any additional income. [2]

Capital Gains Tax

When an individual buys an asset such as a stock, bond or piece of real estate, the difference between, what the he or she paid for asset and the final sales prices is a capital gain. Taxes on capital gains can differ significantly from regular income taxes. Capital gains taxes for stocks, in particular, are lower than taxes on regular income if the filer has held the stock for over a year. These capital gains are classified as long-term.

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%

Unless further legislation is enacted by Congress, at the end of 2008, capital gains rates will revert to their pre-2003 levels. Tax payers in the 10% and 15% ordinary income brackets will have to pay a capital gains tax of 15% and those in the 25%+ tax bracket will have to pay 20%. [3] £££££££££££

Corporate Tax

Unlike individuals who pay taxes based on their income before most expenses, corporations pay taxes on their profits (revenue -expenses). The tax rate for a corporation varies based on the amount of profit it generates in a given year (See chart below). Corporations can also deduct losses for previous years to lower their tax burden.

Taxable Income ($) Tax Rate [4]
0 to 50,000 15%
50,000 to 75,000 25%
75,000 to 100,000 34%
100,000 to 335,000 39%
335,000 to 10,000,000 34%
10,000,000 to 15,000,000 35%
15,000,000 to 18,333,333 38%
18,333,333 and up 35%

C corporation vs. S corporation (sometimes smaller is better)

The C corp is the most common type corporation. Most large corporations fall under this classification. In 1958, however, the federal government approved a new type of classifcation for corporations: One of the main differences between S-corps is that they do not pay corporate income taxes. Instead the individual shareholders of the corporation are taxed on the company's profits based on their individual tax rates, regardless of whether they receive a distribution. This can result in significant tax savings, since the income is only taxed once in this case. Under the typical C corporation the corporation's earnings are taxed first and shareholders are taxed on any dividend distributions made.

Alternative Minimum Tax

As mentioned before, corporations only pay taxes on their profits. This means that they are able to deduct all or most business expenses in order to determine their taxable income. To ensure that corporations pay at least a minimum amount in taxes, the U.S. government established a corporate alternative minimum tax. This tax uses a different calculation to determine the amount of taxes that a company owes.The AMT tax rate for corporations is 20%. [5] When determining what to pay in taxes, a corporation must calculate its AMT and its normal tax rate and pay whichever is higher.

Social Security and Medicare Tax

In addition to the standard personal and corporate income taxes, the federal government also levies social security and medicare taxes on both coporations and individuals. The total social security tax is 12.4% of an employees wages. The employer pays 6.2% and the employee pays the other 6.2%.[6] In 2008, Social Security taxes were only applicable to the first $102,000 of income. [7] In 2009, the amount of income that is taxable will increase to 106,800.

Medicare tax works in much the same way. The total tax is 2.9%, with the employee and employer each paying 1.45%. There is no cap on the amount of an employee's income that is subject to Medicare taxes.

References

  1. Tax Policy Center
  2. Smartmoney.com Alternative Minimum Tax Article, January 9, 2008
  3. Dividends and Capital Gains Planning After the 2003 Tax Act, The CPA Journal
  4. [1]
  5. The Perfect Target for Tax Reform: The Corporate AMT, Heritage.org April, 12, 2005
  6. Social Security and Medicare Rates, SocialSecurity.gov
  7. Contribution and Benefit base, SocialSecurity.gov
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