On the Fifth Day of Christmas My True Love Sent to Me…Explanations of Five Tax Terms and Definitions
The Greek mathematician Plato once said, “A good decision is based on knowledge and not on numbers.” Perhaps the English philosopher and scientist Francis Bacon summed it up best when he simply stated that “Knowledge is power.” Furthermore, “If you have knowledge, let others light their candles in it” advises Margaret Fuller, an American journalist and women’s rights activist.
“If you have knowledge, let others light their candles in it” advises Margaret Fuller, an American journalist...
So, in the spirit of giving during the holiday season as per Fuller’s advice, this month’s TTB post will be dedicated to passing along some general tax knowledge. First I’ll give definitions of five terms commonly used in the tax world. Next, I’ll move into an explanation of four different forms which frequently appear on people’s tax radar. And so, without further ado…
5 Common Tax Terms
A general term for an item which lowers the amount of your income which can be taxed. There is much confusion among the general public about tax deductions (or simply “deductions”) versus tax credits. Speaking broadly, the difference is that while a tax credit (see below) directly reduces a taxpayer’s actual tax liability, a deduction merely reduces taxable income, thus lowering the tax liability indirectly. To use a simple example, if a taxpayer earned $100 under a tax rate of 10%, but gets a tax deduction of $20, the taxpayer goes from owing $10 in taxes on $100 of taxable income to owing $8 of taxes on $80 of taxable income. Therefore, in this example, the $20 deduction has saved this taxpayer $2 on his or her taxes.
An amount of money that a taxpayer is able to subtract from the amount of tax that they owe to the government. Tax credits are usually direct, dollar for dollar reductions of the tax liability due. To use the same simple scenario from above, let’s say this taxpayer who earned $100 under a tax rate of 10%, and thus owed $10 in taxes originally, gets a $20 tax credit. This tax credit would not only cover all the taxpayer's tax debts, it would also result in a $10 tax refund, and so the tax credit has bestowed upon the taxpayer $20 extra. Comparing these results to those of the example given above, it becomes easy to see why tax credits are better for taxpayers than tax deductions: while the $20 deduction earned the taxpayer only $2 extra, the tax credit for the same $20 amount put 20 extra dollars in the taxpayer's pocket.
A dollar amount that taxpayers who do NOT compile itemized deductions (see below) may subtract from their income to lower their tax liability. The standard deduction is based upon your filing status (Single, Head of Household, Married Filing Joint, or Married Filing Separate) and is available to US citizens as well as resident aliens.
A list of expenses, specified by name, that have been arbitrarily determined to be tax-deductible. Some examples of itemized deductions include mortgage interest, real estate taxes, state and local taxes, as well as charitable donations. If the sum of all the taxpayer’s itemized deductions exceeds the standard deduction, then it is this sum that will be subtracted from income on the taxpayer’s tax return instead of the standard deduction. This is why it’s best to have a record of itemized deductions: doing so opens up the possibility of lowering taxable income beyond what is possible with the standard deduction.
A written agreement between two different countries concerning procedures of taxation. Tax treaties detail a systematic way of treating particular items of income which pertain to natives of each respective country who are living or working abroad. One of the main objectives of a tax treaty is to prevent or mitigate double taxation which might otherwise burden the taxpayer within both countries simultaneously.
While some foreign countries (such as Brazil) elect not to enter into a tax treaty with the United States, the U.S. does have tax treaties with many foreign countries. Under these treaties, residents (not necessarily citizens) of foreign countries who are living or working in the U.S. are taxed at a reduced rate, or are exempt from U.S. income taxes on certain items of income received from sources within the United States. These reduced rates and exemptions vary among countries (for example, those for Japan versus those for Italy) as well as between specific items of income (for instance, business income versus investment income).
4 Common Tax Forms
Form 1099-MISC, Miscellaneous Income:
There are two sides to form 1099—it comes into play both for those receiving miscellaneous income and those doling it out. For those receiving miscellaneous income, the income included on the 1099 gets filed as part of your tax return. For those paying out miscellaneous income, a 1099 must be given to each non-employee person as well as certain entities to whom you have paid $600 or more during the year.
For example, if you paid at least $600 in:
Services performed by someone who is not your employee (including parts and materials)
Prizes or awards
Other income payments (for example, paying claimants most of their taxable damage awards in the context of legal cases, with the exception of taxable back pay, physical injury or medical expense cases)
Medical and health care payments, or
Payments to an attorney
Then you may need to give a 1099-MISC to the appropriate recipient of this payment.
Used to request the Taxpayer Identification Number (often referred to as a TIN) or the social security number of a U.S. person, as well as to request certain certifications and claims for exemption, such as exemption from backup withholding (or the practice of withholding a percentage of your earnings to pay your federal income taxes). In addition, withholding agents (such as an agency you work for) may require signed W-9’s from exempt recipients within the U.S. to overcome the presumption of foreign status. Such a presumption of foreign status might need to be overcome, since those who do have foreign status may need to have a form different from the W-9 filed, such as a Form 1042.
A form filled out by an employee so that their employer can withhold the correct federal, state, and/or local income tax from their pay. It’s a good idea to consider completing a new Form W-4 each year and also whenever your personal or financial situation changes.
A form that must be filed by every employer engaged in a trade or business who pays $600 or more (including noncash payments) within the year for services performed by an employee, even if the employee is related to the employer. Employers must file a Form W-2 for each employee from which income, social security, or Medicare tax was withheld. In addition, a Form W-2 must be filed by an employer for each employee from which income tax would have been withheld if the employee had claimed a maximum of one withholding allowance (exceptions which reduce the amount of tax withheld due to the presence of dependents on the taxpayer). A Form W-2 must also be filed by an employer for each employee from which income tax would have been withheld if the employee had not claimed exemption from withholding on Form W-4, Employee's Withholding Allowance Certificate.
If you would like more information on any of these tax terms or tax forms, or if there’s a term or form that is not detailed in this post but you would like to know more about, please feel free to drop me a line in the Comments box and I’ll do my best to get back to you. In closing, I leave you with a quote from American author Louis L’Amour: “Knowledge is like money: to be of value, it must circulate and in circulating it can increase in quantity and, hopefully, in value.”
Hope you had a wonderful holiday season, and have a happy new year!