Taxation

As anyone who has ever filled out a tax return knows, the U.S. tax system is very complex. Therefore, this chapter aims to provide a basic overview and highlights the main provisions.

 

U.S. taxes are imposed on two levels, federal and state, and sometimes a third—local, such as city or county. At the federal level, there is income tax, including corporate and personal income tax, capital gains tax, income tax on dividends, interest and royalties, taxes on partnership profits, and employee payroll taxes. State-level taxes are generally similar to federal, only at much lower rates (0 to 10 percent), plus sales and use taxes. Some counties and cities have their own unique tax regimes, such as income and business taxes and property taxes if a business is located and operated within their territories.

 

Corporations and individuals are taxed, and the type and amount of taxes a businessperson has to pay will depend on the structure of his business. Sole proprietors and partnerships are not taxed on the entity level, and business income, expenses, and deductions flow directly to the owners. They report their business income on their individual income tax returns and are personally responsible for paying taxes. These types of business structures are called pass-through entities for tax purposes. However, the partnership has to file informational income tax return, even if it does not pay taxes on its own. Corporations, on the other hand, are taxed on the entity level first, as they are considered independent business structures fully separate from their owners (shareholders). If the profits are distributed as dividends to the shareholders, the shareholders have to pay additional taxes on their individual income (current federal rate on such dividend income is 15 percent). In this sense, corporations are double-taxed, as compared to other business entities. The legal entity known as an S corporation allows small corporations with less than 100 shareholders, all of who are individuals (not other business entities) and residents of a particular state in which that corporation is formed to be taxed as a partnership. All income of S corporation passes through the entity to its shareholders, and they are personally responsible for filing and paying taxes. S corporation does not pay taxes as an entity. The members of Limited Liability Company (LLC) have an option to choose whether their company will be taxed as a corporation or as a partnership. Single-member LLC is automatically taxed as a partnership. Its members pay income taxes, not the company. LLC with several members can be taxed, as its members prefer. If the LLC is taxed as a partnership, LLC members are taxed on allocations, not distributions of income. This means they must file and pay taxes on the generated income, even if it is not distributed, but left in the company for future expenses and development.

 

Income Tax

 

Generally, all business entities, irrespective of their legal structure, must file an annual tax return. They (or their owners, in the case of a pass-through entity) also have to file quarterly tax returns and make estimated tax payments if they expect to own taxes of more than $1,000 per quarter. Corporations have to make estimated tax payments if they expect to owe tax of $500 or more when they file their returns. U.S. taxes are calculated based on taxable income, gross income earned by the taxpayer minus allowable deductions and adjustments. The most common deductions are various business expenses, losses, depreciation, interest, wages, contributions to the employee benefits plans, state and local taxes, and other operating costs of running a business. The applicable tax rates depend on the net taxable income.

 

Alternative Minimum Tax (AMT)

 

Alternative minimum tax is a flat-rate income tax imposed by the United States federal government on individuals, corporations, estates, and trusts rather than regular income tax when an adjusted amount of taxable income is above a certain threshold. If the application of an AMT results in a higher tax than the regular income tax, AMT is imposed instead of the regular income tax. As with regular federal income tax, rates and exemptions of AMT vary by filing status, but they are completely different from regular income tax. Currently, the lowest AMT rate is 25 percent of taxable income. The AMT is intended to ensure that U.S. taxpayers with substantial economic income pay at least a minimum amount of tax, notwithstanding exclusions, deductions, and credits otherwise available by law.

 

A corporation is exempt from AMT during its first year as a company. Further, corporations with average annual gross receipts less than $7,500,000 for the prior three years are exempt from AMT, but only so long as they continue to meet this test.

 

Consolidated Tax Returns

 

A group of companies consisting of a U.S. parent company and subsidiaries, in which at least 80 percent of interest is owned by a parent company, may be taxed on their consolidated income, by filing a consolidated federal income tax return. In such case, the losses sustained by one subsidiary may be deducted from overall income and offset profits of other subsidiaries or a parent company, therefore lowering the amount of owned taxes. Also, the dividends paid by the affiliated companies to their parent company are exempt from U.S. federal income tax.

 

Capital Gains Tax

 

For corporations, the excess of net gains from the sale of capital assets over net losses from the sale of the assets or net capital gains are taxed at the same rates applicable to the ordinary income. Thus, the current maximum rate is 35 percent. However, capital losses may only be used to offset capital gains and the excess of losses over gains may be carried back three years or forward five years. Losses must be applied to the earliest carryback year before any carryforwards may be used. Gains or losses on the sale or exchange of capital assets held for more than twelve months are treated as long-term capital gains or losses. Gains or losses on the sale or exchange of capital assets held for twelve months or less are treated as short-term capital gains or losses.

 

Net Operating Loss Carryback/Carryforward

 

If a company has an operating loss in any year, this loss can be offset against prior income, as well as any future income. It can be retroactively applied first to the two years preceding the loss year, and then applied to the twenty years following the loss year. The taxpayer can, by filing an election, waive the entire carryback period, and the net operating loss can only be carried forward.

 

Self-Employment Tax

 

Self-employment tax is a Social Security and Medicare tax primarily for individuals who work for themselves. These tax payments contribute to such individuals’ coverage under the Social Security system.  Social Security coverage provides the self-employed with retirement benefits, disability benefits, survivor benefits, and hospital insurance (Medicare) benefits. Individuals who earn more than $400 (or $108.28 if a church employee) have to pay this kind of tax.

 

Employment Taxes

 

When a company has employees, the employer bears the burden of certain employment tax responsibilities. The employer must withheld these taxes from each employee’s salary, make a matching contribution itself, and submit the payment to the government on the employee’s behalf. Employment taxes include the following:

 

Social Security and Medicare Taxes: The employer withholds part of these taxes from the employee’s wages and pays another part of these taxes from the company’s funds on every employee it has. (To find out how much Social Security and Medicare taxes to withhold and pay, see Publication 15 on www.irs.gov).

 

Federal Income Tax Withholding: The employer must generally withhold federal income tax from employee wages and submit it to the government. (To figure how much federal income tax to withhold from each wage payment, use the employee’s Form W-4, Employee’s Withholding Allowance Certificate, and the methods described in Publication 15 on www.irs.gov).

 

Federal Unemployment Tax (FUTA): The federal unemployment tax is part of the federal and state program that pays unemployment compensation to workers who lose their jobs. The employer pays FUTA tax from its own funds. The employers, not employees, pay it.

 

Once the calendar year is over, the employer must furnish copies of Form W-2, Wage and Tax Statement, to each employee to whom it paid wages during the preceding year and must also send copies to the Social Security Administration.

 

The company does not have to withhold or pay any taxes on payments made to an independent contractor, but as mentioned previously, tax authorities are very strict about companies observing the differences between the employees and independent contractors. If the employer improperly classifies an employee as an independent contractor, it can be held liable for employment taxes for that worker, in addition to huge penalties. An independent contractor is someone who is self-employed, retained by a company on a temporary basis for a particular kind of job assignment, and is otherwise fully independent of that company.

 

Excise Tax

 

Certain types of businesses have to pay excise taxes. These may be applicable if the company:

 

     Manufactures or sells certain products;

     Operates certain kinds of businesses;

     Uses various kinds of equipment, facilities, or products; or

     Receives payment for certain services.

 

Excise taxes consist of several broad categories of taxes, including the following.

 

     Environmental taxes

     Communications and air transportation taxes

     Fuel taxes

     Tax on the first retail sale of heavy trucks, trailers, and tractors

     Manufacturers taxes on the sale or use of a variety of different articles

 

For full description of commercial activities that are subject to excise taxes and their categories, see Publication 510 at: http://www.irs.gov/publications/p510/index.html

 

State Income Tax

 

In addition to federal taxes, nearly all U.S. states impose their own income tax. These are similar to federal taxes, but state tax is usually only applicable to income attributable to that particular state. There should be a nexus between the activities conducted in that state and derived income, a physical or business connection between a taxpayer and a state. A business that has an office, employees, or equipment in a state will be taxed by that state. If an individual lives or consistently works in a state, he or she will be considered a resident of that state for tax purposes. However, states can also tax individuals and entities based on other connections, such as frequent business visits. The rates differ from state to state and currently range from 1 to 10 percent. 

 

A taxpayer may be exempt from the imposition of a state income tax if the activity it conducts within the state is limited to mere solicitation for business, such as advertisement. Businesses should take care when evaluating whether activities are protected under this rule, as mere solicitation has a very specific meaning; there is a fine line that must not be crossed. This solicitation exemption does not extend to other types of state and local taxes.

 

If a company has nexus in more than one state, its overall taxable income must be apportioned among the states based on its apportionment factors. Generally the amount of income taxes due in each particular state is based on the extent of the commercial activities conducted in that state.

 

State Sales and Use Taxes

 

States collect sales tax on retail sales within the state and use tax of varying rates in different locations. Companies are generally responsible for collecting these taxes, holding them as a trustee, then submitting them to the government. If the company is not doing business in a particular U.S. state, it generally cannot be forced to collect sales tax on sales within that state.

 

Non-exempted tangible personal property purchased outside of the buyer’s home state and brought back into it, on which the out-of-state seller has not collected sales tax at least equal to the home state’s use tax, is subject to the home state use tax. Out-of-state purchases of tangible personal property intended for resale by the buyer are exempt from home state use tax, whereas, if it is for use or consumption by the buyer, it will apply (absent certain exemptions).

 

New York City Business Tax

 

Certain businesses located and conducting commercial activities in New York City may be subject to NYC corporate and unincorporated business tax.

 

Other State and Local Taxes

 

State and local jurisdictions may impose many additional types of taxes, fees, and other filing requirements. These taxes may relate to property located within the state, payroll, business licenses, industry-related taxes, taxes on special types of businesses, goods, services, gross receipts, and net worth taxes. State and city taxes can typically be deducted from the federal income tax.

 

Tax planning is the main part of business operations, essential for business success. Thus, business owners should consult qualified professionals to manage the complex requirements of the U.S. tax system. Almost all businesses hire an accountant experienced in state and federal tax issues and payroll matters to supervise the business operations and be sure they are in compliance with the extensive and ever-changing tax requirements.

 

Most companies also retain the services of a tax attorney. Tax attorneys do not prepare and file tax returns and other tax-related forms, but they structure, plan, and advise on business and individual tax matters, specific items on the returns, and disclosure issues. While some companies do not need the assistance of a tax attorney on a regular basis, tax attorney services are necessary during the important events in a company’s business life, such as the start-up phase, major transactions, acquisitions of assets, mergers, restructurings, and liquidation. Communications with tax attorneys are protected by the attorney/client privilege.

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