The tax laws were written to incentivize 2 primary goals: (1) creation of jobs and (2) investment of capital in a way that will benefit the U.S. economy. The vast majority of tax deductions and credits are structured in an attempt to accomplish these 2 goals. As a result, taxpayers should structure their investments and business operations in a way that can take advantage of as many of the deductions and credits available as possible.
What Taxes Are You Currently Paying?
The table below provides an example of all the different types of taxes the average individual in the U.S. pays each year.
|Federal income tax||State income tax||City income tax|
|Property taxes||Sales tax||Medicare tax|
|Social security tax||Parking tax||Vehicle registration tax|
|Gasoline tax||Unemployment tax||Investment income tax|
|Liquor tax||Cigarette tax||Hotel tax|
|Estate tax||Local school tax||Business registration fees|
|Recreational vehicle tax||Excise taxes||Self-employment tax|
|Gift tax||Capital gains tax||Tolls|
Types of Income
There are generally 4 different categories of income. The tax treatment of the income you earn will depend largely on which category or categories of income you earn. Having a tax strategy designed by our team can help you restructure your operations and investments in a way that will allow you to earn the most tax-preferred forms of income or otherwise reduce your taxable income.
Earned income is the least preferred form of income from a tax perspective. Earned income generally includes wages received by an employee from their employer.
Employees who receive a W-2 salary from their employer generally have the least flexibility when it comes to claiming deductions. Consequently, salaried employees have a difficult time minimizing the tax costs imposed on their salaries. Wages are also subject to payroll taxes (i.e., social security and medicare taxes). When payroll taxes are taken into account, many individuals, particularly those in high tax states, may find they are paying an effective rate of tax in excess of 50% on their salaries.
There are also very few situations where losses from investments may be used to offset salary income.
2. Business Income
Business income is income from the active operation of a business received by the owner of that business. For example, the profits received by the owner of a restaurant are considered business income. There is a great deal of flexibility available in taking advantage of deductions and credits for owners of businesses to reduce the amount of business income that is subject to tax.
A portion of the business income received by the owner will be subject to payroll taxes. However, with proper planning, the amount of payroll tax paid on the profits of the business may be reduced. Moreover, depending on the type of business, there may be large depreciation deductions available to reduce or fully offset taxable income.
As a general matter, losses from business operations may reduce all other types of income. This is one reason business income is a more tax-preferred type of income than wages.
3. Portfolio Income
Portfolio income is income from investments such as
- Interest income on a loan;
- Dividend income;
- Capital gains; and
- Royalties received for the right to use intellectual property.
Portfolio income other than certain types of capital gains and dividend income are subject to ordinary income tax rates. Capital gains and dividend income may be subject to a lower preferential tax rate. Portfolio income is not subject to payroll taxes. Accordingly, portfolio income, particularly income subject to capital gains tax rates, is always preferred to being paid a salary.
In some cases, there may be limitations on the ability to use losses from portfolio investments to offset other types of income.
4. Passive Income
Passive income includes income from passive investments which is not portfolio income. The most common example of passive income is rental income from real estate investments. Other examples of passive income include profits received from investments in real estate or private equity funds and other allocations of profits received from businesses or investments in which you are not actively involved.
There are commonly a number of large deductions available to offset passive income, such as depreciation deductions. These depreciation deductions can significantly reduce, and in many cases eliminate, the taxes paid on the passive income received. Passive income is also not subject to payroll taxes.
There are a number of limitations that apply to passive income that prevent taxpayers from using losses from passive investments to offset other forms of income.