🧾Taxes and Business Strategy Unit 3 – Income Tax Fundamentals

What's This Unit All About?

• Introduces the fundamentals of income taxation in the United States
• Covers key concepts, definitions, and terminology essential for understanding how income taxes work
• Explores different types of income and their respective tax treatments
• Examines deductions and credits that can help lower an individual's or business's tax liability
  • Includes standard deductions, itemized deductions, and various tax credits
• Explains the process of calculating taxable income step-by-step
• Discusses tax rates and brackets, which determine the amount of taxes owed based on taxable income
• Outlines filing requirements and deadlines for individuals and businesses
• Presents common tax strategies employed by individuals and businesses to minimize their tax burden

Key Concepts and Definitions

• Gross income: total income earned from all sources before any deductions or adjustments
• Adjusted Gross Income (AGI): gross income minus specific adjustments (IRA contributions, student loan interest)
• Taxable income: AGI minus deductions and exemptions, used to calculate the amount of taxes owed
• Deductions: expenses that can be subtracted from gross income to reduce taxable income (charitable donations, mortgage interest)
• Credits: dollar-for-dollar reductions in the amount of taxes owed (Earned Income Tax Credit, Child Tax Credit)
• Progressive tax system: tax rates increase as taxable income increases, with higher earners paying a larger percentage of their income in taxes
• Marginal tax rate: the tax rate applied to the last dollar of taxable income, based on the corresponding tax bracket
• Effective tax rate: total taxes paid divided by total taxable income, representing the average rate at which an individual is taxed

Types of Income and Their Tax Treatment

• Earned income: wages, salaries, tips, and self-employment income, subject to ordinary income tax rates and payroll taxes (Social Security and Medicare)
• Investment income: interest, dividends, and capital gains from investments, often taxed at lower rates than earned income
  • Long-term capital gains (assets held for more than one year) are taxed at 0%, 15%, or 20%, depending on taxable income
  • Short-term capital gains (assets held for one year or less) are taxed as ordinary income
• Rental income: income from renting out property, generally taxed as ordinary income, but certain expenses (mortgage interest, property taxes) can be deducted
• Royalty income: income from the use of intellectual property (patents, copyrights), taxed as ordinary income
• Alimony: income received from a former spouse, taxable to the recipient (for divorces finalized before 2019)
• Social Security benefits: may be taxable depending on the recipient's other income and filing status

Deductions and Credits: Lowering Your Tax Bill

• Standard deduction: a fixed dollar amount that reduces taxable income based on filing status (single, married filing jointly)
• Itemized deductions: an alternative to the standard deduction, allowing taxpayers to deduct specific expenses (state and local taxes, mortgage interest, charitable contributions)
  • Taxpayers should itemize if their total itemized deductions exceed the standard deduction
• Above-the-line deductions: adjustments to income claimed directly on Form 1040, regardless of whether the taxpayer itemizes (IRA contributions, student loan interest)
• Refundable credits: credits that can result in a refund even if the taxpayer owes no taxes (Earned Income Tax Credit)
• Non-refundable credits: credits that can reduce taxes owed to zero but cannot result in a refund (Child Tax Credit, Adoption Credit)
• Business expenses: costs incurred to operate a business, deductible against business income (rent, salaries, supplies)
• Depreciation: the gradual expensing of the cost of long-term business assets over their useful life (vehicles, machinery)

Calculating Taxable Income: Step-by-Step

1. Determine gross income by adding up all income from various sources (wages, investments, rental properties)
2. Subtract above-the-line deductions (also known as adjustments) from gross income to calculate AGI
3. Subtract the greater of the standard deduction or total itemized deductions from AGI
4. Subtract any personal exemptions (if applicable) to arrive at taxable income
   • Note: personal exemptions were eliminated for tax years 2018-2025 under the Tax Cuts and Jobs Act
5. Use taxable income to determine the appropriate tax bracket and calculate the initial tax liability
6. Apply any tax credits to reduce the tax liability, resulting in the final amount of taxes owed or refund due

Tax Rates and Brackets: How Much Do You Owe?

• Tax rates are determined by the taxpayer's filing status and taxable income
• As of 2021, there are seven tax brackets with corresponding rates: 10%, 12%, 22%, 24%, 32%, 35%, and 37%
  • Example: For a single filer, the 22% bracket applies to taxable income between $40,526 and$86,375
• Marginal tax rates apply to each additional dollar of income within a specific bracket
  • Example: If a single filer has $50,000 in taxable income, the first$9,950 is taxed at 10%, the next $30,575 at 12$9,475 at 22%
• Progressive nature of the tax system ensures that higher earners pay a larger share of their income in taxes
• Tax brackets are adjusted annually for inflation to prevent "bracket creep"

Filing Requirements and Deadlines

• Most individuals must file a federal income tax return if their gross income exceeds certain thresholds based on age and filing status
  • Example: In 2021, single filers under 65 must file if their gross income is at least $12,550
• The standard deadline for filing federal income tax returns is April 15th (or the next business day if April 15th falls on a weekend or holiday)
  • Extensions are available until October 15th, but any taxes owed must still be paid by the original deadline to avoid penalties and interest
• Self-employed individuals and businesses may be required to make estimated tax payments throughout the year
• Employers must provide employees with Form W-2 (wage and tax statement) by January 31st
• Financial institutions and other entities must provide taxpayers with various informational forms (1099-INT, 1099-DIV) by January 31st

Common Tax Strategies for Individuals and Businesses

• Maximizing retirement account contributions (401(k), IRA) to reduce taxable income and benefit from tax-deferred growth
• Bunching itemized deductions (charitable contributions, medical expenses) into a single year to exceed the standard deduction
• Harvesting capital losses to offset capital gains and up to $3,000 of ordinary income
• Utilizing tax-advantaged accounts for specific purposes (529 plans for education, Health Savings Accounts for medical expenses)
• Structuring businesses as pass-through entities (partnerships, S corporations) to avoid double taxation
• Claiming bonus depreciation or Section 179 expensing for qualifying business assets to accelerate deductions
• Deferring income or accelerating expenses to manage taxable income across tax years
• Engaging in tax-free exchanges (like-kind exchanges) to defer capital gains on the sale of business property

Real-World Applications and Examples

• Sarah, a single taxpayer, earns $75,000 from her job and$5,000 from freelance work. She contributes $6,000 to her traditional IRA and donates$3,000 to charity. Her taxable income is $71,000 ($75,000 + $5,000 -$6,000 - $3,000), placing her in the 22% tax bracket.
• XYZ Corporation, a C corporation, generates $500,000 in taxable income. As a separate taxable entity, XYZ Corp is subject to a flat 21$105,000.
• John and Mary, a married couple filing jointly, have a combined income of $150,000. They have two children and claim the Child Tax Credit, which directly reduces their tax liability by$2,000 per child, for a total credit of $4,000.
• ABC Partnership, owned equally by two partners, earns $200,000 in net income. As a pass-through entity, the partnership itself does not pay income taxes; instead, each partner reports$100,000 of income on their individual tax returns and pays taxes at their respective rates.
• Emily, a self-employed consultant, makes estimated tax payments each quarter to avoid underpayment penalties. She calculates her expected annual income and uses the IRS Form 1040-ES to determine the amount of each payment.