Taxes 101: Types & Categories
Updated: Dec 4, 2020
When you hear the word "taxes," what comes to mind? Income taxes may take center stage in your mind's eye at the first thought of taxation, especially during tax filing season. You are probably familiar with property tax and sales tax, as well; but did you know that there is a plethora of other tax categories? Though we are certainly acutely aware of some taxes, others are levied more sparingly or are less obvious to consumers.
Taxes are mandatory fees paid by individuals or business entities to finance various government services, programs, and activities. These fees are required and enforced by government entities at the federal, local, and state level. The Internal Revenue Service (IRS) is responsible for collecting federal taxes in the United States.
There are two main types of taxes: direct taxes and indirect taxes.
Direct taxes are paid directly by an individual, business or other entity to the government. The cost of these taxes cannot be passed onto another person or entity; the liability for direct taxes lies entirely with the individual or entity upon which the tax is levied.
Progressive in nature, direct taxes are based on the “ability-to-pay” principle; higher incomes are subject to higher taxes. Common types of direct taxes include income tax, transfer taxes (such as estate or gift taxes), property tax, and tax on capital gains.
Indirect taxes are levied on an individual or entity but passed on to consumers as part of the purchase price of a good or service. This means that the tax burden ultimately lies with consumers rather than the entity being taxed.
Indirect taxes can be further classified as either specific taxes or ad valorem taxes. Specific taxes are levied based on quantity (charged by unit), whereas ad valorem taxes are based on the assessed value of an item (paid as a percentage). Common indirect taxes include excise taxes and customs tax.
Many different types of taxes fund local, state, and federal governments. Payroll taxes, income taxes, and self-employment taxes comprise the largest percentage of federal tax revenues.
In the United States, income taxes must be paid at the federal level; whether you owe state or local income tax depends on your location. Individuals in Georgia are required to pay state income taxes, but Georgia does not have income taxes at the local level.
Individuals who work as employees for a business or other entity usually pay income taxes through a process called withholding, in which their employer withholds a portion of each paycheck. This amount goes toward the employee’s income taxes. An individual’s withholding amount is based on several factors. To indicate the amount of tax to be withheld from each paycheck, employees must file a W-4 form with their employer.
Income earned by self-employed individuals (such as sole proprietors, members of a partnership, or independent contractors) and most investors is not subject to paycheck withholding. Therefore, these individuals generally pay income taxes by making estimated payments throughout the year.
Also referred to as the “payroll tax,” the FICA tax is taken directly from an employee's paycheck via withholding. Paid for by both employer and employee, the FICA tax funds Medicare and Social Security. Though withholding amounts for payroll taxes vary among employees, the FICA tax is assessed at a flat rate.
In lieu of payroll taxes, self-employed individuals must pay self-employment tax, which essentially serves the same function as payroll taxes: funding Medicare and Social Security. Sole proprietors, independent contractors, and members of certain partnerships are required to pay self-employment tax.
An independent contractor performs work or provides services for another entity as a non-employee.
A sole proprietor is the owner of an unincorporated business (in other words, a business that has not been restructured into a separate legal entity such as an S-Corporation).
A single-member LLC or LLP is considered a disregarded entity for tax purposes; although the business is legally separated from its owner, it is taxed through the business owner’s personal tax return, similarly to a sole proprietorship.
Members of partnerships that engage in business activities other than rental real estate are also required to self-employment taxes.
Profits earned by corporations are also subject to taxation. Corporate taxes are based on a company’s earnings after deducting operating expenses, including the cost of goods sold (COGS) and the depreciation of long-term assets.
A concept commonly associated with corporate taxes is the principle of double taxation. Double taxation occurs when income taxes are paid twice on the same source of income. This occurs when income is taxed at the corporate level as well as at the individual level. For example, the profits earned by a C corporation (C corp) are taxed before the distribution of dividends; individual shareholders must then pay income taxes on the dividends they receive.
In order to avoid the disadvantage of double taxation, an eligible business entity may elect to be taxed as an S corporation (S corp) rather than a C corp. Considered a type of pass-through entity, an S corp is not subject to double taxation because its profits are only taxed once; taxation occurs at the individual level but not at the corporate level. This makes it an appealing business structure for companies looking to avoid double taxation of their profits. However, the S corp designation is limited to businesses that meet certain requirements; S corps are only permitted to have class of stock and can possess no more than one hundred shareholders.
Property tax is an ad-valorem tax paid by property owners to local governments. Most commonly associated with home ownership, property taxes are calculated based on the assessed value of an individual’s property. Revenue from property taxes goes toward education, infrastructure such as roads and highways, water and sewer improvements, public servants, and other services to benefit the local community.
Estate tax is the taxation of assets transferred from deceased persons to their heirs. Estate tax is only levied on estates valued above an exclusion limit set by law; only the amount in excess of this threshold is subject to taxation. Estate taxes are assessed by the federal government as well as some state governments. Fees are calculated based on an estate’s fair market value rather than what the deceased individual originally paid for the assets comprising the estate. Under the unlimited marital deduction, assets that are transferred to the deceased individual’s surviving spouse are exempt from estate taxation.
Excise taxes are paid on certain goods such as fuel, tobacco, or alcohol. These taxes are often paid by merchants who then pass on the cost to consumers in the form of higher prices; this results in an indirect tax paid by individuals other than the taxed entity. Excise taxes are sometimes called “sin taxes” because they are commonly levied on goods considered detrimental to society, such as alcohol and cigarettes.
Excise taxes can be categorized as ad valorem or specific taxes, depending on whether the tax is levied on a per-unit basis or calculated as a percentage of an item’s assessed value. Examples of ad valorem excise taxes include firearms, airline tickets, and heavy trucks. Tobacco products, alcohol, and gasoline are subject to specific excise taxes.
We hope this information has been enlightening. For additional guidance from our highly qualified accountants and consultants, give Seymour & Perry, LLC a call at 706-549-8197.
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