Federal Income Tax
As of June 2001, the income tax forms the bulk of taxes collected by the U.S. government. Depending on individual income, it ranges from nothing to 35% of one's income. The income tax is called a progressive tax because it is higher as a percentage of the income of higher-income individuals. It is also assessed on most corporations. This results in double-taxation of the dividends paid to stockholders, although individuals usually pay a preferential tax rate on dividends.
Federal payroll taxes in the United States are primarily collected by employers, for the U.S. Internal Revenue Service. The Federal income tax uses a system of direct withholding. Employers pay part of a taxpayer's income tax directly from their payrolls. The amount of withholding is calculated based on an employee's expected annual salary and the employee's living situation (married or unmarried, number of dependents, other factors). Withholding does not perfectly calculate an individual's tax each year. The difference between the amount withheld and the actual tax is either paid to the government after the end of the year, or refunded by the government.
The U.S. government rewards certain behavior with tax deductions or tax credits. The most famous reduction in taxes is that income used to pay mortgage interest on a personal home is exempted from taxes, if the taxpayer elects to itemize. Taxpayers who do not participate in an employer-sponsored pension plan may contribute up to $3,000 ($3,500 if age 50 or above) into an individual retirement account, and deduct that contribtion from their gross income. The Earned Income Tax Credit benefits low- to moderate-income working families.
There are two ways to calculate income tax. The regular way is based on the gross income minus any applicable deductions and then a marginal tax percentage is applied according to the taxpayer's income bracket. From this result, any applicable tax credits are subtracted and the result is the income tax owed. If the result is a negative number due to refundable tax credits and/or if the Federal Withholding Tax was greater than the income tax that was actually owed, the taxpayer is entitled to a tax refund. A taxpayer eligible for a refundable credit (such as the earned income tax credit) may receive a refund even without paying any federal income tax.
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The second way, the Alternative
Minimum Tax (AMT) is based on the gross income,
computed without regard to certain tax preference
items (such as tax-exempt interest on certain
private activity bonds) and with a reduced number of
exemptions and deductions. This higher income base
is taxed in two rate brackets, 26% and 28%,
depending on taxpayer income. The taxpayer pays the
higher of the two computed tax liabilities.
In the tax year 2000, many taxpayers in Silicon
Valley were caught unprepared by the AMT due to the
sudden decline in technology stock prices. Under AMT
rules, unrealized gains on incentive stock options (ISOs)
are taxed at the date the options are exercised. In
contrast, under the regular tax rules capital gains
taxes are not paid until the actual shares of stock
are sold. For example, if someone exercised a 10,000
share Nortel stock option at $7 when the stock price
was at $87, the bargain element was $80 per share or
$800,000. Without selling the stock, the stock price
dropped to $7. Although the real gain is $0, the
$800,000 bargain element still becomes an AMT
adjustment, and the taxpayer owes thousands of
dollars in AMT.
The AMT was designed to prevent people from using
loopholes in the tax law to avoid tax. However, the
inclusion of unrealized gain on incentive stock
options imposes difficulties for people who cannot
come up with cash to pay tax on gains that they have
not realized yet. As a result, Congress has taken
action to modify the AMT regarding incentive stock
options. In 2000 and 2001, people exercised
incentive stock options and held onto the shares,
hoping to pay long-term capital gains taxes instead
of short-term capital gains taxes. [2] Many of these
people were forced to pay the AMT on this income,
and by the end of the year, the stock was no longer
worth the amount of AMT tax owed, forcing some
individuals into bankruptcy. In the Nortel example
given above, the individual would receive a credit
for the AMT paid when the individual did eventually
sell the Nortel shares.
Another perceived flaw in the AMT is that it hasn't
been changed at the same rate as regular income
taxes. The tax cut passed in 2001 lowered regular
tax rates, but did not lower AMT tax rates. As a
result, certain middle-class people are affected by
the AMT, even though that was not the original
intent of the law. People with large deductions,
particularly mortgage interest and state income tax
deductions, are affected the most. The AMT also has
the potential to tax families with large numbers of
dependents (usually children), although in recent
years, Congress has acted to keep deductions for
dependents, especially children, from triggering the
AMT.
IRS statistics for 2000 show that returns showing
less than $15,000 in adjusted gross income amounted
to 30 percent of total returns filed but accounted
for less than 1 percent of tax paid. By contrast,
although they made up only 2 percent of all
taxpayers that year, taxpayers reporting $200,000 or
more in adjusted gross income paid 45 percent of all
federal income taxes.
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