Navigating the Tax Maze: Understanding Federal, State, and Local Taxes

Those who know me know that I'm a big fan of memes. If you don’t know what a meme is, that's ok. A meme is an image of some sort with words imposed on the image. Some are funny, satirical, serious, or any other emotion. This meme is particularly funny to me because it’s an image of the Hollywood actor Chris Pratt playing the role of Andy in the comedy show Parks and Recreation. Andy is a loveable, not that bright, innocent young man who honestly tries his hardest to be productive and helpful in so many ways.

The meme literally shows a look of bewilderment on this young man's face with the caption, "I have no idea how taxes work… at this point, I'm too afraid to ask." And that my friends sums up how many people I interact with feel. Taxes can be so confusing and overwhelming. Especially when a seasoned tax professional starts rattling off terms such as:

• AGI (which stands for Adjusted Gross Income)

• Taxable Income

• Marginal Tax Rate

• Self Employment Tax

• Long-Term Capital Gains

• Etc.

Another meme that I find to be amusing is this one:

Taxes can and do often feel oppressive. And there are so many types of taxes. So, let's dive into this area of taxes and see if we can help you feel a little less like our friend Andy from Parks and Recreation.

The "Who" of Taxes

When understanding taxes (or really anything), you should know the "W's." In this case, “Who, What, and Why?” There are so many types of taxes; before we discuss them, it's important to understand who is imposing or assessing the tax.

For that, we have:

• Federal Government
• State Governments
• Local Governments

Quick note: This is NOT a conversation about the legality of taxes and whether they are just or unjust.

We're simply here today to educate you about the types of taxes and to help you understand where those taxes are coming from. The whole conversation about taxes being unfair and a burden is 100% absolutely something that we love to not only talk about but also do something about through our CLEAR EDGE Framework to help you pay less to the government. You can learn more by checking out how we help business owners slash their tax bills with a CUSTOM TAX STRATEGY ROADMAP.

Back to the topic at hand, when we understand that the WHO is imposing taxes, we can move on to the what. In this case, what taxes are being imposed on us as taxpayers?

The Federal Government imposes taxes such as:

• Income tax

• Self Employment Tax

• Capital Gains Tax

State Governments generally impose taxes such as:

• Income tax

• Property taxes

Local Governments generally impose taxes such as:

• Sales tax

• Property tax

State and local governments also impose “fees” and other things not labeled as taxes to generate revenue. Examples of these include:

• License fees

• Registration fees

• Inspection fees

Understanding the "Why" of Taxes

Yes, we're going out of order a little bit on the WHO, WHAT, and WHY. But to be honest, this is a pretty brief conversation. The WHY in the conversation of taxes is simple: Operating Income or Revenue.

Yes, the government generates revenue by charging you and me taxes, fees, and licenses. The WHY is to provide the government with operating income to cover expenses. 

And yes, our taxes go towards paying for infrastructure (roads, bridges, etc.), public safety services (fire protection, police services, national defense, etc.), and other public services. The argument of “Is the government bloated and wasteful?” is relevant, and we agree that the government taxes and takes way too much on a general rule and scale.

However, understanding that there is an intrinsic value being provided for taxes and that the evidence of our taxes at work around us is visible is a real and valid point. Again, the conversation of efficiency and stewardship over resources is different. We’ve all likely heard the jokes about the $1,000 toilet seat covers and other stories of government waste.

The bottom line is this: efficiently used or not, the revenue raised by the government in the form of taxes and fees is put to work in our nation. 

Now the "What" of Taxes

This is the primary reason why this article is even being written. Taking it from top to bottom in terms of size and scale, let's dive into the most common types of taxes assessed by each government entity/type. This list is by no means exhaustive but is meant to cover the most common types of taxes that impact most taxpayers and business owners.

If you feel like there is something on this article or list that you would like to see included, please feel free to reach out and let us know.

Federal Government Taxes

Income Taxes

Income tax is the tax people refer to when they refer to "what tax bracket” they're in. Income tax is calculated based on your “taxable income," which is all of your earnings (W-2 wages, business income, gambling winnings, etc.). The United States employs a progressive tax system, meaning that the tax rate increases as the taxpayer's income increases. Each “layer of income” is assessed by its tax rate, which ranges from 0 to as high as 37%.

Income taxes do not include Social Security and Medicare taxes, which are assessed on top of the income tax.

Self-Employment Taxes

Self-employment tax is specifically for individuals who work for themselves. This tax is effectively the equivalent of the Social Security and Medicare taxes that employers withhold from their employees' paychecks. However, since self-employed individuals are both the employer and the employee, they are responsible for the entire amount, which is currently 15.3%.

The self-employment tax rate consists of two parts: 12.4% for Social Security and 2.9% for Medicare. 

Self-employment tax is assessed on income from a Sole Proprietor (Schedule C) and many types of income from Partnerships and/or LLCs that have NOT made the election to be taxed as an S-Corporation. Self-employment taxes are generally only paid on non-passive income, so income types such as rental income or investment income (interest, dividends, and capital gains) are generally exempt from Self-Employment taxes.

Capital Gains Taxes (Short-Term and Long-Term)

Capital gains tax is assessed on the profit (or gain) when an investment or property held for investment is sold. What makes the capital gain a “short” or “long” term is determined by how long the asset was held or owned. 

If the asset was held for more than a year, it is considered a long-term capital gain and is taxed at a lower rate. If the asset was held for a year or less, it is regarded as a short-term capital gain and is taxed at the same rate as ordinary income.

For 2023, the long-term capital gains tax rates are 0%, 15%, or 20%, depending on the taxpayer's income. Short-term capital gains are taxed at the individual's ordinary income tax rate (or the “tax brackets” that range from 0% to 37%).

State Government Taxes

Income Taxes

Many states impose their income taxes on top of the federal income tax. The rates and rules vary by state. Some states have a flat income tax rate, while others have a progressive system similar to the federal government.

Sales Taxes

Sales tax is a consumption tax imposed by the government on the sale of goods and services. It is collected by the seller at the point of sale and passed on to the state. Sales tax rates vary by state, and some localities within states may impose additional sales taxes.

Capital Gains Taxes (Short-Term and Long-Term)

States that have an income tax often also tax capital gains. The treatment of capital gains at the state level can vary significantly. Some states tax capital gains as ordinary income, while others may have different rates or exemptions.

Property Taxes

Property taxes are imposed on property ownership, including real estate and sometimes tangible personal property such as cars and boats. These taxes are usually collected by local governments, but the rates and rules are often set at the state level. 

Property taxes are a significant source of revenue for local governments and are typically used to fund schools, police and fire departments, and other local services.

Local Government Taxes

Income Taxes (Sometimes)

Some local governments, such as cities or counties, impose their income taxes. These are typically in addition to state and federal income taxes and are used to fund local services. Not all localities have income taxes, and the rates can vary significantly.

Sales Taxes

Local governments may impose their own sales taxes in addition to state sales taxes. These local sales taxes can significantly increase the total sales tax rate. 

Property Taxes

Local governments primarily impose property taxes. These taxes are usually based on the assessed value of the property. 

Connecting The Dots

There are many types of taxes, and understanding who and what those taxes are helps you understand how they affect you. Out of all of these taxes, the ones that impact you of the ones mentioned above when you file your Federal and State income tax filings on or before April 15th are:

• Income Taxes

• Self Employment Taxes

• Capital Gains Taxes

While there are methods to mitigate property taxes in some cases and ways to cut back on sales taxes, the most control that a business owner has over their tax liability is through mitigating their income taxes, self-employment taxes, and capital gains taxes.

These taxes can be mitigated using the Make Taxes Fair CLEAR EDGE Framework, where a business owner's tax liability can be significantly reduced by examining:

• Credits: Capturing missed tax credits for the business
• Legal structure: Ensuring that the proper legal structure is being used for the business
• Employees: Finding, retaining, and rewarding employees using tax-optimized tools
• Accumulation of wealth: Building wealth in tax-optimized ways
• Retirement planning: Planning for the future in tax-optimized ways
• Exit planning: Exiting investment assets or your business in tax-optimized ways
• Deduction optimization: Fully capturing all deductions your business is entitled to
• Getting organized: Finding tax efficiencies as you get organized and
• Efficiency: Achieving efficiency with your taxes that has eluded you and your business.

At maketaxesfair.com we believe that taxes can be made fair and that achieving that starts with fundamental and sound education. This article aims to help you understand a little more about the types of taxes that exist. We invite you to learn more about our CLEAR EDGE Framework and how we utilize it to create a CUSTOM TAX STRATEGY ROADMAP for business owners. You can check that out here! And lastly, if you found this to be useful in some way, we invite you to share this with a friend.

Our mantra is that Friends Don't Let Friends Overpay The Government! If you have questions or need assistance, please start a conversation.