What is Income Tax in the US? Definition, Types & Calculation
September 01, 2023
Imposing an income tax is one of the most effective ways for the US government to generate resources for public services and programs.
Income tax regulations also vary per state, and it is essential to know these key differences to ensure you pay the correct amount of taxes annually.
In this article, we will define what income tax is all about, including the different types of income taxes applicable in the US, and explain how to calculate individual income tax.
- Income taxes are direct taxes imposed on an individual's or business’s regular income. The federal, state, and local governments are responsible for setting the tax rate.
- Not all states levy income taxes on their constituents. These states charge higher property or sales taxes to compensate for not imposing state or local income taxes.
- Determining individual tax rates will depend on their filing status, tax bracket, annual income, adjusted gross income, and applicable tax breaks and deductions.
- A company’s or organization’s structure is the basis for assessing the tax treatment of business income.
What Are Income Taxes?
Income taxes are direct taxes imposed by the federal, state, and local governments on income earned by employees, independent contractors, and businesses. Income taxes fund government programs and services to improve public safety and infrastructure, among other things.
The US government imposed the first federal income tax in 1861, during the Civil War. In 1872, the government repealed the said federal tax. The federal income tax laws enacted in 1913 shaped the tax laws and regulations that we know today.
In the U.S., the Office of Tax Policy creates and enacts tax policies, rulings, and programs, while the IRS (Internal Revenue Service) implements these regulations.
The IRS is also responsible for collecting taxes and ensuring all taxpayers fulfill their tax obligations dutifully. A taxpayer’s filing status and income tax bracket help determine the percentage of their income that goes toward paying taxes.
Types of Income Taxes
The different types of income taxes are classified based on the taxpayer type and the government branch imposing the tax.
Let’s explore them one by one:
#1. Individual Income Tax
Individual income tax, also called personal income tax, is the tax imposed on a taxpayer’s earned wages or salaries, dividends, and other types of income earned annually.
In simple terms, it is a tax on salary or regular income imposed by the US government.
The amount of tax levied on individual income depends on the applicable tax deductions and tax benefits. Unlike payroll taxes such as Social Security and Medicare, employees and employers do not share the contributions for personal income taxes.
However, employers are still responsible for withholding a portion of their employee’s wages and salaries to fulfill their income tax obligations.
When filing individual income tax returns, taxpayers must fill out Form 1040 to record or report all of their income sources. As for the income tax in the USA for foreigners, all nonresident aliens generally pay taxes on US-sourced income.
Two different tax rates apply to foreigners: those for effectively connected income and those for fixed or determinable, annual, or periodic (FDAP) income considered non-effectively connected.
#2. Business Income Tax
Business income tax is one of the five general types of business taxes identified by the IRS. Income tax for businesses varies depending on their structure and size.
Examples of business structures classified by the IRS for business income taxation are:
- Sole Proprietorship
- Limited Liability Companies (LLC)
Sole proprietors must report their business income gains and losses on their personal income tax returns. On the other hand, the tax treatment for LLCs will depend on the member count and the agreed-upon arrangement of the organization.
Based on the LLC members’ election, the IRS may treat the LLC as a corporation or a partnership. Partnerships do not pay income taxes because the said taxes are passed through losses and gains earned by each partner.
The difference between capital expenses, operating costs, and the amount of generated revenue determines a business’s taxable income.
#3. Federal, State, and Local Income Tax
The government levies federal income taxes (FIT) on an individual’s or business’s annual earnings. All wages, salaries, bonuses, cash gifts, tips, money earned from gambling, and business income are subject to federal taxation.
Given the scope of the federal income tax, it provides the federal government with the largest source of funding for food and housing assistance, national defense, emergency disaster relief, and pensions and benefits for government workers, to name a few.
The tax rates for federal income tax vary for W-2 or salaried employees and 1099 employees. W-2 employees receive IRS Form W-2 from their employers. They use the said form to report their annual income taxes, including all paid payroll taxes within the year.
Employers share the amount paid for FICA taxes with their employees.
1099 employees, or independent contractors, do not pay federal payroll taxes but instead pay self-employment taxes. They also shoulder the complete percentage of FICA taxes levied on their income.
The tax rates for federal income taxes will increase or change in 2025, per the provisions of the Tax Cuts and Jobs Act of 2017.
Consequently, certain adjustments had to be made to the tax brackets for 2022 and 2023 to accommodate the recent inflation.
State income taxes are direct taxes imposed on income generated within the state. Some states charge a flat tax rate, while others have a progressive tax system.
The following states impose a flat tax rate:
- North Carolina
States that implement a progressive tax rate follow the federal income tax brackets or impose their own tax regulations.
Local income taxes are similar to state and federal income taxes. The general rule is that only areas where state income taxes are imposed can levy local taxes on individual and business earnings.
The local government levies taxes in their specific locale to fund the community's educational, recreational, and public safety programs. Local taxes can also be imposed temporarily, depending on their purpose.
USA States That Don’t Collect Income Taxes
Not all states impose or collect income taxes, and these are the following:
- New Hampshire
- South Dakota
In Washington, income taxes are levied only on high-income taxpayers' capital gains and investment income. New Hampshire does not impose income tax on earned wages but imposes tax on dividends and interest. South Dakota balances its low-income tax rates with taxes on mining and oil corporations.
Note that not imposing income tax does not automatically mean less taxes and expenses on the taxpayer’s part. The authorities governing states and locales without income taxes must find other ways to leverage funding for their programs. In some states, taxpayers pay higher property and sales taxes, for example.
How to Calculate Individual Income Tax
To calculate your individual income tax, you must get the value of your Adjusted Gross Income (AGI) and taxable income using the following equations:
- Adjusted Gross Income (AGI) = Gross Income − Applicable deductions for AGI
- Taxable Income = AGI − Standard or Itemized Deductions
Your AGI will help determine whether you are eligible for tax credits and deductions, while your taxable income is the basis for assessing your tax bracket.
The applicable deductions on your Adjusted Gross Income refer to the deductions and adjustments applied to your salary, such as alimony, health savings account contributions, and retirement plan contributions.
You must also consider the following factors:
- Filing status
- Annual income
- Voluntary and involuntary contributions
- Age (Some tax deductions are applicable when you reach a certain age)
Your filing status determines whether you are eligible for certain tax deductions, such as mortgage interest deductions or interest on college education costs. If you have dependents, you are also subject to reduced tax rates.
Meanwhile, your taxable income will increase or decrease if you have IRA or 401(k) contributions or are court-mandated to pay wage garnishments.
Income tax is an integral component of improving the quality of life in the community as a whole. By dutifully fulfilling your tax obligations, you also do your part in materializing more educational, healthcare, and industrial projects.
On the other hand, it pays to know how income taxes are withheld from your hard-earned salary because, in doing so, you are assured that your employer deducts the correct amount and adheres to all applicable federal, state, or local tax regulations.