An Overview of Tax Law

According to the IRC, income is from whatever source derived and, in most cases, must be recognized. In this context, “recognized” means that you have received cash or some other liquid asset for your earnings to count as income.  Increases in the value of assets do not generate income until they are sold for a profit.  For example, items such as stock or property generally must be sold for the government to have a right to collect taxes on the gain from the sale.

Notice that the definition of income is broad and inclusive of many things. There are certain instances where income is earned without recognition simply because the taxpayer didn’t know their earnings were classified as income by the IRC. An odd example is the revenue generated from selling the ball after catching a record-breaking home run. These instances can possibly bring a citizen in the crosshairs of the IRS. While not exhaustive, this is a list of areas that the federal government generally taxes:

1. Wages and Employee Benefits
2. Self-Employment
3. Capital Gains – Long Term & Short Term
4. Investments – Interest, Dividends, and Stock Options
5. Benefits – Unemployment, Social Security Income, and Retirement
6. Miscellaneous – Canceled Debts, Court Awards and Damages, Alimony, Gambling and Theft

While each item deserves its own attention, for the purposes of this article they are referred to broadly as taxable income. The first step for taxpayers is to report their taxable income on a Form 1040. To make matters more complicated, the taxpayer then reports their adjusted taxable income after taking exemptions into account. The term Adjusted Gross Income (AGI) is often used to depict this number. Tax exempt items are not included as income. There are various tax exemptions under the IRC for which taxpayers can qualify.

Then, taxpayers can subtract from their AGI by choosing the standard or itemized deduction. The standard deduction is a fixed amount by the IRS whereby non-itemizing taxpayers may subtract from their income before the income tax is applied. The standard deduction is $14,600.00 for 2024. Itemized deductions are expenses which the IRC allows the qualifying taxpayer to deduct such as charitable contributions, medical expenses, and mortgage interest expenses. The standard deduction number is usually greater than that of the itemized deductions, so most taxpayers select the standard deduction.

Finally, the taxpayer will pay taxes based on their income bracket. A comprehensive explanation of the tax brackets is beyond the scope of this article, but you should know that there are seven tax brackets. The taxpayer pays taxes based on the tax rate of their income bracket.

The United States, like many other countries, uses a progressive income tax. This means that each tax bracket is taxed at a different rate. For example, the first $10,000 you make is taxed at an entirely different rate than the second $10,000. It is a common misconception that a pay raise can lower your take-home income because of the higher rates in each bracket, but this higher rate only applies to the money earned within that bracket. The rest of your income is taxed at the lower brackets’ rates. When it’s offered to you, always take the pay raise.

Business taxes involve the taxation of entities, whether they are incorporated under the state (corporations) or unincorporated (partnerships). For federal tax purposes, the main entities are the disregarded entity, general partnership (GP), S-Corporation (S-Corp) and C-Corporation (C-Corp). Depending on the entity classification by the IRS, the entity will be taxed under its default or election rules. Note that it is easy to confuse this with what is often called the choice of entity, which is covered by state law. The choice of entity generally involves sole proprietors, general partnerships, limited liability companies (LLC) and corporations. The choice of entity is the entity’s formation structure governed by state law. A tax election is how the entity will be taxed based on the IRC, which is federal law.

Technically speaking, C-Corps are the only entities that pay taxes at the entity level, but that does not make it any easier to understand the tax structure for these entities. For the purposes of an overview, here is how each entity is taxed:

1. Disregarded Entity

A disregarded entity for tax purposes involves two types of businesses: a sole proprietor and the Single Member LLC (SMLLC). Sole proprietors are individuals who run an unincorporated business, whereas the SMLLC involves individuals who organize with the state for their separate legal entity status. For purposes of taxation, both are taxed as individual income, while their entities are disregarded, and income flows through to the owners. This is what is often called pass through taxation.

There are some drawbacks to self-employment around tax time. While the W-2 wage earner has the benefit of having their taxes withheld, the self-employed owner must calculate their own income taxes. Furthermore, the W-2 wage earner only pays half of the taxes for Social Security and Medicare, whereas the self-employed owner pays the full portion (unless they have employees). Calculation may be difficult, but it is even more difficult to calculate the deductions which are afforded to business owners such as business expenses, depreciation, and qualified business income. Due to the complexity, many small business owners forego their eligible deductions. Though an SMLLC’s default tax status is that of the disregarded entity, they are eligible to instead elect to be taxed as an S-Corp, which is discussed in the S-Corp section.

2. Partnership

The partnership classification under the IRS involves two or more partners who are in business together. This involves two people setting up an unincorporated business as a GP or a Multi-Member LLC (MMLLC). There are more partnership structures—this article will only discuss the GP structure. Governed under the Subchapter K of the IRC, the partnership taxation also flows through to the owners.

While the business is not taxed at the entity level, the complex rules regarding taxation for partners within a partnership or MMLLC is based on their interest percentage. Usually, the business earns income at the entity level, and then that income can be distributed to the partners based on the percentage of their ownership. Then, each partner is taxed based on the distributed income. Like sole proprietors and SMLLCs, each partner (provided that they have no employees) will pay the full brunt of the Social Security and Medicare taxes. However, each partner may still qualify for the above-mentioned deductions which most of them forego due to the complexities as mentioned above. Like SMLLCs, MMLLCs can elect to be taxed as an S-Corp as well.

3. S-Corp

An S-Corp is not a formable entity. Rather, it is a tax classification that is only eligible to small business entities. Sole proprietors and GPs are disqualified, but LLCs and corporations may qualify based on the IRC’s requirements. The S-Corp, or Small Business Corporation, is governed by Subchapter S of the IRC. Certain limitations under the IRC prevent big corporations from electing this status. These requirements involve a limit on the number of shareholders, citizenship requirement, and one class of stock. Most LLCs will qualify for this status since it was first created to benefit small businesses.

The S-Corp is also taxed under pass through taxation in that the shareholders are taxed based on how much stock they own in the business. A major difference—and benefit—of an S-Corp is that the shareholder can be paid a reasonable compensation as a W-2 wage earner of the entity, which is taxed the same way as a partner on their distributions. However, shareholders are also paid a distribution which is not taxed. Therefore, an SMLLC or a MMLLC can save on taxes by electing to be taxed as an S-Corp. An eligible corporation will almost always try to elect this status for the same reason, and it is why the IRC prevents big corporations from qualifying with certain limitations. However, an LLC faces the additional burden of filing extra forms to maintain their S-Corp status, so it is recommended for an LLC only if it makes a certain level of income—usually around $40,000.00.

4. C-Corp

The C-Corp classification is governed under Subchapter C of the IRC. It is the only entity that is taxed at both the entity level and at the individual shareholder level. This is what many people refer to as double taxation. This is also the reason why many avoid the C-Corp classification. Even though most of the TCJA is set to expire at the end of 2025, its provision that lowered the corporate tax rate from 35% to 21% is permanent, so the C-Corp classification has recently become a more appealing option. Most C-Corp entities in America are big, profitable and publicly traded companies.

Generally, the corporation pays the 21% tax at the entity level before the distributions to shareholders are taxed based on each shareholder amount of corporate stock. However, unlike the earlier mentioned classifications, the C-Corp entity is not afforded the highly favorable qualified business income deduction. Other deductions are available, which is why the percentage of revenue from taxes collected on Corporate Income is not as high as some would expect. C-Corp status is usually for businesses expecting a very high amount of income. An LLC can elect C-Corp status as well, but it is usually not recommended.

As mentioned above, taxes are as certain as death and are certain even in death. Estate tax is usually labeled as “the death tax” because it taxes the new estate owner after the prior estate owner’s death. The gift tax is exactly what it says it is: a tax on gifts to others prior to death. As seen above, not much revenue is generated on the collection of estate and gift taxes because of what is known as the unified lifetime exemption. This exemption combines two separate lifetime tax exemptions—one for estates, and one for gifts—such that a new maximum exemption limit applies to gifts given during your life and anything that beneficiaries may receive after your death. This exception is especially relevant to professionals who may be helping you with your estate planning, as they are able to effectively treat both estate and gift taxes as one.

Like Income tax, the Estate Tax follows a progressive rate structure. The aforementioned lifetime exemption effectively eliminates all taxes in the lower brackets. The lifetime exemption under the TCJA is $13.16 million dollars for 2024. Therefore, many decedents are able to avoid the Estate Tax entirely.

In addition to the unified lifetime exemption, there is a yearly Gift Tax exemption under the TCJA, which is $18,000 for individuals and $36,000 for married couples. Note that the exemption is not aggregated; rather, it is exclusive to each person being gifted. For example, if a married couple has four children, they can gift each of their children $36,000 per year without having to report it to the IRS. Gift tax rules should be in the forefront when high value assets are being transferred. Even a 7-time Super Bowl Champion with a Super Bowl victory gifting a teammate a 2015 Chevy Colorado is not beyond the purview of the IRS. However, in cases wherethe value of gifts exceeds the annual gift tax exemption amount, the unified lifetime exemption can still be applied to the excess amount

Under the IRC, property passed over to someone at death is treated differently than a normal property. Normally, when you purchase property, the value for which you purchased it is assigned to that property as the basis. Any appreciation on the property from that basis must be recognized and taxed as a gain on a capital asset when you sell it. Property received from estates, however, receives a stepped-up basis, meaning if you receive property as the beneficiary of an estate, the basis becomes the current value of the property. Any appreciation it already received is not taxable, but future appreciation will still be taxed.

With careful estate planning, you can limit the amount that the IRS can collect. Note that in addition to the federal estate and gift taxes, there are inheritance and estate taxes at the state level. Pennsylvania only has an inheritance tax.With proper estate planning, the sum collected from your state’s department of revenue can be significantly reduced.

State and Local Tax (SALT) is dependent on the state that the taxpayer lives and works in. Each state or commonwealth in the Union is like a mini nation with different levels of population and wage earners which affect revenue collection. In addition, some states may have a certain type of tax, while other states do not. For instance, some states have no inheritance tax, others have no estate tax, and one state (Maryland) has both. Furthermore, the local government structure is different for each state. Some local governments do not have the authority to tax whereas others do. This article only covers the areas of tax law that most states have in common. Like the chart above, this chart overviews the revenue generated from SALT:

Type of Tax	$ Billions	Percentage
Property	$688	30.4%
Sales and Use	$534	23.6%
State Income Tax	$612	27%
State Corporate Income Tax	$144	6.4%
Other State Taxes	$226	10%
Other Local Taxes	$60	2.6%
Total	$2,264	100%

Note that this chart aggregates data from all 50 states. Not all 50 states tax in each of these areas. For instance, Texas and Florida do not have income tax. Many states have Property Taxes as well as Sales and Use Taxes, which are not collected at the federal level. That’s why Upset Tax Sales and tax assessment appeals are unique to SALT litigation.Property taxes generate the most revenue for State and Local Governments because of the high equity on real estate.

Furthermore, SALT issues can also involve the U.S. Constitution. While the tax clause under the U.S. Constitution is a concurrent power explicitly given to both the federal and state governments, citizens still come under the protections of due process. State Taxes should not place a burden on interstate commerce. Generally, taxes must be fair and apportioned equally. If they are not, there may be federal protections available to you under the U.S. Constitution.