Taxation

The Internal Revenue Service (IRS) enforces the Internal Revenue Code, which includes federal laws regarding the payment and collection of taxes, such as income, employment, and estate. The individual income tax is determined using a progressive tax rate. This means that tax rates are allocated to income brackets and as income rises, so does the tax rate percentage. In theory, this structure shifts a greater tax burden to those who have higher incomes and thus have a greater ability to pay. In the late 1990s, the tax rates started at 15 percent in the lowest income bracket and gradually increased to an upper limit of approximately 40 percent in the highest income bracket. Corporate taxation has a less progressive structure and is based on a company's net profits.

To determine taxable net income, taxpayers are allowed to subtract certain types of deductions from their gross income. Many of these deductions are intended to stimulate specific types of savings or spending that benefit our society, such as a deduction for charitable contributions. The mortgage deduction is designed to encourage home ownership. A taxpayer is allowed to subtract interest paid on a loan that has been assured of payment by the pledging of a home. The home may be a house, cooperative apartment, condominium, house trailer, or houseboat. In a mortgage loan, property is temporarily transferred to the creditor until the borrower has paid the loan in full. To qualify for the mortgage deduction, the loan may be a mortgage to purchase a home, a second mortgage, a line of credit, or a home equity loan. The points, or fees, paid by a borrower to obtain a home mortgage loan can also be deducted.

Capital gains and losses are taxed at a different rate than ordinary income. Capital gains or losses are created by the sale or trade of a capital asset. Property held for personal use is considered a capital asset. Examples of capital assets include stocks or bonds, a house, a car, furnishings, land, a coin or stamp collection, jewelry or gems, or precious metals.

The sale of noncapital assets is treated as ordinary gain or loss and taxed accordingly. Noncapital assets are often used in the course of a trade or business and include depreciable property (items whose value can be written off on taxes over multiple years), property held for future sale to customers, real property, and accounts or notes receivable. Creative endeavors are also considered noncapital assets and include a copyright on a literary, musical, or artistic composition.

Capital assets are classified as either short term or long term. Long-term capital assets are generally items held for more than one year. Net capital gain is net long-term capital gains less net short-term capital losses. The resulting net capital gain is taxed at a more favorable rate than ordinary income. As an example, during most of the 1990s, ordinary income was subject to a top rate of almost 40 percent while the highest tax rate for net capital gains was 28 percent.

There are additional deductions or credits that taxpayers can subtract from gross income but they are subject to limitations as set forth by the Internal Revenue Code. These deductions include medical and dental expenses, contributions to individual retirement accounts (IRAs), casualty and theft losses, and employee business expenses.