Understanding Basic Tax Concepts

Untangling some key tax terms.

Most people fear taxes and don’t understand them. Accountants toss around terms like standard deduction, FICA, and tax credits as if everyone understands them. However, most don’t, and that’s ok! A good start to understanding our complex tax system is to untangle some bits and pieces of tax lingo.


Income

There are several types of income. Employees earn wage income. Business owners earn business income. Alimony, retirement payments, and even some scholarships are examples of other types of income. The starting point of determining how much income tax a person owes is to add up all their taxable income.


Business Deductions

Deductions reduce income. A business deduction directly reduces business income. Assume a taxpayer owns a small business and has $50,000 in business income. The taxpayer pays $500 per month in business rent. That rent is a business deduction that reduces the taxpayer’s business income. $50,000 in income less $6,000 in total rent equals $46,000.

If the taxpayer in the example above also had a part time job where she made $16,000 during the year, her total income would be $46,000 (the net from her business) plus the $16,000 totaling $62,000.

 
 

Standard Deductions & Itemized Deductions

The tax laws also allow taxpayers a number of other deductions that are not specific for business owners. Items like the charitable and mortgage interest deductions are a couple of examples.

Tracking and adding up these deductions can be a bit onerous. Presumably, for this reason, and to give a slight break to taxpayers, the tax code has what is called a “standard deduction.” The standard deduction is a specified amount by which every tax payer may reduce their income. The 2018 standard deduction for single filers is $12,000 and for married individuals filing jointly, the standard is $24,000.

Taxpayers have the choice to either take the specified standard deduction or to itemize their non-business-related deductions and take that alternative. This is what people refer to when they say “I itemized last year.” The most common itemized deductions are the mortgage interest deduction, medical expense deduction, and charitable deduction.

Typically, you would only want to itemize if your itemized deductions total more than your standard deduction. I speak with several people each tax season who have a question something like “I donated $500. Why does that donation not increase my refund?” If that donation were their only itemized deduction, then their tax filing software is likely automatically giving them the standard deduction which would provide a much better benefit.

Let’s go back to our hypothetical taxpayer. After business income, business deductions, and wage income, the taxpayer’s total taxable income is $62,000. If the taxpayer had minimal itemized deductions, she would take her standard deduction of $12,000 which would then reduce her taxable income to $50,000.


Credits

Unlike deductions which reduce income, credits may result in a dollar-for-dollar reduction in tax. Our hypothetical taxpayer has $50,000 in taxable income after applying her standard deduction. After reaching the $50,000 number, she would apply the tax brackets to actually determine her tax liability. Let’s assume she owes $5,000 tax on that income. If she had a $1,000 credit, the credit would reduce her tax from $5,000 to $4,000.

Here is another, more simplified example. Assume a flat tax of 10%. Taxpayer B has income of $55,000. In scenario 1, taxpayer B has $5,000 deduction. The deduction reduces taxable income to $50,000. 10% on that taxable income equals $5,000.

Now, in scenario B, taxpayer instead has a $5,000 credit, so taxable income remains $55,000. 10% of $55,000 is $5,500. The credit reduces the tax by $5,000, so now the taxpayer in scenario B only owes $500 in tax.


Tax Refund

We all at least kind of know what a tax refund is. However, I talk to many new business owners confused about how the refund works. When individuals receive a paycheck as an employee, the employer withholds taxes and sends them to the government on the employee’s behalf. When that employee goes to file his tax return, the return is essentially reconciling the amount already paid on behalf of the employee with the amount actually owed.

If $5,000 was taken over the course of the year from the paycheck, and the taxpayer only owes $4,000 in taxes once inputting his deductions and credits, he will get a $1,000 refund. If his tax bill is $6,000, he will need to send the IRS $1,000, the difference between his tax bill and the amount withheld.


Non-Refundable Credits

Between the child tax credit and some other common credits, it’s not unusual for some individuals’ tax to be reduced all the way to $0. Some credits are “refundable” meaning that even if a taxpayer’s tax liability is $0, he can get a refund. For example, if a taxpayer has $3,000 in tax liability and a $5,000 credit, the credit will reduce the liability to $0 and still result in a refund to the taxpayer in the amount of $2,000. If, however, the credit is “non-refundable,” that credit will simply reduce the tax liability from $3,000 to $0, but not result in a refund.


In conclusion

Knowing the basics on these concepts will make you a more savvy taxpayer and business owner. There’s no need for you to become a tax pro. Focus your time on your strengths. Just use the info here, so that you can speak the same language as your tax guy or gal.


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