darrensmithcpa

What are the Bush Era Tax Cuts?

You see...

Today I will focus on the Economic Growth and Tax Relief Reconciliation Act (EGTRRA).

The U.S. has a progressive income tax system. That means that lower-income taxpayers pay a lower percentage of their income than do higher-income taxpayers. Early in his term, President Bush and the Congress voted to reduce the tax percentage rates from those of a previous administration. Taxpayers from top to bottom have paid a lower income tax rate for about 10 years. That the Bush administration changed the income tax rates was not unusual; income tax rates have moved up and down numerous times for various reasons under both Democrat and Republican Presidents (BobGriggs.com).

EGTRRA created six tax rate brackets–10%, 15%, 25%, 28%, 33% and 35%, based on income levels. If no extension is passed and signed into law, then the pre-2001 tax rates will go back into effect starting in tax year 2011. The 10% bracket would disappear, and those taxpayers would move up to the 15% bracket, which would apply to all incomes below $34,550. The other tax rates would increase to 28%, 31%, 36% and 39.6% for the highest earners making more than $379,650 (Forbes.com).

To secure the votes required to pass the tax rate reduction, the Bush administration agreed to a time limit; the rates would remain at the lower level for a specific time period, subject to renewal. The law establishing the lower rates is set to expire at the end of this year. Unless an agreement is reached, the tax rates will return to the levels at which they were prior to the reduction.

Today I will focus on the Economic Growth and Tax Relief Reconciliation Act (EGTRRA).

The U.S. has a progressive income tax system. That means that lower-income taxpayers pay a lower percentage of their income than do higher-income taxpayers. Early in his term, President Bush and the Congress voted to reduce the tax percentage rates from those of a previous administration. Taxpayers from top to bottom have paid a lower income tax rate for about 10 years. That the Bush administration changed the income tax rates was not unusual; income tax rates have moved up and down numerous times for various reasons under both Democrat and Republican Presidents (BobGriggs.com).

EGTRRA created six tax rate brackets–10%, 15%, 25%, 28%, 33% and 35%, based on income levels. If no extension is passed and signed into law, then the pre-2001 tax rates will go back into effect starting in tax year 2011. The 10% bracket would disappear, and those taxpayers would move up to the 15% bracket, which would apply to all incomes below $34,550. The other tax rates would increase to 28%, 31%, 36% and 39.6% for the highest earners making more than $379,650 (Forbes.com).

To secure the votes required to pass the tax rate reduction, the Bush administration agreed to a time limit; the rates would remain at the lower level for a specific time period, subject to renewal. The law establishing the lower rates is set to expire at the end of this year. Unless an agreement is reached, the tax rates will return to the levels at which they were prior to the reduction.

An Explanation of Historical Tax Rates vs. Current Tax Rates

I read this article from teachinghistory.org. I thought it gave a very good explanation about the history of tax rates and now have a better understanding of how they work. It’s a little lengthy; I tried to shorten it to hit the important concepts and I left some of the numbers and percentages in to give some perspective. 

During the World War II, the top “marginal rate” was 94%, but 94% of what? Then as now, income tax rates moved up at distinct break points. In this made-up example, consider a 15% rate up to $25,000, 21% from $25,000 to $50,000, and 25% over $50,000. Those making $50,001 or more won’t pay a quarter of their total income, but rather 15% of the first $25,000, 21% of the next $25,000, and 25% of everything above $50K. That’s why the system is called progressive – the percentage rate progresses upward with income, but the higher percentage applies only to new (marginal) income above each break point. In 1944-45, “the most progressive tax years in U.S. history,” the 94% rate applied to any income above $200,000 ($2.4 million in 2009 dollars, given inflation).

Very few individuals encountered this top rate, however. Tax rates have fallen since then: the current top level is 35% of income above $357,000. Brackets also have simplified (24 in the 1950s, just six today), yet the federal government takes in far more revenue than 60 years ago and citizens complain hugely about being over-taxed. What has happened?

Three things, basically.

1. First in World War II, tax law revisions increased the numbers of “those paying some income taxes” from 7% of the U.S. population (1940) to 64% by 1944, vastly broadening the tax base and increasing the total intake.
2. Second, other federal taxes increased substantially. The share of earned income taxed increased fourfold or more since the early 1950s. As well, Medicare and Medicaid taxes appeared in the late 1960s and rose from half a percent then to nearly 1.5% now. Thus many Americans currently pay more for these retirement and medical coverages than they do in regular income taxes.
3. But the biggest blow may have been the evidently sharp increase in state and local taxes since the 1970s. Rising from a national average of $800 per capita (multiply by the number of your family members) in 1977, these taxes neared $4,300 per person by 2008, rising 44% faster than inflation. The principal mechanisms employed by non-federal governments were wage and income taxes, property taxes, and a vast range of fees, all of which went to support public safety (police, fire), health, basic and higher education, roads and other infrastructures, courts, prisons, and the regulation of everyday life (deeds, inspections, voter registrations, licensing, et al.)

Two final notes: despite these surges, Americans remain among the least-taxed citizens of advanced industrial nations, with 28% of gross domestic product taken for taxes, vs. an average of 36% for the 38 member countries of the Organization for Economic Cooperation and Development, while, since 1942, the U.S. has spent far more than any other nation on military and national security needs. Second, none of the above discussion has touched the issue of business taxes, which are included in the U.S. vs. OECD assessment, but rarely examined historically, especially with attention to their state and local components.

Incorporate, or not to incorporate?

As a new business owner, you have to decide whether or not to turn your company into a corporation. When a business becomes incorporated, a separate and distinct legal entity is created. An incorporated business acts independently of its business owners.

Advantages of forming a corporation:

• Asset Protection – If you operate as a sole proprietor or partnership, there is virtually unlimited personal liability for business debts or lawsuits. If you incorporate, generally your personal assets are protected.
• Easier to Sell – a new buyer will not be personally liable for any wrongdoings on the part of the previous owners, which is why corporations are more attractive than sole proprietor or partnerships.
• Tax Savings – because a corporation is separate legal entity, there are many transactions that you can structure between you and your corporation to save big money on taxes
• Privacy and Confidentiality
• Easier to Raise Money
• Perpetuity – can endure almost forever despite what happens to the shareholders, directors, or officers
• Increases Credibility

Disadvantages of forming a corporation:

• Another Tax Return – you’ll have to file 2 tax returns a year, which means increased accounting fees
• Increased Paperwork
• No Personal Tax Credits
• Less Tax Flexibility – As a sole proprietor, if your business experiences operating losses, you could use these to reduce other types of personal income in the year the losses occur. In a corporation, however, these losses can only be carried forward or back to reduce the corporation’s income from other years.
• Liability May Not Be As Limited As You Think – may be undercut by personal guarantees and/or credit agreements
• Registering A Corporation is Expensive

If you do decide to incorporate, there are a few different types to chose from:

C corporation

The traditional form of corporation is the C corporation. C corporations have the most flexibility in structuring ownership and benefits, and most large companies operate in this form. The biggest drawback is double taxation. First the corporation pays tax on its profits; then the profits are taxed again as they’re paid to individual shareholders as dividends.

S corporation and LLCs

These types of corporations avoid the double taxation. Both of these are called “pass-through” entities because there’s no taxation at the corporate level. Instead, profits or losses are passed through to the shareholders and reported on their individual tax returns.

S corporations have some ownership limitations. There can only be one class of stock and there can’t be more than 100 shareholders, none of whom can be foreigners. State registered LLCs have become a popular choice for many businesses. They offer more flexible ownership than S corporations and certain tax advantages.

So, should you incorporate?

You might not need to incorporate. Depending on the size and type of your business, liability may not be an issue or can be covered by insurance. Weigh out the pros and cons and goals of your business, and decide what is best for your and our company.