Saturday, December 8, 2012

Understanding Taxable Income and Marginal Tax Rates

It's become painfully obvious to me that while House Republicans and President Obama continue to duke it out over the top tier Bush tax cuts, most of the country still doesn't understand how all this will impact them.

If we take the President at his word that no household with an income under $250,000 will see their taxes go up, does that mean that every one above that number will automatically see an increase?  The answer is no.

And that's because there's a difference between income and taxable income.  Taxable income is basically gross income minus any deductions or exemptions such as charitable donations and mortgage interest.  Since taxable income is what the IRS uses to determine what taxes we actually owe, under Obama's plan, in order for a household to see a tax increase, it would more than likely have to earn over $300,000.

And even those households which do go over that line aren't likely to see that big a difference in their taxes.  Why?  Because our tax system is based on marginal tax rates.  Those households with a yearly taxable income of more than $250,000 will only have to pay the higher rate on that portion of income over the $250 thousand threshold.

Here's how it works.  Currently there are six tax rates that start at 10 percent and top off at 35 percent.  Obama wants that top rate to revert back to where it was during the Clinton Administration: 39.6 percent.  Assuming that happens, households with a taxable income of, say, $275,000 would pay 33 percent on the first $250,000 and 39.6 percent on the remaining $25,000.

In other words, it isn't all or nothing.  The fact is that the overwhelming majority of American households would see either no increase at all in their taxes or, at worst, a modest bump in them.

And regarding small businesses, it's important to note that the vast majority of them would, in all likelihood, not be impacted at all by the top rate going back up to 39.6 percent.  The reason for this is that they are all required to file a 1120S (S-Corp) along with their personal return.  The 1120S includes gross receipts along with any and all costs associated with the business, including payroll, insurance, payments to suppliers, rent, etc.  In other words, the actual income of a small business is what it gets to keep after it pays its expenses, not what it earns.  A company that grosses $1 million in sales, but has $800,000 in costs, would report $200,000 of "ordinary business income" on line 21 of its 1120S.  As they say in basketball, no harm no foul.

So you see, when all is said and done, it's pretty hard to understand why the GOP is still stubbornly resisting a tax rate hike that will have little to no impact on the middle class and affect a tiny percentage of small businesses.  Clearly they know they are fighting a lost cause.  The President has the upper hand here.  If he plays it well, he will prevail in the end.

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