Understand what direct tax is, the various taxes, challenges in tax provision and compliance, and the need for state apportionment tools for businesses.
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When a taxpayer must pay taxes directly to the government, meaning the taxes cannot be shifted to other entities or individuals, it is known as direct tax. This is the opposite of indirect tax. Sounds pretty straightforward, right? Think again.
The reality is that there are various types of direct tax and understanding the differences is important in helping taxpayers stay in compliance and navigate the costs they may encounter.
To help companies better understand the nuances, this article will take a deeper dive into the layers of direct tax and the tools and resources to help firms better serve their clients.
What is direct tax?
Direct tax is a tax paid directly by the taxpayer to the government and cannot be shifted, like federal income tax. This is the opposite of indirect tax, which is a tax levied on goods and services and can be passed on to another entity or individual.
The tax is progressive in nature or, in other words, is largely based on the ability-to-pay concept. What does this mean? It means that a taxpayer who makes a high income will pay a disproportionate share of the tax burden, while a taxpayer who makes a lower income will face a relatively small tax burden.
As noted earlier, there are various types of direct tax, which is where things can start to get complex. The more common types of direct tax are:
- Individual income tax
- Corporate income tax
- Capital gains tax
- Estate tax
- Property tax
- Payroll tax
Individual income tax
One type of direct tax is individual income tax, which is also known as personal income tax. This is a tax imposed on the salaries, wages, investments, or other forms of income that a person or household earns.
The U.S. levies a progressive individual income tax, which is imposed at the federal level, as well as in the majority of states. The income tax rates range and kick in at specific income thresholds.
Corporate income tax
Incorporated businesses are taxed on their profits (minus allowable deductions), which is known as corporate income tax.
Corporate income tax is a significant source of revenue for governments and is actually the third-largest source of federal revenue, albeit smaller than individual income tax and payroll taxes.
While some have to calculate their income tax provision, some U.S. businesses are not subject to corporate income tax because they are taxed as “pass-through” entities (i.e., C corporations, S corporations, sole proprietorships, LLCs, and partnerships).
Capital gains tax
Capital gains tax is a tax levied on the profit made from the sale of an asset, such as property and stocks, but the tax rates vary and that variance will depend on two factors. Those factors are: one’s income level and how long the asset was held. The latter refers to whether it is considered a long-term capital gain (held one year or more) or short-term capital gain (held less than one year).
Estate tax
Estate tax is a tax levied on the net value of a person’s taxable estate (after any exclusions or credits) at the time of their death. The estate pays the tax before the assets are distributed to the heirs.
This is not to be confused with an inheritance tax, which is levied on the heirs of the deceased. The federal government does not levy an inheritance tax.
Property tax
Property tax, which is a critical source of revenue for state and local governments, is a tax imposed on both commercial and residential “real property” like buildings and land. It is also levied on tangible personal property such as inventories, business equipment, and vehicles.
What can make property tax especially tricky to navigate is that varies significantly among states and localities.
Payroll taxes
Payroll taxes, which are taxes paid on the salaries and wages of employees, are used to finance such programs as Medicare and Social Security. These taxes are collected via payroll deduction and remitted to the federal government.
Employees and employers are both expected to pay an equal share of Social Security and Medicare taxes. However, those who are self-employed obviously do not have an employer who can remit the tax on their behalf. Therefore, a self-employed person must cover both the employer and employee portions of the tax on their own.
Examples of direct tax
To further illustrate, let’s look at a few examples.
With individual income tax, if Sallie makes $150,000 in a year, for instance, and owes the government $30,000 in taxes, that $30,000 would be a direct tax.
Another example is property tax. Jim owns a home that’s valued at $400,000, and the town charges a $30 tax on every $1,000 of the home’s tax-assessed value. This means Jim would owe a direct tax of $12,000 ($400,000/$1,000 = 400 x 30).
Understanding tax provision
Direct tax compliance involves having the right tools and resources in place for accurate tax provisioning. What is a tax provision? It is the estimated amount of income tax that a company is legally expected to pay to the IRS for the current year.
Unfortunately, estimating the tax provision each year is no small feat and can prove to be a heavy administrative burden on tax departments. Challenges can include:
- Keeping pace with tax law changes
- Reliance on time-consuming, manual processes
- Inefficient data collection
Therefore, it is important to have robust tax provisioning software in place to help eliminate errors, automate the corporate financial close, and save crucial time during the tax provision process.
Understanding state apportionment
Another important factor is state apportionment. State income tax is a direct tax on business income that a C corporation, also known as a C corp, has earned in a state.
Calculating state income can quickly get complex, especially if a company does business in multiple states. This is because each state gets to decide what matters most — payroll, property, or sales — and in what ratio to account for them.
Entities that are subject to apportionment and do business in multiple states face the issue of tracking corporate income tax laws in multiple places. Further fueling the complexity is the fact that sales tax laws can frequently change. For smaller companies with limited resources to track every detail of state tax law staying in compliance can be extremely difficult.
Given the complexities surrounding state apportionment, it is important to have a state apportionment tool that enables even the smallest tax team to stay on top of changes and effectively calculate, track, and record taxable income.
Differences between direct and indirect taxes
As noted earlier, direct tax is the opposite of indirect tax. Direct tax is a tax levied on companies, as well as individuals, that cannot be passed on to another taxpayer. The taxpayer is liable for the tax payment, which is collected directly by the government.
On the other hand, indirect tax, which is levied on goods and services, is a tax that can be passed on to another entity or individual. The manufacturer or supplier passes on the tax to the consumer, who is the one ultimately paying the tax. The manufacturer or supplier collects the tax and then remits it to the government.
Another important difference between the two is that direct tax is progressive, meaning that the tax burden increases with income. Indirect tax is applied uniformly irrespective of the income level of individuals, which is known as regressive.
Direct tax may seem straightforward and the software benefits may be clear at first glance; however, it can quickly become complex and prove to be an administrative burden. That’s why it is important to turn to a solutions provider like Thomson Reuters who can help you ensure compliance.
Direct taxes
- Levied on people and entities
- Are typically proportionate to the taxpayer’s income or assets
- Considered a progressive tax
- Non-transferrable, the tax is borne by the taxpayer
- Examples include income tax, corporate tax, and property tax
Indirect taxes
- Levied on goods and services
- Are based on the value of the good or service
- Considered a regressive tax
- Transferrable, with consumers ultimately paying the tax. In the case of customs duties, excise taxes, and tariffs, the cost is embedded in the price of the product or service
- Examples include VAT, GST, customs duties, and tariffs