Agribusiness Library

LESSON L060056: FEDERAL AND STATE INCOME TAXES

Objectives1. Define income tax, examine the federal income-tax brackets, and compare state income-tax rates.

2. Define common income-tax terms, and demonstrate the ability to correctly complete the state and national income-tax forms.

3. Analyze methods or strategies used to manage or reduce income taxes.

Terms•Adjusted gross income

•Form 1040

•Head of household

•Income tax

•Taxable income

•W-2 form

•W-4 form

An income tax is a levy on the taxable income (net earnings) of individuals, partnerships, corporations, or other entities.

The income tax levied on companies taxes the company’s net profit and is often referred to as the corporate income tax.

Income taxes are the main revenue source for the federal government and most state governments.

A. At the federal level, there are six tax brackets for four different filing classifications: single, married filing jointly, married filing separately, and head of household. Head of household is a status that can be claimed by a person

(single or married) who supports one or more people who are close relatives in one household.

In 2009, individuals filing as single would pay the following tax rates: 1. 10 percent for those earning up to $8350 2. 15 percent for those earning from $8,351 to $33,950 3. 25 percent for those earning from $33,951 to $82,250 4. 28 percent for those earning from $82,250 to $171,550 5. 33 percent for those earning from $171,550 to $372,950 6. 35 percent for those earning more than $372,950

B. Nine states do not impose a personal income tax, but many states rely on income taxes as a major source of revenue. Seven states have a flat rate income

tax, which ranges from as low as 3 percent in Illinois to as high as 5.3 percent in Massachusetts.

Thirty-four states have a progressive income tax system where rates are as low as 0.5 percent for low-income individuals (in Oklahoma) to as high as 10.3 percent for high-income individuals (in California).

Unfortunately, the United States income-tax laws are complex. In fact, few people are aware of and have a good understanding of all

that the laws include. However, the basics of the income tax are fairly easy to understand. Knowing the basic terminology and becoming familiar with the

commonly used federal income-tax forms provides people with the necessary knowledge to make sound tax decisions.

A. Adjusted gross income (AGI) is calculated by subtracting allowable deductions (e.g., contributions to health savings accounts or individual retirement accounts) from an individual’s gross income. If an individual earns a salary of $80,000 per year, he or she does not

pay the 25 percent tax rate on the entire $80,000. The individual only pays the 25 percent tax rate on the taxable

income.

B. Taxable income is the amount of income that is subject to income taxes, which is determined by subtracting itemized deductions or the standard deduction from the taxpayer’s adjusted gross income. Taxpayers have a choice to deduct from

their adjusted gross income the standard deduction or itemized deductions in calculating taxable income.

A taxpayer would deduct whichever one is greater so that taxable income is as small as possible.

C. Itemized expenses include items such as home loan interest, state and local taxes, medical and dental expenses, and gifts to charities. In 2009, the standard deduction for

an individual filing as single was $5,700, but it is adjusted yearly.

Thus, if an individual has medical expenses, home loan interest, and gifts to charity that total more than $5,700, he or she should itemize deductions instead of taking the standard deduction when determining taxable income.

D. As mentioned previously, the U.S. income tax is a bit complex. That is partially due to the number of forms that may be used

when filing federal income taxes.

The following are just a few of the most commonly used forms.

1. Form 1040 is the standard form used for individual tax returns and is sometimes referred to as the long form. Individuals with simple taxes (e.g., those taking the standard

deduction and with a taxable income below $100,000) may be able to use the 1040A form—known as the short form— or may use an even easier form known as the 1040EZ.

The 1040 form has 11 attachments (known as schedules) that may need to be used in conjunction with the 1040 form. a. Schedule A is the tax form used to report itemized deductions.

Schedule A is used by individuals who chose not to take the standard deduction.

b. Schedule B is used to report interest or dividend income if it exceeds $1,500.

c. Schedule C is used to report profit or loss from self-employed businesspeople.

d. Schedule D is used to report capital gains or losses. Capital gains may occur when an individual sells stocks, bonds,

property, livestock, or other non-inventory assets at a profit. e. Schedule F is used to report profit or loss for self-employed

farmers. f. Schedule J is used to report farm income that is averaged over a

period of several years.

2. The W-2 form is used to report wages paid to employees and to report the amount of federal and state taxes that have been withheld. The W-2 form should be filed with the 1040.

3. A W-4 form is used by an employee and is provided to the employer so the employer can determine the appropriate amount of tax withholding to deduct from an employee’s wages.

Even the most patriotic citizens would probably prefer to pay less in income tax if they could legally reduce their income tax bills.

To reduce the amount of income taxes owed by an individual or a business, the individual or business needs to reduce the taxable income by reducing AGI, increasing tax deductions, and taking advantage of tax credits.

A. Reducing adjusted gross income (AGI) will result directly in reducing income taxes.

The most common method to reduce AGI is through contributions to a 401(k) or another eligible retirement plan at work. 1. Other eligible deductions to AGI include items such as

contributions to a traditional individual retirement account and student loan interest paid.

2. Entrepreneurs or other business owners may reduce their AGI by pre-paying future business expenses prior to Dec. 31. This is advisable only if profit projections for the next year are

below the current year. If business is expected to be similar to the current year, then pre-

paying future business expenses in the current year will do nothing other than delay the payment of income taxes the following year.

This could push the business owner into a higher tax bracket.

B. Reducing taxable income is the key to a small tax bill, and itemizing deductions instead of taking the standard deduction may reduce taxable income. This is the case if an

individual’s eligible itemized expenses (e.g., medical expenses, home loan interest, and gifts to charity) are higher than the standard deduction.

Taxable income can be reduced further by making larger or additional contributions to charities.

C. Several tax credits are available to taxpayers. However, not everyone qualifies for a tax credit. A few examples of tax credits

include the Earned Income Tax Credit, Child Tax Credit, Adoption Tax Credit, tax credits for taking college courses (e.g., the Hope Credit and Lifetime Learning Credit), and First-Time Homebuyer Credit.

REVIEW•What is income tax? What are the federal income-tax brackets? What are tax rates for federal and state income taxes?

•What are the most common income-tax forms, and how are they properly completed?

•What methods or strategies can be utilized to reduce income-tax bills?