Income Tax

An income tax is a tax whose base is income: the money and other value a person or business receives over a period, typically a year, minus what the law allows to be subtracted. The federal income tax is the largest U.S. tax of this kind. It applies to individuals, corporations, estates and trusts under Subtitle A of the Internal Revenue Code, titled "Income Taxes", and is administered by the IRS.

The constitutional basis is the Sixteenth Amendment, ratified in 1913: "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 words "without apportionment" are the point: they free an income tax from the Constitution's rule that direct taxes be divided among the states by population.

How it differs from other taxes. Tax systems can tax income, consumption, property or transfers. A sales tax is triggered by a purchase, a property tax by ownership of real estate or other property, and the gift and estate taxes by transfers of wealth. An income tax looks at flows over a year: wages, business profits, interest, dividends, rents, retirement distributions and gains from selling property, measured whether the money was spent or saved.

Who pays it. Individuals file Form 1040 and pay on their taxable income at progressive rates, so higher slices of income are taxed at higher rates. A regular corporation pays its own income tax, at a flat 21% under section 11(b), and its shareholders pay again on dividends. Partnerships, S corporations, and limited liability companies taxed as partnerships or disregarded entities generally pay no federal income tax themselves; their income passes through to the owners' returns. Estates and trusts pay on income they keep, using their own compressed rate schedule, while income they distribute is generally taxed to the beneficiaries.

What it is charged on. The tax is charged on taxable income, not on every dollar received. Gross income includes income "from whatever source derived", but the law then excludes some items (municipal bond interest, gifts received, most life insurance proceeds), allows some deductions in arriving at adjusted gross income, and then subtracts either the standard deduction or itemized deductions. Credits then reduce the tax itself. The Taxes pillar walks through the computation, including how brackets work.

What is in the same subtitle and what is not. Subtitle A also contains the tax on self-employment income and the 3.8% net investment income tax, which are figured on the individual income tax return. The Social Security tax and the Medicare tax withheld from wages are in a different part of the Code, Subtitle C, "Employment Taxes". They apply to wages (the Social Security tax only up to an annual wage base), with no deductions or brackets of the income tax kind. So a person can owe payroll tax on wages while owing no income tax at all.

States and localities. States set their own income taxes under their own laws, with their own rates, deductions and credits, and they differ on whether to levy one at all. A state return may start from a federal figure such as adjusted gross income, but the federal definition does not bind the state. Some cities, counties and school districts levy a local income tax as well, often based on where a person works.

Pay as you go. The federal income tax is collected during the year, through withholding from wages and pensions and through quarterly estimated payments on other income, and reconciled when the annual return is filed. Underpaying during the year can produce a penalty even when the balance is paid on time in April.

1. Add up income. Wages, business profit, interest, dividends, rents, taxable retirement distributions and gains from sales make up gross income, less any items the law excludes.

2. Subtract deductions. Adjustments such as deductible IRA and HSA contributions produce adjusted gross income. Then the standard deduction or itemized deductions, and certain other deductions, produce taxable income.

3. Apply the rates. For an individual, each band of taxable income is taxed at its own rate; long-term capital gains and qualified dividends have their own lower rates.

4. Subtract credits and add other taxes. Credits reduce the tax directly. Self-employment tax and the net investment income tax are added on the same return.

5. Compare with what was paid. Withholding and estimated payments are credited, producing a refund or a balance due.

An example of what falls inside and outside it: during the year Ravi earns an $80,000 salary, $1,000 of bank interest and a $4,000 long-term gain on stock he sells, and his parents give him $15,000 toward a home. His gross income for the income tax is $85,000 ($80,000 plus $1,000 plus $4,000); the gift is not income to him. Payroll taxes (the Social Security tax and the Medicare tax) apply only to the $80,000 of wages, and his sales and property taxes are separate levies on what he buys and owns.

Pros

• Taxing income, with rates that rise as income rises, ties what people pay to their ability to pay more closely than a tax on purchases does.
• Exclusions, deductions and credits let the tax account for family size, retirement saving, health costs and other circumstances.
• Withholding spreads payment through the year rather than demanding it in one lump.

Cons

• Measuring income requires rules for basis, timing, deductions and dozens of special cases, which makes the income tax one of the most complex parts of federal law.
• Income from capital is taxed when realized, so timing choices change tax bills, and the rules reward those who can plan around them.
• Corporate profits paid out as dividends are taxed twice, once to the corporation and again to the shareholder.
• Layered federal, state and local income taxes, each with its own rules, multiply the paperwork for people who move or work across borders.