This article has been written by Mayank Jain pursuing the Diploma in US Intellectual Property Law and Paralegal Studies from LawSikho. This article has been edited by Zigishu Singh (Associate, Lawsikho).
Table of Contents
Introduction
One of the most confusing aspects of American life, whether you are an International or domestic citizen, is ‘filing taxes’. Every individual, whether a citizen or a non-citizen,has an obligation to pay taxes in accordance with the law of the nation. To begin with, one should know that it is the Internal Revenue Service known as the IRS which is the tax collection agency for the United States federal government. Putting it all together, we can say that the IRS is the agency responsible for federal taxes. It does not end here, as the US has a multi-layered income tax system under which taxes are imposed by federal, state, and sometimes even the local governments. Along with filing federal tax forms, you may also be required to file a state income tax return by the filing deadline. It’s a separate requirement from federal tax returns and failure to file it may result in heavy penalty charges. State tax penalties are just as harsh as those imposed by the IRS. The only states that do not charge state income tax are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. Let’s see it through a real-life example. In the case of filing taxes for the state of California, you may be required to connect with California’s state agency, that is, The Franchise Tax Board. Now, before you get into the world of taxation you need to understand how taxation structure in the United States works.
Structure of US taxation system
The US tax structure is divided into federal, state, local, and special-purpose jurisdiction. Unlike India in which there is central taxation, in the US it is primarily divided into federal and state, having their different tax implications. This means that, in India, there is a need to file only one income tax return whereas in the US we have to file two separate tax returns one for federal and another for the state. There might be cases where the counties or villages may charge their separate tax in addition to the state taxes.
Income tax is in accordance with the tax accounting rule and therefore differs from financial reporting. Hence, there must be no misconceptions regarding taxable income from financial reporting. For instance, in the case of federal tax refunds, a businessman, while preparing a balance sheet and other financial documents of the firm will include all the income even though it is non-taxable and the Internal Revenue Service (IRS) will not tax that exempt income.
Individual Taxpayer Identification Number (ITIN)
In 1996, the Internal Revenue Service (IRS) created the ITIN program to help non-citizens who are not eligible for SSN to be able to pay taxes without any hurdles.
When we study about taxation system, we need to have a clear understanding of a primary form of national ID in U.S i.e Individual Taxpayer Identification Number (ITIN) & Social Security Number(SSN).
As far as the US is concerned, the “ITIN” i.e. Individual Taxpayer Identification Number is for non-citizens or people with foreign status or citizens of the country not having SSN. So, in a situation where a person is a non- US resident, he/she needs to refer to ITIN, which is a nine-digit number in the format of XXX-XX-XXXX which permits you to file an income tax return in case you don’t have an SSN.
ITIN is basically concerned with corporations, estates and trusts, partnerships, and others. It doesn’t provide legal immigration status or work authorization.
How is ITIN useful?
You may use ITIN:
- To file a tax return;
- To file a late tax return (once the deadline is over);
- To open a bank account;
- To report money earned by individuals while using social security numbers not given to you by the government;
- To claim dependents’ exemptions;
- ITIN can also be used to claim various kinds of social benefits.
Filling procedure
A person having a foreign status needs to fill “Form W-7” to get an individual taxpayer Identification number. While applying for ITIN a person will be asked to provide proof of country of origin, Identity, and all other documents as asked by the IRS. Once you have applied for it, it may take a minimum of 6 weeks before you get the ITIN letter.
The IRS does not voluntarily report you to United States Immigration and Citizenship Services for getting an ITIN.
Social Security Number (SSN)
Coming to SSN, it’s also a nine-digit number that the government issues to all citizens and to all persons who are eligible to be residents. It provides legal immigration status or work authorization.
For instance, if you are hired for a job, the employer will ask you for SSN. SSN helps the government to keep records of individuals’ income and the number of years worked. One can claim various benefits using this number.
For every resident taxpayer “SSN” i.e. Social Security Number is mandatory. For a non-citizen person to obtain such a number, he or she needs to fill in a social security card (SSC) i.e., “Form SS-5”. In the process of filling for SSC, you are required to provide your identity, immigration status, work eligibility, and age.
A person under no circumstances should possess both an ITIN and an SSN at the same time. The citizens, as well as residents both, are taxed on global income and they are also allowed to apply for the foreign tax credit. What is important to note here is that the US is one of the two countries in the world that taxes its non-resident citizens on worldwide income in the same manner as residents. The other country that does the same is “Eritrea”. In case of US citizens having a foreign bank account or financial assets that exceed 10,000 US dollars at any time during the ongoing calendar year then an ‘F-Bar’ form is required to be filed.
Income taxation in the United States
This is one of the most familiar and important types of direct tax. After receiving their income, individuals are required to pay taxes to the federal and state. Taxation is basically a tax return by tax residents.
Who are the tax residents?
All the US citizens plus the green card holders or someone present in the US for some specific period that will make a person qualify to be a resident categorized as tax residents. And therefore, every person who is a tax resident needs to file a tax return to the government.
The United States (US) has a progressive tax system, which is based on the fundamental principle of “Earn High Pay High” wherein if you earn high you have to pay higher taxes, keeping in mind the objective that someone with lower income should be subjected to pay lesser tax compared to higher-income earning person.
The Internal Revenue Service (IRS) allows a standard deduction for certain taxpayers that has to be chosen. This conceptually means that a specific amount will be reduced from the income you are taxed and not the tax that will be paid to the government. This deduction is not available to all. It is not constant for everyone and varies according to one’s filing status for instance when some taxpayer claims you as dependent or the person is 65 or older and/or blind.
Tax credits are distinguished from deductions, the difference seems to be subtle but tax credits are going to actually reduce the tax dollars that are due and owed to the government rather than reducing the actual income.
There are other taxes as well such as corporate income tax (CIT) which is levied by federal and state governments on corporations or business houses. A corporation falls into two categories basically being C corporation & S corporation which is discussed ahead. The payroll taxes are taxes paid on the wages and salaries of employees. Similarly, there are Capital Gains Taxes, generally these are levied on Capital assets which include everything owned and used for personal purposes or investment e.g., stocks, bonds, homes, etc. These are the basic categories of taxes on the income that you earn:
Types of Income Tax Return/ Tax Form
Taxpayers are needed to fill an ITR (income tax return) form giving their details of particulars like income earned and tax applicable on that income and then submit it to the income tax department. All U.S. tax returns are submitted to the Internal Revenue Service (IRS), the federal tax authority in the U.S.
Form 1040 – Individual Tax Returns
Who and when should be filed?
This form is filled by the individuals who are deemed a resident of the United States for tax purposes and is one of the types to report taxable income. It is required to be filled if the income crosses a threshold limit to determine whether additional taxes are owed or whether the filer will receive a tax refund. The filing modalities that one needs to know that it can be filed by the paper where you simply fill the form and send it to the IRS. It can also be done through the internet. There are also several variants available for Form 1040 which are Form 1040-NR for non-resident aliens, Form 1040-SR for taxpayers who are 65 years or older, and Form 1040-X which is used to make corrections on form 1040. Now, there are ‘5 filing statuses’ for individuals, first being single, the other is head of household, the third being married filing jointly, the fourth is married filing separately and the last is qualified widow(er). Every individual filer who earns a certain amount of income must file this type of tax return.
Form 1041 – Estate and Trust
Who must file?
This form is filed by a fiduciary of an estate and/or a trust. Here the fiduciary is the trustee of a trust or an executor, administrator, personal representative, or person in possession of a property of the decedent’s estate (e.g., savings accounts, stocks, bonds). Schedule K-1 (Form 1041) is an official IRS form used to report a beneficiary’s share of an estate or trust. Further like 1040, it is also filled by paper or online. One can choose the accounting method such as cash or accrual, while preparing the tax return. Income Tax Return for Estates and Trusts is required if the estate generates more than $600 in annual gross income in case of it being of a resident person but if it is non-resident, there is a need for form to be filed regardless of how much income is reported.
Form 1065- Partnerships
It is filed by domestic as well as foreign partnerships. Like Form 1040 or 1041, it can also be filled by paper or in online mode.
IRS defines a partnership as two or more people who carry on a trade or business together. It gives the IRS details of the company’s financial status for the year. Along with Form 1065, the partnership must also fill Schedule K-1. This schedule identifies the percentage share of gains and losses assigned to each partner. Taking into consideration the accounting methods, one can go for the cash, accrual, or hybrid accounting methods by filing a tax return.
Form 1120 – Corporations
All domestic corporations including corporations in bankruptcy must file an income tax return whether or not they have taxable income. It can be filed through paper or online or both. Permissible accounting methods include cash, accrual, hybrid, which clearly reflects the income and one can use it consistently. C corps (standard corporation under IRS rules) are separately taxable entities and file a corporate tax return under Form 1120. In the instances where the business houses have distributed dividends, they may face double taxation as they are then considered personal taxable income.
Form 1120-S – S Corporation
A corporation or other entity must file Form 1120-S if
- it elected to be an S corporation;
- the IRS accepted the election, and
- The election remains in effect.
S corporation is a corporation that has elected a special tax status with the IRS and therefore has some tax advantages and is usually the one filling this form. This business structure allows a corporation to pass corporate income, losses, deductions, and credits through to shareholders for federal tax purposes.
Accounting methods include cash, accrual, hybrid.
Therefore based on the above observations for the purpose of filing an income tax return, one should see to which of the categories it belongs.
Now here are few things you need to know before you begin filing:
- Federal and state taxes must be filed each year on or about April 15 for income earned in the US during the previous calendar year.
- Your tax status may be different from your immigration status in the US. The IRS does consider you a resident if you have been living in the US for five calendar years. It is called a substantial process. You can visit the IRS website to know whether you fulfil the criteria for the substantial process.
- The federal or state government may withhold the taxes from your paycheck and you can determine the amount of taxes to be withheld but if you have underpaid your taxes you will need to pay the amount you owe to the IRS.
- Beware of scams, no government agency or US law enforcement agencies such as the IRS or FBI will ever call you and demand money from you.
Conclusion
As an overall conclusion, I would say that filing taxes in the United States is in no way simple by their design and there are a plethora of forms to fill and additional attachments that you may have to make. Unlike India which has a Central taxation system, the US has separate mechanisms for federal and state. There is a statement by the IRS saying that an average taxpayer spends 12 hours working on it and ends up paying an average of 230 dollars to get the paperwork filed. When you look at tax structures from around the globe the process is even simpler in places like Belgium, Spain and Denmark. IRS claims that if the filer knows how to navigate the tax code, then the forms in schedules are actually designed to help and save money. Paying tax essentially through a defined tax code is not there to harm anyone. It is for the filer to go through over the course of a year and make sure that their money is spent where it is resourceful and reduces their ‘s liabilities.
References
- https://www.investopedia.com/terms/f/form-1065.asp
- https://www.wolterskluwer.com/en/expert-insights/s-corp-vs-c-corp-differences-benefits
- https://www.taxesforexpats.com/expat-tax-advice/Citizenship-Based-Taxation-International-Comparison.html
- https://www.rpi.edu/dept/advising/free_enterprise/us_government/taxation.htm
- https://www.investopedia.com/articles/personal-finance/082415/whats-wrong-american-tax-system.asp
- https://www.investopedia.com/ask/answers/060515/what-difference-between-state-income-tax-and-federal-income-tax.asp.
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