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Introduction to Common U.S. Taxes

Even when taxes are not the focus of the discussion, tax implications of business transactions and property transfers often are considered in the decision making process.  For example, should a business order and pay for next year's input at this time, or should a married couple give some of their property to their grandchildren.  This page briefly introduces several common forms of U.S. taxes, such as income, estate and gift taxes.  This discussion, however, is not intended to offer tax management strategies.

Income, estate and gift taxes are imposed by several levels of government:  federal, state and infrequently, local governments.  This discussion focuses on federal law; however, the basic principles of these several taxes often are similar regardless of which level government is imposing the tax.

All statements on this page are general descriptors; each topic contains numerous details and exceptions that are beyond the scope of this introduction.  Readers are urged to seek competent professional advice before making decisions that have major tax implications.

Income tax

Income tax is imposed on the income earned by individuals and other taxpaying entities, such as estates, trusts, and some businesses.  The tax is paid by the person or entity that earned the income.  The amount of tax is calculated annually as a percent of the taxpayer's taxable income for that year.

Income is defined to include wages, salaries, profit from business activities, and earnings from investments, such as rent, interest and dividends. 

Income also includes capital gains, that is, the profit or gain a taxpayer realizes when a capital asset is sold.  Land or corporate shares, for example, are capital assets.  A taxpayer may buy a tract of land for $15,000.  This cost is considered the basis (for income tax purposes) for this land.  Several years later when the taxpayer sells the land for $22,000, the taxpayer will report a capital (taxable) gain of $7,000; that is, the $22,000 selling price minus the $15,000 basis.

Proceeds from loans, inheritances, and gifts are examples of transactions that are not considered income.

In calculating taxable income, certain expenditures are subtracted (deducted) from total income, such as business expenses (including depreciation of business assets and interest on business loans) and an allowance for certain personal expenditures (such as, property tax, medical expenditures and charitable contributions).

In summary, income tax is an annual tax imposed on income earned by individuals and other taxpaying entities.

Estate tax

Estate tax is based on the value of property held at time of an individual's death.  The tax is paid by the estate before the property is distributed to heirs.  The amount of tax is calculated as a percent of the value of the taxable estate.

The decedent's property that transfers to the decedent's surviving spouse or to charitable entities is not included in the taxable estate.  Accordingly, an individual can assure no tax on their estate by arranging before death that all their property goes to the surviving spouse or charities at the time of death.  Many individuals, however, want some or all of their property to pass to someone other than a spouse or charities.  Accordingly, these persons will have property that is subject to an estate tax.

To further reduce the burden of an estate tax, federal law provides a tax credit.  Restated, the personal representative of the decedent's estate will calculate the amount of estate tax on the decedent's property, but then subtract the amount of tax credit provided by federal law.  For persons who die in 2009, the credit has the effect of allowing $3,500,000 of property to pass to heirs (other than the spouse and charities) without the estate having to pay a federal estate tax.

Several other points about inherited property.

• An estate is not subject to an estate tax unless the estate is worth more than $3.5 million dollars, but with some planning, owners of larger estates can take steps to minimize taxes (such as dividing ownership between married spouses) -- see an appropriate professional.
• "For Estate Tax Purposes in years 2006, 2007 and 2008 the Unified Credit [was] $780,800 and the Applicable Exclusion Amount [was] $2,000,000... For Estate Tax Purposes in year 2009 the Unified Credit is $1,455,800 and the Applicable Exclusion Amount is $3,500,000." Excerpt from Internal Revenue Service.
• Unless Congress amends federal tax law, there is no federal estate tax in 2010.  Furthermore, the amount of credit for estate tax will be reduced in 2011, meaning that estates of persons who die after 2010 will be more likely to incur a federal estate tax than those who died during the previous decade.  Check with a credible tax law resource for up-to-date information about the federal estate tax credit.
• See http://law.freeadvice.com/tax_law/estate_tax_law/unified_tax_credit.htm or http://fsc.fsonline.com/fsj/archive/2004est.html or http://unifiedtaxcredit.com/.

• Receiving an inheritance is not "income" to the heir; that is, it is not subject to income tax. 
• Another question with respect to taxes and inherited property is "does the heir pay income tax on the capital gains when the property is sold after it is inherited." The general answer is that property which passes through an estate receives a "step-up" in basis which prevents many heirs from having to report any capital gains on inherited property that is sold soon after the property is inherited. For example, individual A purchased a tract of land for $15,000 in 2000; that amount ($15,000) would be the basis in the land for A. When A dies in 2007, the land has a value of $22,000 and B receives the land as an inheritance from A. Under federal income tax land, the basis in the land for B is "stepped up" to $22,000; that is, the value for the purpose of A's estate. If B then sells the land for $22,000 (its value), B has no capital gain (taxable income) from selling the inherited property (the selling price of $22,000 minus the basis of $22,000 results in no taxable gain). This tax outcome is different than if A had gifted the land to B in 2007 -- as described in the next section.
• Alternative scenario: If A had not died but instead sold the land in 2007 for $22,000, A would have had $7,000 taxable income ($22,000 selling price minus the $15,000 basis). Thus a statement that is sometimes made is "pass appreciated property through an estate in order to get a step up in basis" to minimize income tax.
• Another scenario: If the land appreciates between the time that B inherits it and sells it, B would have capital gain on that amount. For example if B sold the inherited land for $23,500, B would have a gain of $1,500, that is, the difference between the stepped up basis of $22,000 and the selling price of $23,500.

Also see Estate Tax at http://www.irs.gov/businesses/small/article/0,,id=164871,00.html.

Gift tax

A gift tax is based on the value of the property that is being given away.  Any gift tax is the responsibility of the donor, and the amount of tax is a percent of the amount of the taxable gift.

• An item sold for less than its market value will be considered a gift; for example, a parent selling property with a market value of $25,000 to a son or daughter for $9,000 will be considered to have made a $16,000 gift.

• A gift will not be considered a "taxable gift" if total gifts from the donor to the donee are less than $13,000 (in 2009) for the year.  This amount is known as the "annual exclusion".
• A donor has an annual exclusion for each donee, so an individual who wants to give property to three persons in 2009 could give as much as $13,000 to each donee without concern about gift tax.  A married couple could give as much as $26,000 to one individual in 2009 without concern about gift tax.
• A gift that exceeds the annual exclusion (such as, $20,000 given to one donee) would be a taxable gift, but may not require a tax payment because federal law provides a "lifetime" credit for gift tax.  However, the amount of gift tax credit used during the donor's lifetime is considered in calculating the donor's subsequent estate tax credit.  This means an individual who uses the gift tax credit during his or her lifetime to offset gift tax is reducing the amount of credit that will be available to the individual's estate at the time of the individual's death. See  http://law.freeadvice.com/tax_law/gift_tax_law/unified_estate_gift_tax.htm.  Due to the complexity of the "unified" estate and gift tax, individuals are urged to consult with appropriate tax professionals.
• There are other important provisions in gift tax law that minimize the amount of tax that will result from giving property (such as, gifts between spouses are exempt from gift tax) -- again, see an appropriate professional.

• Receiving a gift is not "income" to the donee; that is, it is not subject to income tax. 
• Another question with respect to taxes and gifted property is "does the donee pay income tax on the capital gains when the property is sold after it is received as a gift." The general answer is that property which is given to another person has a "carry over" basis. For example, individual A purchased a tract of land for $15,000 in 2000; that amount ($15,000) would be the basis in the land for A. If A gives the land to B in 2007 when the land has a value of $22,000, B's basis in the land would be carried over from A; that is, B's basis would be $15,000. If B then sells the land for $22,000 (its value), B has $7,000 taxable income from selling the gifted property (the selling price of $22,000 minus the basis of $15,000). This tax outcome is different than if the land had passed to B as an inheritance from A -- as described in the previous section.

Also see "Frequently Asked Questions on Gift Taxes" at http://www.irs.gov/businesses/small/article/0,,id=108139,00.html

For further information about federal estate and gift taxes, see Estate and Gift Taxes at http://www.irs.gov/businesses/small/article/0,,id=98968,00.html.

Other taxes

This section introduces several other common taxes.

Property tax -- Property tax is generally imposed by local governments, such as cities, counties, school districts, and other local taxing authorities.  The tax is based on the value of the taxpayer's property, such as their residence, business property, and land.  The tax is calculated based on the appraised value of the taxed property and the "mil rate" imposed by the taxing authority (that is, a specified number of "tenths of a cent" in tax for every dollar value of  property). 

An individual's property may be subject to several property taxes, such as the school district, the city, the county, the local airport authority, and a special district assessment for a flood protection project.  It is a common practice for each taxing authority to collect their tax through the county which then distributes the appropriate amount to each taxing authority.  Thus, the property owner often pays the tax to the county for all the local taxing authorities.

Real property (land, buildings and fixtures) are often subject to property tax; it is not common for government to impose a property tax on personal property (such as, vehicles, home furnishings, jewelry).  Property tax is generally collected each year.

Sales tax -- A sales tax is generally imposed by state and local governments to be paid by consumers for items they purchase, such as vehicles, meals away from home, furniture, and appliances.  The tax is usually calculated as a percent of the retail selling price.  The tax is paid by the consumer at the time of the retail purchase; the merchant tracks the tax collection and submits the proceeds to the taxing authority on a regular basis (e.g., monthly, quarterly).

Laws vary among jurisdictions; for example, some states do not impose sales tax on consumer items that are considered necessities, such as food, clothing and prescription medicine.  Taxpayers need to familiarize themselves with sales tax laws in their jurisdiction due to the wide variation in practices among state and local governments.

Self-employment tax -- Self-employment tax is a federal tax imposed on earned income received by self-employed persons.  It is comparable to employment taxes (Social Security and Medicare taxes) paid by employed persons and their employers.  Earned income includes profit from a business that the self-employed person is operating (that is, a business in which the taxpayer is materially participating in operating the business).  Earned income generally does not include rent, interest or dividend income.

• See http://www.irs.gov/businesses/small/article/0,,id=172179,00.html.

Conclusion

This page introduced several types of U.S. taxes.  An income tax is imposed on the taxpayer's income, whereas gift and estate taxes are based on the value of property that is transferred by the taxpayer during his or her lifetime and at the time of his or her death.  Other common taxes include property tax (based on the value of property owned by the taxpayer), sales tax (based on the item's retail selling price) and self-employment tax (based on a self-employed taxpayer's earned income).

Last updated November 30, 2009

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