This article has been written by Rajendra Utpat, pursuing a course on Personal Branding Programs for Corporate Leaders, and has been edited by Oishika Banerji (Team Lawsikho).
It has been published by Rachit Garg.
Table of Contents
Introduction
Every country has its own taxation system and therefore the USA is not an exception to it. Like every country, the USA levies income tax on income generated by its citizens and residents and it is enforced and administered by the Internal Revenue Service (IRS). In this article we will take an overview of the taxation of individuals in terms of how it is calculated, what are the inclusions in and exclusions from income, forms for return filings, due dates of filing and tax payment and consequences for non-filing return and non-tax payment, rates of taxation etc.
Individual taxation in the USA
It is necessary to note that the United States levies tax on its citizens as well as its residents on their worldwide income. Those who fall under the ambit of non-resident aliens are taxed on their US-source income alongside income that is connected with any US trade or business, subject to certain exceptions.
Calculation of income
Calculation of taxable income is derived by following formulae. Finding out taxable income is the base for calculating tax on income of an individual.
| Particulars | Amount in US $ |
| Gross income | XXX |
| Less-Adjustments | (XXX) |
| Adjusted Gross Income (AGI) | XXX |
| Less-Itemized deduction or standard deduction | (XXX) |
| Taxable income before QBI deduction | XXX |
| Less-QBI deduction | (XXX) |
| Taxable Income | XXX |
| Federal income taxes on taxable income | XXX |
| Less-Tax credits | (XX) |
| Add -Other taxes | XXX |
| Less-payments | (XXX) |
| Tax due or refund | XXX |
Inclusions in income
In general, the following types of income are included in the tax returns of US individuals:
- Salary income
- Interest from bonds, fixed deposits, saving bank accounts
- Dividends on shares, mutual funds
- State/local income tax refunds
- Alimony received or spouse support payments
- Business income from a partnership, sole proprietorship, Scorp, etc
- Capital gains from the sale of property, personal items
- Withdrawal from Individual Retirement Accounts (IRA)
- Pension and annuity at the time of retirement
- Rental income/loss from renting of business/personal property
- K-1 flow through income/loss(income pass through partnership/S-Corp etc)
- Unemployment income
- Social Security Benefits
- Other income
Deductions from income to arrive at AGI (Adjusted Gross Income)
The following adjustments are made from gross income in calculating the adjusted gross income (AGI) of an individual:
- Educator expenses;
- IRA contributions;
- Interest paid on a student loan for education;
- Health insurance premiums;
- Moving expenses are allowed now only to military persons;
- 50% of self-employment tax;
- Self-employed retirement;
- Interest withdrawal penalty; and
- Alimony paid,
Itemized and/or standard deductions
Taxpayers have the option to claim either Itemized or standard deductions which lowers taxable income. Following are some of the itemized deductions:
- Medical expenses are subject to AGI limitations;
- State/local on real property and/or income tax except for foreign tax;
- Interest expenses (Home and investment);
- Contributions for philanthropic purposes are subject to AGI limitations; and
- Casualty/theft losses attributable to federal disasters are subject to AGI limitation.
Standard deductions
This deduction is allowed if an individual opts to not to take benefit of itemized deductions. Standard deduction varies according to tax filing status of an individual. Secondly, standard deduction amounts are linked to inflation adjusted figures. Figures are updated every year. For the calendar year 2022 standard deductions are as follows:
| Filing status | 2022 tax year |
| Single | $12,950. |
| Married, filing jointly | $25,900. |
| Married, filing separately | $12,950. |
| Head of household | $19,400. |
Qualified Business Income (QBI ) deduction
It is a newly introduced deduction in 2017 and became applicable for tax years beginning after December 31,2017. Many individuals, who conduct businesses in the form of sole proprietorships, partnerships, S corporations, trusts and estates may be eligible for a qualified business income deduction. It is quite a complex calculation and needs a separate article to explain the concept and hence details are not discussed here.
Returns
Form 1040, is the main federal income tax form people use to report income to the IRS, claim tax deductions and credits and calculate their tax refund or tax bill for the year. Four variations of the 1040 form (1040A and 1040EZ no longer exist):
- Form 1040: This is the most common return used by Individual USA taxpayers.
- Form 1040-SR: This form is used by taxpayers of the age of 65 and above.
- Form 1040-NR: This form is for non-resident.
- Form 1040-X: This form is for taxpayers who wish to amend previously filed form 1040. Form 1040 contains following schedules:
- Schedule 1
This can be used if the taxpayer has additional income, such as unemployment compensation, prize or award money, gambling winnings. Have any deductions to claim, such as student loan interest deduction, self-employment tax, educator expenses.
- Schedule 2
This is to be used by taxpayers if they have to owe other taxes, such as self-employment tax, household employment taxes, additional tax on IRAs or other qualified retirement plans and tax-favored accounts, AMT, or need to make an excess advance premium tax credit repayment.
- Schedule 3
This is to be used by taxpayers if they have to claim any credit that they claim on Form 1040 or 1040-SR, such as the foreign tax credit, education credits, general business credit. Have other payments, such as an amount paid with a request for an extension to file or excess social security tax withheld.
- Schedule A (Form 1040), for Itemized Deductions
This schedule needs to give information about Schedule Itemized Deductions, including recent updates, related forms, and instructions on how to file.
- Schedule B (Form 1040), Interest and Ordinary Dividends
In this schedule, taxpayers need to give information about income earned from interest and ordinary dividends.
- Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship)
Here taxpayers need to report any profit/loss generated from the business.
- Schedule D (Form 1040), Capital Gains and Losses
Capital gain and or losses will be reported here by the taxpayer. Also taxpayers will report here sales, exchanges or some involuntary conversions of capital assets, certain capital gain distributions, and nonbusiness bad debts.
- Schedule E (Form 1040), Supplemental Income and Loss
This schedule is for information about Supplemental Income and Loss, Schedule E is used to report income from rental properties, royalties, partnerships, S corporations, estates, trusts etc.
Due dates for filing returns and tax payments
As most of USA taxpayers are calendar year filers the due date for filing returns is April 15 of the following year. For example, the return for calendar year 2022 will be filed on April 15, 2023. If the due date falls on a holiday, Saturday, or Sunday then it will be filed on the next business day.
Consequences for non-filing return and tax payment
If the return does not get filed in time then there is penalty from 5% to maximum of 25% unpaid tax for each month or part of the month. If the taxpayer does not pay the taxes in time then there will be a penalty of 0.5 % to maximum of 25% of unpaid taxes for each month or part of the month.
Rates of individual taxation
Rates of taxes for an individual again depend upon their tax filing status. Secondly, these rates are progressive in nature and are subject to change every year as they are inflation indexed. These rates vary from 10% to 37%.
Filing status
In the USA, an individual has to be careful about his/her filing status because it affects the rate of tax to be applied, standard deduction or itemized deductions to be claimed, amount of tax credits if eligible etc. Also whether taxpayers married or divorced or widowed affect filing status.
Filing status in USA
There are five filing statuses in the USA, namely:
- Single- This is for taxpayers who are unmarried or divorced and staying separately.
- Married filing jointly-This is for married taxpayers. They can file joint returns with their spouse. If any one of the spouses passes away then still they can use this status for the tax year in which the spouse passes away.
- Married filing separately- If married taxpayers wish then they can file married filing separately.
- Head of household-This is for unmarried taxpayers who paid more than half of the cost of home expenses for themselves and a qualifying person living in a home for the half a year.
- Qualifying widower-This is for taxpayers whose spouse died during one of the previous two years and dependent child. There are other conditions which need to be followed.
If taxpayers are not sure about their filing status, they can use the What Is My Filing Status?, which is an Interactive Tax Assistant tool of IRS.gov. This tool can also help taxpayers who are eligible for more than one status find the one that will result in the lowest amount of tax.
Tax credits
Tax credit is the amount that taxpayers can deduct from taxes they owe. There are three types of tax credits:
- Refundable- They are paid in full. An example is Earned income credit.
- Non-refundable-Non refunded but reduce taxes you owe. Examples of nonrefundable credit are:
- Adoption credit.
- Lifetime learning credit.
- Residential energy credit.
- Work opportunity credit.
- Child and Dependent Care Credit.
- Other dependents credit.
- Retirement Savings Contributions credit.
- Child Tax Credit (CTC).
- Mortgage interest credit.
- Partly refundable – No fully refundable. An example is American opportunity tax credit
Alternative minimum tax (AMT)
The Alternative Minimum Tax (AMT) is considered to be a separate tax system that requires some taxpayers to calculate their tax liability twice,
- Firstly, under ordinary income tax rules and regulations,
- Secondly, under the AMT, and thereafter supposed to pay whichever amount is highest.
The difference between the ordinary tax system and AMT is that the latter has fewer preferences and different exemptions and rates in comparison to the former. In regards to the USA, an individual AMT is to be imposed under a two-tier rate structure of 26% and 28%. If we take into account the tax year of 2021-2022, the 28% tax rate was applicable to taxpayers who were falling within the taxable income of above USD 199,900 (USD 99,950 for married individuals filing separately). Further, for the tax year of 2022-2023, the 28% tax rate applied to taxpayers with taxable incomes above USD 206,100 (USD 103,050 for married individuals filing separately). Thus, there was a rise in the slab of taxable income in 2022 from that of 2021. It is necessary to note that the AMT is payable only to the extent it exceeds the regular net tax liability. AMT liability is determined by the foreign tax credit, to the extent of the foreign tax on the foreign-source AMT income (AMTI), which is also subject to certain exemptions.
Medicare contribution tax
Since 31st December 2012, a 3.8% ‘unearned income Medicare contribution’ tax became applicable on the lesser of:
- The net investment income for the tax year of the taxpayer, or
- The excess modified adjusted gross income over a threshold amount belonging to the taxpayer (generally, USD 200,000 for single taxpayers and heads of households; USD 250,000 for a married couple filing a joint return and surviving spouses; and USD 125,000 for a married individual filing a separate return).
The tax, in addition to the regular income tax liability, applies to all individuals who are subjects of the US taxation system and are not non-resident aliens.
State and local income taxes
The majority of the states in the USA alongside municipal authorities are responsible for imposing income tax on individuals who are either working or residing within their jurisdiction. While there are about 50 states who impose a personal income tax, states which are exceptions to the same are Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Furthermore, New Hampshire and Tennessee (until 1 January 2021) tax only dividend and interest income. There are also a few states who impose an income tax at a rate exceeding 10%.
Conclusion
What we see above is just the tip of the iceberg of US taxation. As already mentioned, this subject is very vast and details about each of the items discussed above need separate articles for each one of them.
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