How the U.S. Tax System Works: A Comprehensive Overview

A tax system is the method a government uses to collect revenue from citizens and businesses to fund public services. This revenue supports infrastructure like roads and bridges, national defense, and social programs. Through this legally mandated process, the government provides services such as public education, healthcare initiatives, and law enforcement that would be impractical for individuals to manage alone.

Governing Bodies and Tax Law Creation

The U.S. Constitution grants Congress the power to create federal tax law. Legislation begins in the House of Representatives, where it is drafted by the House Committee on Ways and Means. After passing the House, a bill moves to the Senate for review by the Senate Committee on Finance, which can amend it.

If the two chambers pass different versions, a Conference Committee with members from both negotiates a compromise bill. This final version must be passed by both the House and Senate before being sent to the President to be signed into law.

The resulting laws are compiled into Title 26 of the U.S. Code, more commonly known as the Internal Revenue Code (IRC). The U.S. Department of the Treasury and its agency, the Internal Revenue Service (IRS), are responsible for interpreting the complex IRC. The Treasury issues regulations, while the IRS provides further guidance through publications like Revenue Rulings and Revenue Procedures to help taxpayers comply with the law.

Beyond the federal system, state and local governments have their own authority to levy taxes. State tax laws are created by state legislatures and vary significantly. Local governments like counties and cities also impose taxes, with authority granted by the state, to fund services such as schools and police departments.

Types of Taxes Levied

Income Taxes

Income tax is levied on the earnings of individuals and corporations. It is the largest source of federal revenue and is also used by most states. The tax is a percentage of taxable income, defined as gross income minus allowable deductions. The federal income tax is progressive, meaning higher income levels are taxed at higher rates.

Payroll Taxes

Mandated by the Federal Insurance Contributions Act (FICA), these taxes fund Social Security and Medicare. FICA taxes are split between employees and employers, with each paying a percentage of an employee’s wages. The Social Security portion is 6.2% for both the employee and employer on earnings up to an annual limit, which is $176,100 for 2025. The Medicare portion is applied to all of an employee’s wages without a limit.

Sales Taxes

Imposed by state and local governments, sales taxes apply to the sale of goods and services; there is no federal sales tax. The tax is collected by the seller at the point of sale and remitted to the government. Rates and the types of goods subject to tax vary widely, and many states exempt necessities like groceries and prescription drugs.

Property Taxes

Property taxes are levied by local governments and are a major funding source for public schools and community services. This tax is based on the assessed value of real property, including land and buildings. The amount of tax is determined by multiplying the property’s assessed value by the local millage rate.

Estate and Gift Taxes

Estate and gift taxes are federal taxes on the transfer of wealth. The estate tax applies to property transferred at death, while the gift tax applies to transfers made during life. For 2025, the combined federal gift and estate tax exemption is $13.99 million per individual. This exemption is scheduled to be reduced by about half at the end of 2025 unless Congress acts to extend it. The annual gift tax exclusion allows individuals to give up to $19,000 to any number of recipients each year tax-free.

Excise Taxes

Excise taxes are levied on specific goods, services, or activities by federal, state, and local governments. Common examples include taxes on gasoline, tobacco, alcoholic beverages, and airline tickets. Unlike percentage-based sales taxes, excise taxes are often a flat amount per unit, such as cents per gallon of fuel.

The Individual Taxpayer’s Journey

Information and Preparation

The first step for a taxpayer is determining their filing status, which dictates their tax rates and standard deduction. The five statuses are:

• Single
• Married Filing Jointly
• Married Filing Separately
• Head of Household
• Qualifying Widow(er)

A taxpayer must identify all sources of taxable income, such as wages on Form W-2 or freelance income on Form 1099-NEC. Other common sources include interest, dividends, capital gains, and retirement distributions.

Taxpayers can reduce their taxable income with either the standard deduction or itemized deductions. The standard deduction is a fixed amount based on filing status, age, and blindness. A taxpayer can instead itemize if their total eligible expenses, such as state and local taxes (capped at $10,000), home mortgage interest, and charitable contributions, exceed their standard deduction.

After calculating taxable income, tax credits can directly reduce the tax owed. Unlike deductions, which lower taxable income, credits provide a dollar-for-dollar reduction of the tax liability. Major credits include the Child Tax Credit, the Earned Income Tax Credit, and education credits.

The Filing and Payment Process

Once a tax return is complete, it must be submitted to the IRS. The most common method is electronic filing (e-filing) through tax software or a tax professional, which is faster and more secure than filing by mail.

If the return shows a tax liability, payment is due by the filing deadline, typically April 15th. The IRS offers several payment options, including direct bank withdrawal, debit or credit card, or a mailed check.

A refund is due when the amount of tax withheld and any estimated payments exceed the total tax liability. The fastest way to receive a refund is via direct deposit, which the IRS issues for most e-filed returns in less than 21 days. Requesting a paper check can take six weeks or more.

Core Concepts in Business Taxation

Taxation Based on Business Structure

A business’s legal structure determines its federal tax obligations. Many small businesses are pass-through entities, where profits and losses are passed to the owners to report on their personal tax returns. A sole proprietorship reports business income on Schedule C (Form 1040) with the owner’s personal return.

Partnerships and S corporations are also pass-through entities with more formal requirements. A partnership files an informational return on Form 1065 and provides each partner a Schedule K-1 detailing their share of the results. An S corporation files Form 1120-S and distributes Schedule K-1s to its shareholders.

In contrast, a C corporation is a separate taxable entity from its owners. The corporation pays tax on its net income by filing Form 1120. This can lead to “double taxation,” where the corporation pays tax on its profits, and shareholders also pay personal income tax on any dividends received from those profits.

Key Business-Specific Tax Items

A primary concept in business taxation is the deductibility of expenses that are both “ordinary” and “necessary” for the business. An ordinary expense is common in the industry, while a necessary expense is helpful and appropriate. Examples include the cost of goods sold, rent, utilities, and employee wages.

Businesses with employees have payroll tax responsibilities. Employers must withhold federal income tax and the employee’s share of FICA taxes from wages and remit these amounts to the IRS along with the employer’s matching share of FICA taxes.

Employers are also responsible for paying federal and state unemployment taxes. Under the Federal Unemployment Tax Act (FUTA), a tax is levied on employers at a rate of 6.0% on the first $7,000 of each employee’s wages. Employers can receive a tax credit of up to 5.4% for timely payment of state unemployment taxes, reducing the effective FUTA rate.

Tax Administration and Enforcement

After a return is submitted, the IRS’s automated systems scan for mathematical errors or missing information. If a simple mistake is found, the IRS may correct it and send the taxpayer a notice proposing changes to the tax owed. This automated check is not an audit.

An audit is a formal review of an individual’s or organization’s financial information to ensure it was reported correctly. The IRS selects returns for audit using a computer program called the Discriminant Information Function (DIF) system, which scores returns based on their potential for errors, as well as through random sampling.

There are three main types of audits:

• Correspondence audit: Conducted by mail and requests documentation for a specific item.
• Office audit: Requires the taxpayer to visit an IRS office to present records to an auditor.
• Field audit: An IRS agent visits the taxpayer’s home or business for a thorough review.

Following an audit, the examiner provides a report of their findings. If the taxpayer agrees, they can sign an agreement and pay any additional tax, penalties, and interest. If they disagree, they have the right to appeal the decision within the IRS. If a tax liability remains unpaid, the IRS may begin the collection process.