What You Need To Know About The American Tax System 

It’s no secret that the American tax system is incredibly complex. Many people think it is incomprehensible and unfair, only benefiting corporations and big businesses and not the mass working population.  

To help you understand the American tax system better, we’ll go over how the system works and highlight some major issues that arise in this vast, complicated setup in this post. 

Let’s get to it!

How does the American tax system work?

Once you make over a certain amount of money, you must pay taxes, so it’s crucial to get a general understanding of how the tax system works in the United States.

Overview

The federal government can only function financially through collecting taxes and fees from many different sectors of the economy, and you might not be surprised to learn — the largest sources of government revenues are individual income taxes and payroll taxes.

While nearly all American citizens have to pay taxes, the type and amount of taxes paid are individually different. Well-off Americans pay a larger share of their income in individual income taxes, corporate taxes, and estate taxes compared to lower-income groups. However, lower-income groups pay a greater portion of their earnings to payroll and excise taxes than wealthy Americans.

Overall, the U.S. tax code is progressive, with higher-income taxpayers paying a larger share of their income in taxes. That is true, but high-income Americans can benefit disproportionately from tax breaks, which are also known as tax expenditures. Some find this extremely unfair, and we’ll take a look at that later in this post. 

How it’s managed

The Internal Revenue Code (IRC), generally known as the tax code, is written by Congress, the legislative part of the United States government. The tax code governs tax collection, the application of federal tax laws, and the issue of tax refunds, rebates, and credits. These functions are carried out by the Internal Revenue Service (IRS), a government department of the United States Department of Treasury.

What are the different types of taxes?

There are so many different types of taxes in the U.S. But don’t worry, not all taxes apply to everyone. Below are some examples of the most common taxes:

Income tax 

The U.S. federal income tax is a tax imposed by the Internal Revenue Service (IRS) on the annual earnings of individuals, corporations, trusts, and other legal entities. Federal income taxes apply to all forms of earnings, including wages, salaries, commissions, bonuses, tips, and investment income.

In the U.S.tax system, federal income tax rates for individuals are progressive. As taxable income increases, so does the tax rate. Federal income tax rates range from 10% to 37% and are staggered at specific income thresholds. These are called tax brackets, and income that falls within each bracket is taxed at the corresponding rate.

Capital gains tax 

The tax on the profits generated from an investment after it has been sold is known as capital gains tax, so please note that no taxes are due on stock shares until they are sold, regardless of how long they are kept or how much their value increases. 

The capital gains tax rate in the United States now applies exclusively to income on the sale of assets held for more than a year, also known as long-term capital gains. The current rates are 0%, 15%, or 20%, depending on the taxpayer’s tax bracket for the current year. The short-term capital gains tax is applied to assets that are sold within one year of their purchase date. Ordinary income is taxed on this profit. For most low-to-middle-income taxpayers, this is a higher tax rate than the capital gains rate.

Payroll tax 

A payroll tax is a percentage withheld from an employee’s pay and paid to the government on the employee’s behalf by their employer. Federal payroll taxes are subtracted from an employee’s wages and remitted to the Internal Revenue Service (IRS).

Sales tax 

A sales tax is a government-imposed consumption tax on selling goods and services. The majority of sales taxes are collected by retailers and passed on to the government. Depending on the regulations in the jurisdiction, a business is liable for sales taxes if it has a link or connection to that area, which can be a store or office, an employee, an associate, or some other presence.

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What are the different types of taxpayers? 

We can divide taxpayers into two main categories: 

1. Individuals

Individual taxpayers go into one of 2 groups: citizen or immigrant (an alien is a person who resides within a country’s borders and is not a national of that country). A citizen can also be classed as a resident or a non-resident.

2. Corporations 

Domestic, foreign, and partnership corporations are the three types of corporations. There are two types of foreign corporations: resident foreign corporations and non-resident foreign corporations. 

A foreign corporation engaged in trade or business in the country is referred to as a resident foreign corporation. A foreign corporation that is not engaged in trade or business within the country but receives income from sources within the country is known as a non-resident foreign corporation. 

A partnership is a business arrangement in which two or more people share a company’s ownership and management responsibilities. Because a partnership is not a legal entity apart from its owners, it does not pay taxes.

What Does the Government Actually Do With The Taxes It Collects?

The U.S. government collects income taxes and payroll taxes from individuals and corporate income taxes from companies. The government then distributes the money to different government agencies for specific purposes that benefit or protect the nation and its citizens. Social Security and welfare programs, the education system, national parks, police departments, and the maintenance and development of public infrastructure are all funded by U.S. tax dollars.

What are the main issues with the American tax system? 

Most taxpayers agree that some form or amount of taxation is necessary to fund the government. However, there are many differing views about the size of government and its corresponding funding, the optimal structure of a tax system that’s fair to all, the system’s effective rates, and its impact on different groups in society.

As with all systems, individuals and corporations will do their best to find workarounds and loopholes to use to their advantage. And it is who can take advantage of these loopholes that seems to be unfair, with most taxpayers believing the U.S. tax system favors the wealthy and doesn’t benefit the majority of the population.

Most U.S. taxpayers consider an income tax system that applies higher rates on higher income levels to be fair. At the moment, it doesn’t seem to be that way especially when it comes to businesses, particularly large corporate businesses.

Let’s look at some of these issues in more detail.

1. Higher Benefits for Higher Tax Brackets

Although tax rates on taxable income are progressive, which means big businesses should be paying more, there are ways for these corporations to pay a lesser rate. Ways that lower-income individuals can’t. Let’s have a look at some below:

Exemptions and exclusions for certain types of income—for example, tax-exempt interest paid on state and local government bonds.

Special, lower rates for some income categories, such as capital gains and dividends

Deductions for a wide range of expenditures, including some business expenses

These adjustments can result in much lower effective tax rates on the incomes of high-income, wealthy individuals, which lower incomes miss out on. These deductions can also enable taxpayers with extremely high earnings and investment returns to avoid any tax liability at all.

2. Deductions and tax credits

Deductions benefiting taxpayers by lowering their taxable income are regressive. To calculate how much deductions you can take, multiply the amount of your deductible expenses by your marginal tax rate. For instance, if your income is in the top 37 percent tax bracket, every $100 saved from income that would otherwise be taxed at this rate saves the taxpayer $37. If the appropriate rate is 24%, a $100 reduction in income would result in only $24 in savings. 

Meanwhile, with a tax credit, a taxpayer can only save a flat rate that is equal for everybody. Regardless of income level or tax category, a 20% tax credit will save taxpayers $20 in tax liability for every $100 spent.

However, most tax credits are non-refundable. If your tax credits are higher than your tax liability, you won’t be able to take advantage of the credits’ benefits fully. 

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3. Corporate Tax Avoidance

Currently, the tax law generally applies a corporate income tax of 21%. However, many U.S. corporations pay far lower rates or no tax at all because of substantial business write-offs and aggressive tax planning. Once again, these write-offs just aren’t available to the vast majority of U.S. taxpayers.

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The bottom line 

Most Americans would like to see a less complex and fairer tax system. The tax code is constantly being updated, which can be even more confusing. New guidelines, new forms, and new criteria are always being introduced. Stay on top of your taxes and up-to-date with the latest tax changes by subscribing to the Shoeboxed blog. We’re here to help!

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Two Most Common Business Strategies To Avoid Corporate Income Tax Issues

Multinational corporations strategically employ international transfer pricing and tax inversion to place their operations in low tax-rate countries, resulting in lower income taxes. 

1. International transfer pricing

What is international transfer pricing? 

Companies can manage where their profits are reported through international transfer pricing. International transfer pricing is the act of selling products from one division to another within the same corporation, but located in different countries. 

In other words, they strategically place operations in low tax-rate countries. 

What are the benefits of international transfer pricing?

  • Tax benefits 

When a company is able to provide accurate transfer pricing documents, it is eligible for a number of tax breaks that allow it to avoid paying taxes in many countries.

  • Avoid high tariffs 

By sending goods to nations with high tariff rates and employing low transfer charges, transfer pricing helps to reduce duty expenses by lowering the duty base of such transactions.

  • Lower tax rate 

Transfer pricing ensures profits for products and services in many countries with a lower tax rate. 

  • Reduce tax liability 

A transfer pricing document serves as a foundation for calculating the entire cost of association between two organizations, which aids in the avoidance or reduction of tax liability.

  • Reduce duty costs 

In international trade, duty costs are a significant challenge. You will have to deal with such costs on a regular basis if you run a worldwide corporation.

Transfer pricing aids businesses in lowering their duty costs. Furthermore, organizations can ship goods to nations with high tariffs at low transfer costs.

  • Reduce income taxes 

Organizations can also significantly cut their income taxes in nations with high tax rates. This is accomplished by overpricing the items being exported to countries with lower tax rates.

As a result, overall profits are balanced, and enterprises can make more money.

What are the risks involved in international transfer pricing? 

  • There may be disagreements between an organization’s divisions about pricing and transfer procedures.
  • In terms of time and labor, there are significant additional costs associated with implementing transfer prices and maintaining a comprehensive accounting system to support them. Transfer pricing is a time-consuming and sophisticated approach.
  • It’s tough to set pricing for intangible commodities such as services.
  • Buyers and sellers fulfill various jobs and, as a result, take different risks. For example, the seller may decline to provide a product guarantee. However, the buyer’s price would be affected by the discrepancy.

Case study

According to the Corporate Finance Institute, Google can be a good case study of how a big corporation employs the international transfer pricing strategy. 

In Singapore, Google has a regional headquarters and an Australian subsidiary. Users and Australian businesses benefit from the Australian subsidiary’s sales and marketing help. Google uses the Australian subsidiary for research services all around the world. 

Google Australia had a profit of roughly $46 million on revenues of $358 million in 2012-13. After claiming a $4.5 million tax credit, Google Australia had a projected tax payment to be AU$7.1 million.

Read more if you’re interested: 

2. Tax inversions

What is tax inversion?

Another strategy that corporations can use to decrease the tax rate is to move their legal headquarters to a location with lower tax rates. 

Corporations can do the tax inversion practice because the corporate structure is relatively flexible. On the other hand, if the business’ structure leans more towards a partnership, where the partnership’s tax law is different from country to country, this inversion practice is not possible. 

What are the benefits of tax inversions? 

Corporations invert to take advantage of reduced tax rates, mainly found in tax-haven countries. A company’s global income is no longer taxed in the United States once it has been inverted. It is only responsible for paying taxes on income earned in the United States.

What are the risks involved in tax inversions?

1. There’s a chance you’ll lose your expertise. 

You need to work with tax and legal consultants who have completed inversions in the country where you seek to re-incorporate. Tax inversion isn’t a “do-it-yourself” undertaking.

2. The danger to shareholders. 

It’s also crucial to consider any potential tax implications for your stockholders. You’ll be trading shares in the old firm for shares in the new one when you incorporate. Shareholders may face severe tax repercussions if it is not correctly constituted.

3. The danger of making the front page. 

In addition, tax inversions aren’t widely discussed in the media. Despite being fully legal, opponents contend that the practice is unpatriotic and unfair. While it’s doubtful that Congress will adopt new legislation prohibiting tax inversions anytime soon, the U.S. Treasury Department is considering what steps it may take to discourage them further in light of recent media attention.

Case study 

According to the American For Tax Fairness Organization, Walgreens, which had $72 billion in U.S. sales in 2014, inverts with a Swiss corporation and will likely save $4 billion in U.S. income taxes over the next five years. If Pfizer was successful in its attempt at an inversion with AstraZeneca in the UK, it would have saved $1 billion a year in taxes in the US. 

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National governments on avoiding income taxes

 Do large corporations abuse these tax rules to evade legitimate income taxes? 

This is entirely up to national governments to decide. 

One example of the relationship between the government and corporations regarding the tax inversions is the U.S. government’s policy on reporting income arising from intellectual property. 

In 2008, the U.S. government decided that all U.S.-based corporations must compute how much income is generated from intellectual property. Then the corporations must pay U.S. income tax on that intellectual property-related income no matter where the income is generated in the world. 

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How to File Taxes as an Independent Contractor: A Step-by-Step Guide

If you work as a freelancer or self-employed person, you likely get paid as an independent contractor rather than an employee. This kind of work affects the way you file and pay your taxes. You’ll have extra responsibilities, file additional forms to make sure you’re paying the government enough during the year, and pay a self-employment tax. 

It’s important to understand independent contractors’ taxes correctly so you won’t get slapped with fines and penalties by the IRS. This article will give you an overview of independent contractors’ taxes and a step-by-step guide on how to file as an independent contractor. 

What is an independent contractor?

An independent contractor refers to a person, business, or corporation that provides products or services under a written contract or a verbal agreement. Unlike employees, independent contractors do not work for an employer on a regular basis but rather on a project-by-project basis, when they may be subject to the agency’s laws.

The key characteristic of an independent contractor is the ability to retain control over the work they’re being paid to complete. According to that guideline, there is a wide range of careers that allows you to work as an independent contractor, including, but not limited to:

  • Freelance accountants or bookkeepers
  • Freelance writers
  • Virtual assistants
  • Hairstylists
  • Lawn care providers
  • Physicians
  • Dentists
  • Mechanics
  • Carpenters
  • Manicurists 
  • Personal trainers
  • Therapists

You may qualify as an independent contractor regardless of your business’s structure. For example, you could be considered an independent contractor if you work as a sole proprietor, form a limited liability company (LLC), or a corporation. In short, you can be considered an independent contractor as long as you’re not classified as an employee. 

Note: If you run a small business and hire people to work for you, you’ll have to classify them as independent contractors or employees. Misclassifying an employee as an independent contractor could trigger an IRS tax penalty

How to file taxes as an independent contractor

Before you start gathering paperwork and crunching the numbers in preparation for tax season, you need to be sure if you need to file taxes. In the US, you’ll only need to file a tax return if your annual net earnings as an independent contractor total more than $400. 

Filing independent contractor taxes will take different steps depending on your business structure. However, they generally share the same steps in common that you need to follow.  

Specify tax deductions for independent contractors

As an independent contractor, you may be eligible for certain deductions for both business and personal expenses. Those deductions can significantly lower your taxable income for the year, so be sure to save these kinds of receipts:

  • Business travel, accommodations, and meals expenses
  • Marketing and advertising expenses
  • Gas, car mileage, and other vehicle-related expenses
  • Equipment purchases
  • Rental or lease payments
  • Home office expenses, including mortgage and property taxes
  • Self-employment retirement plan expenses
  • Business insurance 
  • Phone and internet bills
  • Legal expenses

Independent contractors can also claim a deduction for out-of-pocket health insurance premiums. This deduction includes medical, dental, and long-term care insurance premiums. You may also be eligible to deduct the expenses for your spouse’s and children’s insurance. However, there is an exception that if you have access to a spouse’s insurance plan, you can’t deduct health insurance premiums.

Other independent contractors’ deductions include mortgage interest, student loan interest, and real estate taxes. An independent contractor can also get a tax break for contributing to a self-employed retirement plan or a traditional IRA (Individual Retirement Account.) 

Fill out essential tax forms for independent contractors

There are hundreds of IRS forms when it comes to filing taxes. Fortunately, as an independent contractor, you only need to focus on a couple of essential documents. Let’s take a closer look at the essential records that an independent contractor needs to complete for tax season:

  • Form 1040: Both traditional employees and independent contractors must complete and submit Form 1040 before the tax deadline each year. This form records the details and specifics of your gross income and calculates how much you owe Uncle Sam or how much of a refund you can get back.
  • Schedule C: You need to submit this form together with your Form 1040 if you work as a sole proprietor or are the only owner of an LLC. You’ll have to provide precise details regarding your income, mileage records, inventories, and business expenses in this form. 
  • Schedule SE: This document helps you determine the amount you owe in self-employment taxes based on your net income for the year.  
  • Form 1099-MISC: While Form 1040 and Schedule C are the paperwork you submit to the IRS, Form 1099-MISC is the document you receive from clients you’ve done business with throughout the year. It’s a record of the payment you received from the companies who hired your services.

Set up a practical timeline to pay your taxes

Now that you have a better understanding of what is an independent contractor and how to file taxes as an independent contractor, let’s make your tax-filing process more efficient with a practical timeline. 

  • Keep track of your business expenses and earnings 

An independent contractor usually works with many different projects, contracts, and clients. This makes staying on top of all these earnings and expenses a bit tricky. Using a meticulous tracking tool of your business’s inflows and outflows throughout the year will help make tax season less stressful.

  • Set up a payment plan

Instead of paying a sizable amount of taxes at the end of the fiscal year, you can consider planning as soon as you receive your first paycheck of the year. Try estimating how much money you expect to make and how much you anticipate owing for taxes at the start of the year. Based on this estimate, you can make payments quarterly to reduce the expected total of your tax liability.

As payments come in, set aside a certain amount to a separate account to get ahead of your tax bills. You can avoid overspending that part of your income by saving them for a later date.

  • Note your deadline

When you run your own business, you’ll be accountable for keeping track of various critical deadlines. One of them is the deadline by which you must file your taxes. It could be a good idea to mark your calendar for April 15th, the last day to submit your taxes to the IRS.

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The bottom line 

After knowing how to file taxes as an independent contractor, it’s time to start gathering all your tax information, receipts, and other expenses documents, storing them all in a safe place before filing your taxes. 

Shoeboxed is a receipt management application that turns your receipts and business documents into a digital format in just one click by taking a picture straight from your smartphone or scanning a pdf. It automatically extracts, categorizes, and human-verifies important data from your receipts so that you can go over and check your records anytime with ease. Shoeboxed ensures you will always have your receipts securely stored and ready for tax purposes.

Access your Shoeboxed account from your web browser or smartphone app. Stay audit-ready with Shoeboxed for FREE now!