Income taxes in the United States are an enormous and complex issue. Corporate taxes in the United States are progressive taxes. A progressive tax is a tax in which the tax rate increases as the taxable amount increases. To fully understand the effect of tax deductions, we must consider the marginal tax rate, which is the amount of additional tax paid for each additional dollar earned. The marginal tax rate is dependent upon a jurisdiction’s tax structure, usually referred to as tax brackets.
Business taxation differs depending upon the legal form of the business. Which legal form to take is driven by the objectives of the company, but taxation also plays a vital role. Tax law contains built-in trade-offs for each business form, and companies often must give up some liability protection or flexibility.
This list describes the tax treatment of different types of businesses in the United States:
Sole proprietorship: A sole proprietor reports all income and expenses for the business on their personal income tax statement. The business is not taxed as a separate entity. Thus, all income is taxed as personal income.
Partnership: For tax purposes, partnerships are treated similarly to a sole proprietorship—the owners pay personal income tax on their distributive share of the business’s taxable income. The partners’ distributive shares represent the allocation among them under the partnership agreement.
C corporation: A C corporation refers to any corporation that is taxed separately from its owners. Most of the largest companies in the United States are C corporations. The earnings of a C corporation are taxed at both the entity level and the individual level.
S corporation: The S corporation is a hybrid entity wherein the income, deductions, and tax credits of the business are taxed at the shareholder level as opposed to the entity level.
Limited liability company (LLC): An LLC is considered a pass-through entity, which means the LLC itself does not pay federal income taxes on business income. Instead, income “passes through” to individual members of the LLC, who pay federal income tax earned from the LLC via their own individual tax returns. LLCs filing partnership returns pay self-employment tax on their share of partnership earnings. If the LLC is a corporation, normal corporate tax rules will apply.
IN CONTEXT
In the United States, taxable income for a corporation is defined as all gross income less allowable tax deductions and tax credits. This income is taxed at a specified corporate tax rate. This rate varies by jurisdiction and is generally the same for different types of income. Some systems have graduated tax rates—corporations with lower levels of income pay a lower rate of tax—or impose tax at different rates for different types of corporations.
In the United States, federal rates range from 15% to 35%. States charge rates ranging from 0% to 10%, deductible in computing federal taxable income. Some cities charge rates up to 9%, also deductible in computing federal taxable income. Corporations are also subject to property tax, payroll tax, withholding tax, excise tax, customs duties, and value-added tax. However, these are rarely referred to as “corporate tax.”
terms to know
Progressive Tax
A tax in which the tax rate increases as the taxable amount increases.
Marginal Tax Rate
The amount of additional tax paid for each additional dollar earned.
Jurisdiction
The limits or territory within which authority may be exercised.
Distributive Share
The allocation of income and expenses among partners under a partnership agreement.
Pass-Through Entity
A type of business structure that does not pay federal income taxes itself on business income; the tax responsibility is passed on to the business owners.
2. Tax Deductions
A tax deduction is a sum that can be removed from tax calculations. Specifically, it is a reduction of the income subject to tax. Often, these deductions are subject to limitations or conditions.
Expenses incurred in order to generate profit for a company are referred to as business expenses. These can be categorized into cost of goods sold and ordinary expenses—also known as trading or necessary expenses.
Cost of goods sold: Nearly all income tax systems allow a deduction for the cost of goods sold. This can be considered an expense or simply a reduction in gross income, which is the starting point for determining federal and state income tax. Several complexities must be factored in when determining the cost of goods sold, including assigning a dollar amount to a good/service when it is difficult to assign value, deciding which period costs will be recognized, and determining whether costs of goods not sold or those that have been depreciated will be recorded.
Ordinary expenses: According to tax law, the United States allows as a deduction “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business . . . .” Generally, this business must be regular, continuous, substantial, and entered into with an expectation of profit. Ordinary and necessary expenses tend to be those that are appropriate to the nature of the business, the sort expected to help produce income and promote the business, and those that are not lavish and extravagant.
EXAMPLE
An ordinary expense could be interest paid on debt or interest expense incurred by a corporation in carrying out its trading activities. Such an expense comes with limitations, though, such as limiting the amount of deductible interest that can be paid to related parties.
Other types of expenses, such as nonbusiness expenses, may be tax deductible as well. A loss recognized on a nonbusiness asset is typically classified as a capital loss. This can have an impact on one’s realized capital gains and must be accounted for appropriately.
Corporate taxes in the United States are considered to be progressive. That is to say, taxes are charged at a higher rate as income grows. To fully understand the effect of tax deductions, we must consider the marginal tax rate, which is the rate of tax paid on the next or last unit of currency of taxable income. The marginal tax rate is dependent upon a jurisdiction’s tax structure, usually referred to as tax brackets. To determine the after-tax cost of a deductible expense, we simply multiply the cost by one minus the appropriate marginal tax rate.
Tax deductions and tax credits are often incorrectly equated. While a tax deduction is a reduction of the level of taxable income, a tax credit is a sum deducted from the total amount of tax owed. It is a dollar-for-dollar tax saving. Tax credits may be granted in recognition of taxes already paid, as a subsidy, or to encourage investment or other behaviors.
EXAMPLE
A tax credit of $1,000 reduces taxes owed by $1,000, regardless of the marginal tax rate. A tax deduction reduces a corporation’s income by $1,000, saving it the amount of its marginal rate.
To determine the tax saving of deductible expense, we simply multiply the tax deduction by the marginal tax rate. For instance, if the marginal tax rate of a corporation is 28%, and they have a tax deduction of $1,000, they will have a tax saving of $1,000 × 28%, or $280.
try it
A corporation is weighing either a one-time tax credit of $3,000 it would receive for purchasing an electric cart to use in its production facility or a depreciation tax deduction of $2,000 for the next 4 years if it buys a gas-powered cart.
Tax credit: Reduces overall taxable income by $3,000 for 1 year Tax deduction: Reduces overall taxable income by $2,000 over 4 years
Year 1: $2,000 × 25% = $500 tax saving
Year 2: $2,000 × 25% = $500 tax saving
Year 3: $2,000 × 25% = $500 tax saving
Year 4: $2,000 × 25% = $500 tax saving
In this case, taking the tax credit offers the corporation a better tax benefit.
A tax credit may be granted in recognition of taxes already paid, as a subsidy, or to encourage investment or other behaviors.
terms to know
Capital Gains
Profits that result from the disposition of capital assets, such as stocks, bonds, or real estate due to arbitrage.
Tax Deduction
A reduction of the level of taxable income.
Tax Credit
A sum deducted from the total amount of tax owed.
3. Depreciation
According to the IRS, depreciation is an annual income tax deduction that allows businesses to recover the cost or other basis of certain property over the time the property is used. Depreciation is considered an expense on the income statement and reduces the book value of an asset in the balance sheet, although there is no actual cash outlay. The IRS allows depreciation as an incentive for companies to invest in certain plant assets. Depreciation reduces net income, which reduces overall tax liability. Calculating depreciation begins with estimating the useful life of the asset and then calculating the corresponding depreciation rate that will result in extinguishing the value of the asset from the books when the estimated useful life ends. There are several methods used to calculate depreciation. It is up to corporations to choose which method works best for them.
Straight-line method: This method reduces the book value of an asset by the same amount each period. This amount is determined by dividing the total value of the asset, less its salvage value, by the number of periods in its useful life. This amount is then deducted from the income in each applicable period. Straight-line depreciation is the simplest and most often used technique.
formula to know
Straight-Line Depreciation
Declining balance method: This method provides for higher depreciation expenses in the earlier years of an asset’s life and gradually decreases expenses in subsequent years. Under this method, the annual depreciation expense is found by multiplying the book value of the asset each year by a fixed rate. Since the book value will differ from year to year, the annual depreciation expense will subsequently differ. Since the declining balance method will never fully amortize the original cost of the asset, the salvage value is not considered in determining the annual depreciation.
formula to know
Declining Balance Depreciation Rate
Declining Balance Depreciation Amount
hint
Some businesses use a similar method of depreciation called double-declining balance. This method doubles the declining balance depreciation rate, which accelerates the depreciation of an asset even faster than the declining balance. It is calculated by dividing 2 by the useful life of the asset. Double-declining balance enables a business to reduce its net income by large amounts in the early years of an asset’s life and less as the asset grows older.
Activity depreciation methods: Activity depreciation methods are not based on time but on a level of activity. When the asset is acquired, its life is estimated in terms of this level of activity. This could be the number of miles driven by a vehicle or a cycle count for a machine. Each year, the depreciation expense is calculated by multiplying the rate by the actual activity level. The most common activity depreciation method is the units of production method.
formula to know
Units of Production Depreciation Rate Per Unit
Units of Production Depreciation Expense
big idea
Depreciation expense affects net income in each period of an asset’s useful life. Therefore, it can be deducted from taxes owed in each of these periods. In other words, depreciation allows a company to properly identify the amount of income it generates in a given period. As with all expenses, a dollar of taxes that a company can defer until later is a dollar that can be used in profit-generating operations today.
terms to know
Depreciation
An annual income tax deduction that allows businesses to recover the cost or other basis of certain property over the time the property is used.
Salvage Value
The estimated value of an asset at the end of its useful life.
Amortize
To wipe out a debt, liability, and so on, gradually or in installments.
4. Individual Taxes
In the United States, there is a broad variety of state, local, and federal taxes that must be taken into account. Here is a chart that depicts the level of tax received by the U.S. federal government from each source in 2010:
In the United States, income taxes are a major source of federal revenue, funding essential government services and programs. These taxes are levied on the income of individuals, businesses, and other entities by federal, state, and sometimes local governments. The federal income tax system, administered by the IRS, is progressive, meaning that tax rates increase as income increases.
The federal income tax applies to all forms of income, including wages, salaries, investments, and other earnings. Taxpayers must file an annual tax return to report their income and calculate their tax liability, based on their filing status. The tax code provides various deductions, credits, and exemptions to reduce taxable income, including these:
Medical expenses
State and local income and property taxes
Interest expense on certain home loans
Gifts of money or property to qualifying charitable organizations, subject to certain maximum limitations
Losses on non-income-producing property due to casualty/theft
Contribution to certain retirement or health savings plans
Certain educational expenses
Federal income tax rates are divided into brackets, each with a specific tax rate. The tax liability is calculated progressively, meaning different portions of income are taxed at different rates.
In addition to federal income taxes, many states and localities impose their own income taxes. State income tax systems can vary widely. Some states have a flat tax rate, while others have progressive rates similar to the federal system. A few states, like Florida and Texas, do not have a state income tax at all.
term to know
Filing Status
A status defining the type of tax return form an individual will use, which is based on marital status and family situation.
4b. Other Taxes
Other individual taxes include the following:
Payroll taxes: Payroll taxes are imposed on employers and employees and on various compensation bases. These include income tax withholding, Social Security and Medicare taxes, and unemployment taxes.
Sales tax: Sales tax is an indirect tax levied at the state level, including taxes on retail sales, lease and rental of goods, as well as some services. Many cities, counties, transit authorities, and special-purpose districts impose an additional local sales tax. Sales tax is calculated as the purchase price times the appropriate tax rate. Tax rates vary widely by jurisdiction, from less than 1% to over 10%. Nearly all jurisdictions provide numerous categories of goods and services that are exempt from sales tax or taxed at a reduced rate.
Property tax: Most jurisdictions below the state level impose a tax on interests in real property (land, buildings, and permanent improvements). Property tax is based on the fair market value of the subject property. The amount of tax is determined annually based on the market value of each property on a particular date. The tax is computed as the determined market value times an assessment ratio times the tax rate.
Estate and gift taxes: The estate tax is an excise tax levied on the right to pass property at death. It is imposed on the estate, not the beneficiary. Gift taxes are levied on the giver (donor) of property, where the property is transferred for less than adequate consideration. The federal gift tax is computed based on cumulative taxable gifts and is reduced by prior gift taxes paid. The federal estate tax is computed on the sum of taxable estate and taxable gifts and is reduced by prior gift taxes paid. These taxes are computed as the taxable amount times a graduated tax rate (up to 35%). The taxable values of estates and gifts are the fair market value.
summary
In this lesson, you learned about business taxation and received a brief overview of the tax treatment of different types of businesses in the United States. Corporations pay many different kinds of taxes but benefit from tax deductions for business expenses incurred in order to generate a profit. Tax deductions, not to be confused with tax credits, reduce corporate taxable income. Depreciation expenses also reduce taxable income and may be calculated through the straight-line method, the declining balance method, or activity depreciation methods. Individual taxes in the United States comprise the largest source of income for the government and take the form of income taxes and other taxes like payroll taxes, sales tax, property tax, and gift and estate taxes.
To wipe out a debt, liability, and so on, gradually or in installments.
Capital Gains
Profits that result from the disposition of capital assets, such as stocks, bonds, or real estate, due to arbitrage.
Depreciation
An annual income tax deduction that allows businesses to recover the cost or other basis of certain property over the time the property is used.
Distributive Share
The allocation of income and expenses among partners under a partnership agreement.
Filing Status
A status defining the type of tax return form an individual will use, which is based on marital status and family situation.
Jurisdiction
The limits or territory within which authority may be exercised.
Marginal Tax Rate
The amount of additional tax paid for each additional dollar earned.
Pass-Through Entity
A type of business structure that does not pay federal income taxes itself on business income; the tax responsibility is passed on to the business owners.
Progressive Tax
A tax in which the tax rate increases as the taxable amount increases.
Salvage Value
The estimated value of an asset at the end of its useful life.
