State and Local Income Taxes

Certain state and local income taxes are administered by the state and local governments and can be computed in different ways. Some follow the same system as the federal income tax and some have their own system. There are even states that have no income tax at all: Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming, New Hampshire, and Tennessee. Local taxes work in the same way. State income taxes fund the state government, while local income taxes fund the local governments.

Ad Valorem Taxes

An ad valorem tax is placed on the value of an asset a person owns. There are traditionally two types of ad valorem taxes: personal property and real estate.

Personal property tax is placed on the value of an asset that is not real estate, such as automobiles, stock, bonds, boats, and so on. The tax is usually computed by multiplying the fair market value of the property by a set percentage. Some states that don’t have an income tax (e.g., Florida) may have a personal property tax instead. Other states have an income tax as well as a personal property tax.

Real estate tax is placed on the value of real estate property. It's usually assessed by the state and local governments and, like personal property tax, it's calculated by taking a set percentage and multiplying it by the fair or assessed value of the property. Ad valorem taxes usually fund state and local governments. 

Sales Tax

There is no federal sales tax (yet!). Instead, sales tax is imposed by state and local governments as another way to collect revenue. Different states tax different items at different rates, and it is usually assessed when the item is purchased by the ultimate consumer. For example, Pennsylvania currently taxes most nonnecessity goods at a rate of 6% applied at the cash register. Five states don’t have a sales tax—Delaware, Montana, New Hampshire, Oregon, and Alaska—but Alaska's local municipalities may impose one. People who live in sales tax states may try to avoid paying sales tax by purchasing items (especially large-ticket items) in non-sales-tax states to save money.

What is so wrong about that? Well, if the consumer brings it back to their resident state to use, and if there would have been sales tax on that item if purchased in the resident state, then the consumer is expected to pay that state a sales tax on the item—called a use tax. If they don’t, they may be subject to fines and penalties, and possibly an audit, too. This is becoming very prevalent with online sales transactions. Taxpayers usually pay use tax on items when filing their state tax returns or by filling out a special form, depending on the location.

Learn more about Internet sales tax in the article Internet Sales Tax: A 50-State Guide to State Laws, by Diana Fitzpatrick.

Joe purchases a car in Delaware for $10,000. Delaware does not have sales tax. Joe’s home state of Pennsylvania assesses a 6% sales tax on all car purchases. When Joe returns home, he is required under law to pay Pennsylvania the state sales tax of 6% on that automobile. If he fails to do so, the state can require payment and penalize him for nonpayment. With regard to a car purchase, owners usually have to prove payment of sales tax before they can register the vehicle. Many people have tried this form of sales tax avoidance.

Payroll Tax

You may remember payroll tax from your prior Introduction to Accounting course. If you have a job, your employer is required to withhold taxes from your wages. But employers are also required to pay taxes based on your wages! Why? Because the taxing authority says so!

Employers assume the burden of these taxes and calculate them as part of your annual compensation package. So what are these payroll taxes?

FICA

The Federal Insurance Contribution Act (FICA) is comprised of two taxes: Social Security and Medicare. The federal government states that each employee must contribute to these benefit plans and that the employer must also contribute on behalf of the employee. The taxes are applied to the employee's annual wages, and the Social Security portion of the tax has a maximum limitation.

For Social Security,

• employers pay 6.2% of gross wages up to the annual limitation per employee, which changes each year, and
• employees pay 6.2% of gross wages up to the annual limitation, which changes each year.

For Medicare,

• employers pay 1.45% of gross wages with no limitation per employee, and
• ​employees pay 1.45% of gross wages with no limitation.
• ​If earned income including self-employment income is above a certain level for a taxpayer or taxpayers (determined by filing status)
  • individuals will pay an additional 0.9% Medicare tax on gross wages and
  • individuals will pay an additional 3.8% Medicare tax on net investment income.

 A self-employed taxpayer must pay both the employer and the employee parts of FICA taxes.

SUTA

The State Unemployment Tax Act (SUTA) is imposed by the state in which the employee resides and is used to fund the state unemployment system. Usually, only employers are required to pay this tax based on a certain amount of the earnings of each employee.

FUTA

The Federal Unemployment Tax Act (FUTA) is paid by the employer to help fund state unemployment benefits. This tax is computed on the first $7,000 of each employee's gross wages at 0.6% each year.

Excise Tax

Excise taxes are imposed by the federal, state, and local governments, and the most well-known is on gasoline. The gas tax in particular is usually imposed by both federal and state governments, and different states, of course, have different rates. Like sales tax, this tax is usually added to the price per gallon seen at the gas pump.

Other types of excise taxes are applied to alcohol and tobacco products, gambling revenues, and even your cell phone bill. If you're starting to see a pattern here, it's no coincidence. Most people call this the “sin tax” because it's placed on items that the government may not want consumers to use, at least not in excess. Therefore, these items get taxed additionally to raise the cost and, possibly, discourage purchases. Although excise taxes are usually built into the price of the item at purchase, some are added afterward (e.g., hotel excise taxes).

Estate and Inheritance Taxes

The federal government only taxes estates, not inheritances. But what's an estate? According to the IRS, an individual's "gross estate includes all property in which the decedent [individual] had an interest (including real property outside the United States)" at death (Internal Revenue Service, 2017). The estate tax comes into play when the person dies, at which time federal taxes must be paid on whatever assets the person owned at death. If you're reading carefully, right about now you're probably thinking, "Wait, a person even pays tax at death?" And the answer is yes—sort of. Estate taxes can be a complex area.

In general, people who have estates in excess of $5.6 million at death would have to pay a federal estate tax. In addition, their state of residence might require payment, too. Some states have estate taxes due at death just like the federal government; however, other states only assess an inheritance tax.

If, according to Merriam-Webster's Online Dictionary (n.d.), an inheritance is "money, property, etc., that is received from someone when that person dies," then an inheritance tax is the amount the government expects from the person receiving inherited property. The inheritor is responsible for paying the required inheritance tax, which is usually imposed at a rate based on the inheritor's relationship to the deceased. The closer in relationship, the lower the tax rate, so that in most states, property passed from one spouse to the other escapes tax entirely.

Learn more about which states impose different taxes in the article State Tax Chart: Which States Collect Income Taxes, Sales Taxes, Death Taxes and/or Gift Taxes?, by Julie Garber.

Let's go back to that question from earlier: Does a person have to pay taxes at death? Sort of—depending on the tax. Remember it this way: 

• Estate taxes are assessed on the person who died for the right to give the assets away.
• Inheritance taxes are assessed on the recipient of property at the death of another person for the right to receive that property.

Gift Tax

One last tax we need to look at is gift inter vivos, or gift tax. It's one that people sometimes wonder about and don’t really understand. It's unusual because it taxes not the recipient of the gift but the donor, and because not all gifts are taxed. Because it's usually a federal tax, we'll focus on the federal version here, but be aware that some states are starting to impose gift taxes, as well. It's covered in more detail on the next page because it's a little more complicated than the others! So let's move on to understand more.