Income Tax 101

I already addressed the general concepts being proposed in the first article of my series on tax reforms, giving a historical perspective and some basic economic principles (Part 1).  The conclusion is that the tax cuts being proposed by the Trump Administration and the GOP will not work, at least not to create the end result they are telling everyone to expect.  The way that I see it is this:  The people working on this plan, Steve Mnuchin, Donald Trump, Mick Mulvaney, Paul Ryan, and the rest, are not stupid people.  They know the history, they know basic economics, and most of them know a fair amount about private sector businesses.  The other thing they all have in common is that they are all either billionaires, or they owe their careers in politics to billionaires that support them and make sure they get elected year after year.

“We The People” are being screwed by the system once again if this passes!

Here’s my point…they are all, as a group, ignoring the facts, ignoring the history, and ignoring the needs of all of us and the country in both the long and short term, and simply charting a course that will serve their immediate needs, and those of their influential supporters in the best way possible…and in the process, selling all of us out.  There, I said it…we are being screwed by the people with the money once again, by a corrupted system that only cares about the optics of political victory, the splash in today’s headlines, and most of all, how much more money can they make.  It is not a Conservative versus Liberal issue.  It is a good policy versus bad policy issue, and more importantly as I continue to say, it is a “have’s” versus “have not’s” issue.

Before we get to how we should proceed, if you are not familiar with how income taxes are collected, or what they are based on, please read my brief summary of income taxes that are related to businesses, and the owners of businesses.  If you already know all about taxes, then go ahead and scroll down through the next few sections, otherwise, here is what you need to know:

Basics of Income Taxes

The first premise I would like to establish is that the concept of “Tax Reform” should not automatically mean tax “cuts”. Tax policy is complex, to say the least; however, it serves two basic purposes.  Primarily, it provides the means for the government to generate the revenue required to function and provide the programs and services it currently does, or may intend to, provided sufficient funding can be secured.  Secondly, when it comes to tax policy, it is also a mechanism through which the government has the opportunity to influence the behavior of both businesses and individuals when it comes to how they allocate their financial resources, or simply put how each spends their money.

By and large, there are two camps related to corporate tax policy, the Liberal and Conservative schools of thought. I think most people know the core beliefs of each side of the aisle, but to summarize them:

  • Conservatives generally believe that the free market system, competitive capitalism, and private enterprise create the greatest opportunity and the highest standard of living for all. They will argue that free markets produce more economic growth, more jobs and higher standards of living than those systems burdened by excessive government regulation.
  • Liberals general believe that a market system in which government regulates the economy is best. Government must protect citizens from the greed of big business, because unlike the private sector, the government is motivated by public interest. They will argue that government regulation in all areas of the economy is needed to level the playing field.

It is my position that in this area, neither side is completely right or completely wrong. My belief is that ultimately the most important consideration needs to be what is good for the majority of the people within our country, and a blending of Conservative and Liberal perspectives is the way to achieve that goal.

Facts Related to Corporate Tax Policy

The total tax revenue of the Federal government is approximately $3.2 trillion annually, and of that Corporate Income Tax represents approximately 11% or $352 billion.

Category Percent Total Amount
Individual Income Tax 47.00% $1,504,000,000,000
Payroll Taxes 33.00% $1,056,000,000,000
Corporate Income Tax 11.00% $352,000,000,000
Excise Taxes 3.00% $96,000,000,000
Estate Taxes 0.60% $19,200,000,000

Other Taxes

5.40%

$172,800,000,000

Total Federal Income 100.00% $3,200,000,000,000

NOTE:  That figure only includes C-Corporations, which are taxed as a business entity, and not the majority of all businesses which include Limited Liability Corporations (LLC), S-Corporations, Sole Proprietorships and Partnerships which are all taxed differently, with the income of the business being passed through directly to the individual tax returns of the owners or partners (I will refer to these entities as “Pass Through Businesses” for the purposes of this article.

How Big is the Segment of “Pass Through Businesses”?

Pass Through Businesses employ more than 50% of the private sector workforce, account for 37% of all private sector payroll, and make up more than 60% of the net business income in America, so while they are not specifically effected by the Corporate Tax Rate, they are obviously a major component of our economy and tax policies that pertain to them will need to be addressed as well.

What is the difference between a C-Corporation and a Pass Through Business?

Unlike Pass Through Businesses, where all of the profit of the business is passed through to the owner’s individual income tax, the profit of a C-Corporation is taxed at the corporate level, separate from the owners (shareholders), and is subject to the Corporate Tax Rate we are discussing. Keep in mind, this is not the only kind of tax borne by a Corporation, but I am focusing on it for this discussion.

How do the profits of a Corporation transfer to the owners (shareholders)?

The portion of the overall corporate profit that is paid out to the owners is called a dividend. It is paid out by the corporation after corporate income tax has been paid on all profit, and then the dividends are subject to individual income taxes at whatever rate the shareholder is required to pay, which is where the phrase “double taxation” is used to describe the tax implications faced by a C-Corporation and its shareholders. For example, if the C-Corporation has $100 in pre-tax profit per share, the corporation will pay $35 in taxes to the Federal government. Then the Corporation can decide to pay out $5 per share in dividends out of the $65 retained earnings (after corporate income tax is paid), and the shareholder will be required to pay anywhere from 10% to 39.6% of that $5 in individual income tax, depending on what tax bracket their total income puts them in.

This is different than normal payroll expenses, such as salaries, hourly wages and bonuses, which are taken out of a businesses profit BEFORE their income tax owed is calculated, reducing the overall tax liability of the corporation.  In my opinion, this is not necessarily bad for a normal investor that does not actually work for the corporation, however it is quite punitive when you think about small closely held corporations, where the shareholders are all members of a very small group, most or all of which actually work for the corporation on a full time basis, and it is their only source of income.  This is one area that I think is ripe for tax reform, which will be discussed later.

How else are owners (shareholders) of a Corporation are taxed?

The other way that the owners (shareholders) of a C-Corporation are taxed is through a capital gains tax, which takes effect when a shareholder sells some or all of the shares they own in a C-Corporation at a price greater than they originally paid for the shares. Short term capital gains (on investments held for less than 1 year) are taxed at the same rate as the rate you pay in individual income taxes. Long term capital gains are taxed at a reduced rate, ranging from 0 to 20% depending on your individual income tax bracket.

Are there any other kinds of taxes related to businesses?

With Pass Through Businesses, the owners are also subjected to an additional tax, called Self-Employment Tax, that is in addition to their normal individual income tax and is used to fund their contribution to Social Security and Medicare because they did not receive normal paychecks, and therefore, did not have those taxes deducted like most people do. The only difference is that unlike an individual employee, who only pays 50% of the total taxes in these two areas (because the employer pays the other 50%), a self-employed person actually pays the full 100% of these two taxes.

Income Tax 101 Conclusion

As you can see, even broken down in as simple of terms as possible, the tax code related to businesses is quite complex.  In my opinion, it’s not the complexity or the different levels of tax that are the problem though, it is that the current tax code, as well as the proposed cuts being outlined by the Trump Administration do not prompt the behaviors that would be in the best interest of America and the majority of the people that call it home.

Please proceed to Part 3, which will be posted shortly, to learn about proposals that would lead to the improvements so desperately needed.

2 thoughts on “Income Tax 101”

  1. Thank you for the summarized explanation. In the presidents great new tax plan, he said it will help 30 million businesses! When if fact it will only help 670,000 businesses. Which basically comes down to the 1%!!!!
    Unless your company profits more than 46,000 dollars a year. The new tax codes WILL NOT HELP YOU AT ALL!!!!

    Like

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