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Tax Fundamentals

Tax obligations vary dramatically by jurisdiction, entity type, and circumstance. Before any tax-related assistance, establish three things: the relevant jurisdiction(s), the entity type, and the tax year in question. Tax law changes frequently—current rules must be verified for the specific year. This primer covers universal concepts; jurisdiction-specific rules are in sub-slices.

Core Concepts

Taxable income differs from cash received or gross income. It's gross income minus allowable deductions, calculated according to jurisdiction-specific rules. The distinction matters because some income is excluded (gifts, certain benefits), some is deferred (retirement contributions), and deductions vary by entity type and circumstance.

Marginal tax rates apply only to income within each bracket—not to all income. Progressive tax systems divide income into brackets, taxing each portion at its applicable rate. Moving into a higher bracket increases tax only on income above the threshold, not on income below it. This is the single most common misconception among taxpayers.

Tax credits reduce tax owed dollar-for-dollar. Deductions reduce taxable income, meaning their value depends on marginal rate. A $1,000 credit saves $1,000 in tax. A $1,000 deduction saves $1,000 × marginal rate (e.g., $220 at 22%). Refundable credits can exceed tax liability and result in payment to the taxpayer; non-refundable credits can only reduce liability to zero.

Basis represents your investment in an asset for tax purposes—typically acquisition cost plus improvements minus depreciation. When selling, tax applies to the gain (sale price minus basis), not the full sale price. Basis adjustments include capital improvements (increase), depreciation taken (decrease), and certain distributions (decrease). Inherited assets typically receive a stepped-up basis to fair market value at death; gifts generally carry over the donor's basis.

Realization versus recognition: Economic gain exists when asset values increase, but tax typically isn't owed until a triggering event (sale, exchange, distribution). Realization is the event that crystallizes gain or loss. Recognition determines how much is reported and when. Some realized gains can be deferred (like-kind exchanges, installment sales) or excluded (primary residence gain exclusions). This distinction drives major planning strategies.

Capital versus ordinary: Most jurisdictions distinguish between capital gains (from asset sales) and ordinary income (wages, interest, business income). Capital gains often receive preferential rates, but only for assets held longer than specified periods. Short-term capital gains typically face ordinary income rates. The holding period starts the day after acquisition.

Entity Types and Tax Treatment

Tax treatment depends fundamentally on entity structure. The key distinction is between pass-through entities (income taxed once, at owner level) and separately taxed entities (income taxed at entity level, then again when distributed).

Sole proprietorships and single-member LLCs (by default) are "disregarded entities"—the entity doesn't exist for tax purposes, and all income flows directly to the owner's personal return. Simple, but offers no separation between business and personal liability for tax purposes.

Partnerships and multi-member LLCs (by default) file informational returns showing each partner's share of income, deductions, and credits. The entity pays no tax; partners report their share on personal returns whether or not cash is distributed. Partnership tax is notoriously complex, with special allocations, basis calculations, and anti-abuse rules.

S corporations similarly pass through income to shareholders, but have restrictions: limited to 100 shareholders, one class of stock, shareholders must be individuals (not entities) and usually residents of the jurisdiction. S corporations can provide self-employment tax savings compared to partnerships, but require reasonable compensation to owner-employees.

C corporations pay entity-level tax, and shareholders pay again on distributions (dividends). This "double taxation" can be disadvantageous but also enables income splitting, tax-deferred reinvestment, and access to certain benefits. C corporations have no restrictions on shareholders or stock classes.

Entity choice affects not just income tax but employment taxes, ability to raise capital, administrative burden, and exit planning. The optimal structure depends on specific circumstances and may change over time. Entity elections (like LLC electing S corporation treatment) can sometimes provide benefits of multiple structures.

Filing Obligations and Timing

Filing requirements depend on income thresholds, filing status, income types, and entity structure. Below-threshold filers may still benefit from filing (refundable credits, recovering withholding). Obligations exist even when no tax is owed.

Estimated taxes are required when withholding won't cover tax liability—typically for self-employment income, investment income, or other non-wage income. Most jurisdictions impose penalties for underpayment regardless of whether the balance is paid by the filing deadline. "Safe harbor" rules provide penalty protection when estimated payments meet prior-year liability or a percentage of current-year liability.

Withholding is tax collected at the source. Employers withhold from wages; payers may withhold from dividends, interest, and other payments. Withholding is a prepayment mechanism—actual liability is determined on the return, with refunds or balances due accordingly.

Tax years are typically calendar years for individuals, but entities may choose fiscal years in some jurisdictions. The tax year determines which rules apply—rates, thresholds, and provisions often change annually.

Jurisdiction Complexity

Tax rules vary enormously by jurisdiction. Key jurisdiction considerations:

Residency determines tax obligations. Rules for establishing, changing, and proving residency differ by jurisdiction. Some jurisdictions tax worldwide income of residents; others tax only local-source income.

Multi-jurisdiction situations arise when income is earned in one place, residence is in another, or entities operate across boundaries. Treaties may provide relief from double taxation but add complexity.

Sub-national taxation exists in many countries. US states have independent tax systems with varying rates, bases, and rules. Canadian provinces, Australian states, and many others similarly impose additional layers.

International considerations include foreign tax credits, reporting requirements, and anti-avoidance rules. Cross-border situations require specialist knowledge.

For jurisdiction-specific guidance, see:

Common Misconceptions

"Higher bracket means paying more on all income." Marginal rates apply only to income within each bracket. Earning more never results in lower after-tax income due to bracket progression alone.

"No 1099 means no reporting obligation." Income is taxable regardless of information reporting. Lack of a form doesn't eliminate the obligation to report.

"I can deduct my home office." Home office deductions have specific requirements (regular and exclusive use, principal place of business or meeting space) that many don't meet. Employee home offices face additional restrictions in many jurisdictions.

"Business losses always offset other income." Passive activity rules, at-risk rules, and hobby loss rules can limit the ability to use business losses against wages or other income. Losses may be suspended and carried forward.

"Paying by the deadline avoids penalties." Estimated tax penalties apply based on when payments were due during the year, not just whether the final balance is paid timely. A large balance due at filing often indicates estimated payment penalties.

"Cash transactions aren't taxable." Payment method doesn't affect taxability. Cash income is reported the same as any other income.

"The standard deduction is always simpler." While the standard deduction avoids itemization complexity, some taxpayers benefit significantly from itemizing. The decision requires comparing total itemizable deductions to the standard amount.

Key Principles for Tax Assistance

Always establish jurisdiction before providing specific guidance. A general statement about "tax treatment" is meaningless without knowing which rules apply.

Verify the tax year. Rules, rates, and thresholds change frequently. Guidance must be current for the specific period.

Distinguish between tax planning (prospective, choosing among options) and tax compliance (retrospective, reporting what happened). Different considerations apply.

Recognize complexity boundaries. Tax situations involving international elements, business entities, trusts, estates, or significant transactions typically require professional guidance. General knowledge helps frame questions but doesn't replace expertise.

Never assume. Taxpayer circumstances vary enormously. What applies to one situation may not apply to another seemingly similar one.