What’s the Difference Between Federal, State, and Local Taxes?
Taxes are an integral part of how governments operate, providing the necessary funding for public services, infrastructure, and various governmental functions. However, the tax system in the United States is complex, with multiple layers of taxation at the federal, state, and local levels. Understanding the differences between these types of taxes is crucial for both individuals and businesses, as each type of tax has distinct rules, rates, and purposes.
Federal, state, and local taxes are imposed by different levels of government and affect taxpayers in various ways. These taxes can include income taxes, sales taxes, property taxes, and other specific levies. In this blog post, we will explore the fundamental differences between federal, state, and local taxes, examining how each type of tax functions, who is responsible for paying them, and how they impact your financial obligations.
Federal Taxes
Federal taxes are imposed by the federal government and are applicable to individuals and businesses across the entire United States. These taxes are governed by the Internal Revenue Code (IRC), a comprehensive set of laws that dictates how federal taxes are collected, enforced, and managed by the Internal Revenue Service (IRS).
· Income Tax:
o The federal income tax is perhaps the most well-known type of tax, and it applies to the income of individuals, corporations, and other entities.
o Individuals are subject to a progressive tax rate, meaning that as income increases, the rate at which income is taxed also increases. The federal income tax rates range from 10% to 37%, depending on the taxpayer’s income bracket.
o Employers are required to withhold federal income taxes from employees’ wages and remit them to the IRS, while individuals must file annual tax returns to reconcile their tax liability.
· Payroll Tax:
o Payroll taxes, also known as FICA (Federal Insurance Contributions Act) taxes, fund Social Security and Medicare. These taxes are split between employees and employers, each paying 7.65% of the employee's wages.
o Self-employed individuals must pay both the employer and employee portions, totaling 15.3%, under the Self-Employment Contributions Act (SECA).
· Corporate Tax:
o Corporations in the U.S. are subject to a flat federal corporate income tax rate, which currently stands at 21%. This tax is levied on the profits of corporations, after deductions for business expenses.
o Corporate taxes are separate from individual income taxes, though the income distributed to shareholders as dividends may also be taxed at the individual level.
· Estate and Gift Taxes:
o The federal government imposes taxes on the transfer of wealth through estate and gift taxes. The estate tax is levied on the value of an estate before it is passed on to heirs, while the gift tax applies to transfers of property made during an individual's lifetime.
o There are exemptions for both estate and gift taxes, meaning that only transfers exceeding certain thresholds are subject to taxation.
· Excise Taxes:
o Federal excise taxes are specific taxes on particular goods, services, or activities, such as gasoline, tobacco, alcohol, and airline tickets. These taxes are typically included in the price of the goods or services.
State Taxes
State taxes are imposed by individual states and can vary significantly from one state to another. Each state has the authority to design its tax system according to its needs and policies, resulting in a diverse landscape of tax obligations depending on where you live or operate a business.
· State Income Tax:
o Most states impose an income tax on individuals and corporations. However, the rates, brackets, and rules for state income taxes differ from the federal system.
o States may have progressive tax rates, flat tax rates, or no income tax at all. As of now, nine states, including Florida and Texas, do not impose a state income tax on individuals.
o States with income taxes generally require taxpayers to file a state tax return in addition to the federal tax return. The income reported on the federal tax return typically serves as the basis for calculating state income tax liability.
· Sales Tax:
o Sales tax is a consumption tax imposed by states on the sale of goods and services. The rate varies from state to state, with some states having no sales tax and others imposing rates as high as 7% or more.
o Retailers are responsible for collecting sales tax at the point of sale and remitting it to the state. Consumers indirectly pay this tax when purchasing goods and services.
o Some states exempt certain items, such as groceries or prescription drugs, from sales tax, while others may have special tax holidays where certain purchases are tax-free.
· Property Tax:
o Although property taxes are typically associated with local governments, in some states, the state government also plays a role in assessing and collecting property taxes.
o Property taxes are based on the assessed value of real estate and are a primary source of funding for public schools and local government services.
o The rules for property tax assessments and rates vary widely by state, with some states having higher property taxes to compensate for lower income or sales taxes.
· Excise Taxes:
o Like the federal government, states also impose excise taxes on specific goods and activities, such as gasoline, alcohol, tobacco, and gambling. The rates and specific items subject to excise taxes differ from state to state.
· Inheritance and Estate Taxes:
o In addition to federal estate taxes, some states impose their own inheritance or estate taxes. These taxes apply to the transfer of assets after death, with varying thresholds and rates depending on the state.
o States may have different exemptions or lower thresholds than the federal government, meaning that estates not subject to federal taxes might still be taxed at the state level.
Local Taxes
Local taxes are levied by municipal, county, or other local governments. These taxes fund services and infrastructure that directly impact the community, such as public schools, emergency services, road maintenance, and public safety.
· Property Tax:
o Property taxes are the most common form of local taxation and are based on the value of real estate, including land and buildings. These taxes are typically the primary source of revenue for local governments.
o The local tax assessor’s office determines the value of the property, and the property tax rate, often expressed as a millage rate, is applied to this value.
o Property taxes are usually due annually, and failure to pay them can result in penalties, interest, or even foreclosure.
· Sales Tax:
o In addition to state sales taxes, local governments may impose their own sales taxes. These are often referred to as local option sales taxes.
o Local sales tax rates vary widely and are typically added on top of the state sales tax. For example, a state may have a 6% sales tax rate, while a city within that state imposes an additional 2% sales tax, resulting in a total sales tax rate of 8%.
o Local sales taxes fund community-specific projects, such as infrastructure improvements, public transportation, or local government services.
· Income Tax:
o While less common, some localities impose a local income tax on residents and workers. These taxes are generally a small percentage of the income and are collected in addition to federal and state income taxes.
o Local income taxes are typically used to fund municipal services such as police and fire departments, public parks, and local government operations.
· Utility and Use Taxes:
o Local governments may also impose taxes on utilities (e.g., electricity, water, and sewage) or use taxes on goods purchased outside the locality but used within it.
o Utility taxes are usually a fixed amount or percentage added to utility bills, while use taxes are meant to capture revenue from transactions that would otherwise avoid sales tax.
· Business License Taxes:
o Local governments often require businesses to obtain a license to operate within their jurisdiction. The cost of this license can vary based on the type and size of the business.
o Business license taxes are a significant source of revenue for local governments and are used to fund a variety of community services.
Conclusion
Understanding the differences between federal, state, and local taxes is essential for both individuals and businesses, as it allows you to navigate the complexities of the tax system more effectively. Each level of government imposes taxes to fund its operations and provide necessary public services, but the rules, rates, and responsibilities vary significantly.
Federal taxes apply uniformly across the country and are governed by the Internal Revenue Code, impacting income, payroll, and corporate profits. State taxes, on the other hand, differ from one state to another, with variations in income, sales, and property taxes that reflect the unique needs and policies of each state. Finally, local taxes are imposed by municipalities and counties to fund community-specific services, with property taxes being the most common form of local taxation.
For taxpayers, it's crucial to stay informed about your obligations at each level of government. Understanding where your tax dollars go and how they are calculated can help you make informed financial decisions and ensure compliance with all tax laws.
If you have questions about how these different types of taxes impact you or need personalized guidance, please reach out to our Hotline. Our Hotline network of attorneys is ready to help and waiting for your questions.