Understanding US Tax Rules by Residency, Entity Type & Income Source

[Last Updated on 3 weeks ago]

Why do two taxpayers with similar earnings often owe completely different amounts of tax—and why do CPAs spend so much time reconciling federal, state, and local rules before filing a return?

The answer lies in how the U.S. tax system applies multiple layers of taxation across different entities, residency classifications, income types, and jurisdictional authorities. 

Every major tax type—federal income tax, state income tax, payroll tax, self-employment tax, sales and use tax, property tax, corporate tax, pass-through entity tax, excise tax, and estate and gift taxes is governed by its own statutory framework, IRS forms, and compliance workflows.

At the federal level, the government collected over $4.7 trillion in revenue in 2023, with individual income taxes representing the largest share of federal collections.

For the same year, state and local governments collected approximately $2.04 trillion in total tax revenue, according to the National Association of Home Builders.

Of that amount, property taxes alone generated about $797 billion, accounting for nearly 38% of all state and local tax collections nationwide—a key reason why property tax remains the backbone of municipal funding across the U.S.

These layers of taxation interact differently depending on the taxpayer’s category and income type. A W-2 employee receives a Form W-2 and has payroll taxes handled through employer filings, such as Form 941.

A self-employed taxpayer files Schedule C, calculates SE tax using Schedule SE, and may need Form 1040-ES estimated payments.

Partners in a pass-through entity like a partnership or multi-member LLC rely on Form 1065 and Schedule K-1 (Form 1065).

S-corporation shareholders use Form 1120-S and Schedule K-1 (1120-S), while C-corporation shareholders depend on Form 1120 and dividend reporting through Form 1099-DIV.

Investors report gains and losses on Schedule D, receive trade reporting via Form 1099-B, and record interest and dividends using Forms 1099-INT and 1099-DIV. Homeowners track deductible mortgage interest through Form 1098 and claim property taxes on Schedule A.

Cross-border taxpayers add even more complexity. Green card holders are taxed as resident aliens  often meeting the Substantial Presence Test. Nonresident aliens follow a completely different regime outlined in Publication 519 and may need to file Form 1040-NR. International taxpayers frequently rely on U.S. tax treaties.

For CPAs, these distinctions shape everything from entity taxation to withholding, nexus, filing thresholds, and audit exposure. AI Tax Assistant like CPA Pilot streamline this analysis by surfacing relevant IRS citations, mapping entity-level tax impacts, generating client-ready explanations, and accelerating multi-state or cross-border compliance research.

To build a proper foundation, we begin with the most essential question of all: Who is actually subject to U.S. tax? Residency classification determines which tax rules apply, which forms are required, and which planning strategies CPAs must consider.

Who is Subject to U.S. Tax?

Understanding who the United States taxes is the foundation of every compliance decision. The IRS uses citizenship, residency status, and presence in the country to determine whether a person is taxed on worldwide income or only on U.S.-source income.

• U.S. Citizens and Resident Aliens

If you’re a U.S. citizen or you count as a resident for tax purposes, the IRS taxes your income no matter where you earn it. Wages, business income, rental income, foreign income — it all has to be reported.

The IRS classifies U.S. citizens and resident aliens as being subject to worldwide taxation. This means that all income—whether earned inside or outside the United States—must be reported on Form 1040.

• Green Card Holders and the Substantial Presence Test

If you have a green card or you spend enough days in the U.S. to meet the Substantial Presence Test, the IRS treats you like a U.S. resident for tax purposes.

Green card holders are permanent residents, and the IRS automatically treats them as resident aliens. People without a green card may still become resident aliens if they meet the Substantial Presence Test (SPT) —a formula based on the number of days spent in the U.S.

• Nonresident Aliens and U.S.-Source Income

If you don’t live in the U.S. long enough to be a tax resident, the IRS usually taxes only your U.S.-source income. That means U.S. wages, U.S. rental income, and some kinds of investment income.

Nonresident aliens generally pay U.S. tax only on income earned within the U.S., such as wages earned while working in the U.S., business activities in the U.S., or rental income from U.S. property. They typically file Form 1040-NR.

Why CPAs Focus on Residency First?

For CPAs, the first step in any tax engagement is confirming a client’s residency status. It affects the forms they file, the income they must report, and whether treaties can lower their tax.

Residency classification determines:

• Whether the taxpayer files Form 1040 or Form 1040-NR
• Whether worldwide income is taxable
• Whether foreign tax credits, exclusions, or treaties apply
• Whether a client qualifies for treaty benefits under U.S. tax treaties 

AI Tax Assistants like CPA Pilot help firms quickly surface:

• Treaty language
• Residency rules from Publication 519
• SPT calculations
• Filing obligations across multiple jurisdictions

Now that we’ve clarified who the U.S. taxes are , the next step is understanding how the U.S. tax system is structured — at the federal, state, and local levels, and across direct and indirect tax types.

Understanding the U.S. Tax System: Structure and Layers

The U.S. tax system operates across multiple government levels and applies different rules depending on the type of transaction or income. 

Understanding these layers helps CPAs and taxpayers determine which taxes apply and how each one is administered.

– Federal, State, and Local Tax Authorities

In the U.S., taxes come from three places: the federal government, your state, and sometimes your city or county.

Each level has its own authority to impose taxes:

• The federal government administers major national taxes, including individual income tax, payroll taxes, corporate income tax, estate tax, and excise taxes.
• States may apply income taxes, sales taxes, corporate and franchise taxes, and property taxes (often administered locally).
• Local governments – Counties, cities, school districts—primarily levy property taxes and sometimes local income or occupational taxes.

These layers can overlap in ways that affect both individuals and businesses.

– Tax Categories: Earn, Buy, and Own

In the U.S., taxes fall into three buckets: what you earn, what you buy, and what you own. This framework helps classify taxation:

• Earn: Wages, business income, investment income → subject to income, payroll, or SE taxes
• Buy: Goods and certain services → subject to sales, use, and excise taxes
• Own: Property, wealth transfers → subject to property, estate, and gift taxes

– Direct vs. Indirect Taxes

Direct taxes are paid straight to the government. Indirect taxes are built into the price of what you buy.

• Direct taxes: income tax, corporate tax, property tax, estate tax
• Indirect taxes: sales tax, use tax, excise taxes, customs duties

Indirect taxes are collected by a business at the point of sale and passed along to the government.

– Progressive, Flat, and Regressive Tax Patterns

Some taxes go up as your income goes up. Others stay flat or take a bigger share from lower earners.

• Progressive taxes (like federal income tax): Rates increase as taxable income increases.
• Flat taxes (some state income taxes): Everyone pays the same percentage.
• Regressive taxes (many consumption taxes): Lower-income households spend a larger share on taxable goods.

– Marginal vs. Effective Tax Rates

Your marginal tax rate is your next-dollar rate. Your effective tax rate is your average rate.

• Marginal rate: the rate applied to the highest portion of your taxable income.
• Effective rate: your total tax divided by your total income.

These two numbers are often confused, leading to misunderstandings when CPAs explain tax liability to clients.

– Taxable Income, Deductions, Credits, and the SALT Cap

Your taxable income comes from your total income minus adjustments and deductions. Credits reduce your tax dollar for dollar.

Key components:

• Taxable income: gross income minus adjustments and deductions
• Deductions: reduce the amount of income subject to tax
• Credits: directly reduce tax liability (some refundable, some not)
• SALT deduction: allows itemizers to deduct state and local taxes paid, capped at $10,000 under current law

With the tax system’s structure and categories clarified, the next step is to look at U.S. income taxes, including federal brackets, state-level differences, common forms, and planning considerations.

U.S. Income Taxes: Core Rules and Filing Mechanics

U.S. income taxes apply to earnings from employment, business activities, and investments. Each income category has its own rules, rate structure, and compliance requirements, which CPAs must evaluate to determine the taxpayer’s filing position and planning opportunities.

– Federal Income Tax Structure and Brackets

Federal income tax is built on a progressive rate structure, meaning different portions of taxable income are taxed at different rates depending on filing status. CPAs assess both the marginal rate applied to the top portion of income and the effective rate across total income after deductions and credits.

– State Income Tax Models and Local Add-Ons

State and local tax obligations differ across the U.S. Some states use progressive brackets, others a flat tax, and several impose no income tax at all. Local jurisdictions may add wage or occupational taxes that apply separately from state rules. 

State Income Tax Models At a Glance

Model	Example States	Notes
No Income Tax	TX, FL, TN, WY, NV, SD, WA	No state-level earned income tax.
Flat Tax	CO, IL, IN	Single rate regardless of income level.
Progressive Tax	CA, NY, NJ	Rates rise with income brackets.
Local Add-On Tax	NYC, Philadelphia	City-level income or wage taxes may apply.

– Capital Gains, Dividends, and Investment Income

Capital gains and investment income are taxed differently from wages. The tax rate is determined by the type of income and how long the asset was held.

Summary of Investment Income Treatment

Income Type	Tax Treatment	Relevant Forms
Short-Term Capital Gains	Taxed as ordinary income	Schedule D, 1099-B
Long-Term Capital Gains	Preferential 0%, 15%, or 20%	Schedule D, 1099-B
Qualified Dividends	Preferential capital gains rates	1099-DIV
Nonqualified Dividends	Ordinary income rates	1099-DIV
Interest Income	Ordinary income	1099-INT

– Common Federal Income Reporting Forms

Different income streams flow through different IRS documents, and reconciling them correctly is essential for accuracy and audit protection.

Income Type	IRS Form
Wages	Form W-2
Interest	Form 1099-INT
Dividends	Form 1099-DIV
Investment Sales	Form 1099-B
Business Income	Schedule C
Capital Gains	Schedule D

Key Planning Strategies and Common Misconceptions

Effective income tax planning revolves around controlling the timing, character, and recognition of income. Many misunderstandings arise from confusion over marginal vs. effective tax rates and from incorrectly assuming that all income is taxed equally. 

Key Planning Levers

• Timing capital gains or losses to manage brackets
• Contributing to tax-advantaged accounts
• Adjusting deduction strategies (standard vs. itemized)
• Avoiding phaseout cliffs for credits
• Evaluating optimal filing status

Income tax is only one component of taxes tied to earnings. The next section explains how payroll tax and self-employment tax apply to wages and business income — and why CPAs treat them differently when preparing filings or advising on entity structure.

Payroll and Self-Employment Taxes

Payroll taxes and self-employment taxes apply specifically to earned income—wages, salaries, tips, and net earnings from self-employment. 

These taxes fund Social Security, Medicare, and certain employer-level obligations. Unlike income taxes, they apply regardless of deductions or credits, which makes them a major focus for CPAs advising employees, employers, and business owners.

– Payroll Tax Breakdown for Employees and Employers

Payroll taxes are composed of:

• Social Security tax: 6.2% withheld from wages up to the annual wage base
• Medicare tax: 1.45% withheld from all wages
• Additional Medicare tax: 0.9% applies to high earners above certain thresholds

Employers must match the Social Security and Medicare amounts withheld from employees. Employers remit and reconcile these taxes through federal payroll filings.

Example: An employee earning $70,000 pays Social Security tax only on income below the wage base, while Medicare applies to the full $70,000. The employer matches both portions.

Employer Responsibilities: Employers handle withholding, matching taxes, and filing payroll reports.
They may also need to comply with state unemployment tax (SUTA) and federal unemployment tax (FUTA) requirements, depending on their jurisdiction and workforce size.

– Self-Employment Tax Mechanics and Deductions

If you work for yourself, you pay self-employment tax instead of payroll tax. Self-employed individuals pay both the employer and employee portions of Social Security and Medicare through self-employment tax:

• Social Security portion: 12.4%
• Medicare portion: 2.9%
• Additional Medicare tax may apply for high earners

The self-employed taxpayer can deduct the “employer-equivalent” portion of SE tax on their federal return.

Common Compliance Traps & How CPA Pilot Helps?

Payroll mistakes can get expensive. CPAs watch for misclassification, missed deposits, and wrong tax calculations.

• Worker misclassification → treating employees as contractors
• Underpayment of employment taxes → incorrect deposit timing
• Ignoring Additional Medicare thresholds
• Incorrectly calculated self-employment earnings
• Missing state or local payroll obligations

CPA Pilot assists firms by:

• Flagging misclassification risk indicators
• Linking IRS guidance automatically inside workflows
• Running estimated tax scenarios for both payroll and SE tax
• Attaching correct IRS form references for quick filing navigation

Payroll and self-employment taxes are only part of the picture for businesses. The next section explains how entity-level taxes—such as C-corporation tax, pass-through income rules, and state franchise or gross-receipts taxes—affect business owners and their advisors.

Business and Entity-Level Taxation

Business taxes in the U.S. depend heavily on the entity structure. Different rules apply to corporations, partnerships, LLCs, and sole proprietorships. CPAs evaluate these structures not only for tax liability but also for compliance risk, profit allocation, payroll requirements, and state-level obligations.

– C-Corporations and Double Taxation

A C-corporation pays its own tax. Then shareholders pay tax again when they receive dividends. C-corporations are separate taxpaying entities. They file Form 1120 and pay tax on their net income at the federal corporate tax rate. When profits are distributed to shareholders as dividends, individuals pay tax again—this is known as double taxation.

Key characteristics:

• Tax is imposed at the entity level
• Dividends create a second layer of tax at the shareholder level
• Losses remain inside the corporation; they do not pass through to owners
• Corporations may be subject to state corporate income taxes

– Pass-Through Entities: S-Corps, Partnerships, Sole Props

In a pass-through business, the company doesn’t pay income tax. The owners do. Pass-through structures do not pay federal income tax at the entity level. Instead:

• Partnerships file Form 1065
• S-Corps file Form 1120-S
• Sole proprietors file Schedule C
• LLCs choose their tax classification

Income, losses, credits, and deductions flow through to the owners via Schedule K-1, and owners report them on their personal returns.

Distinctive features:

• No entity-level federal income tax
• Profits are taxed whether distributed or not
• S-corp owners must pay themselves reasonable compensation
• Partnership owners may owe self-employment tax depending on their role and income type

– State-Level Business Taxes and Alternative Bases

States don’t all tax businesses the same way. Some use income, some use revenue, and some use franchise or margin taxes.

Beyond federal rules, states apply their own business tax systems. These may include:

• State corporate income tax
• Gross receipts taxes (e.g., Ohio CAT, Washington B&O)
• Margin or franchise taxes (e.g., Texas Franchise Tax)
• Entity-level PTE (Pass-Through Entity) taxes were created to bypass the SALT deduction cap

Many of these systems use alternative bases, such as:

• Gross revenue
• Gross margin
• Net worth
• Capital stock

Rules vary widely and affect business location decisions, apportionment, and multistate filings.

Entity-Choice Scenarios for CPAs

Choosing the right business structure can change how much tax someone pays — and how they pay it.

CPAs evaluate entity choice based on:

• Total tax liability (federal + state + payroll/SE layers)
• How profits are extracted (salary, draws, dividends)
• Owner participation and reasonable compensation rules
• Eligibility for the Qualified Business Income (QBI) deduction
• S-Corp payroll vs partnership SE tax mechanics
• Multistate and nexus considerations

Entity choice is a planning strategy, not just an administrative formality.

Understanding business-level taxation sets the stage for another important category: consumption taxes. These include sales, use, and excise taxes — all of which affect how businesses collect, remit, and structure product pricing.

Consumption Taxes: Sales, Use, and Excise

Consumption taxes apply when businesses sell products, provide taxable services, or handle goods subject to special federal or state taxation. These taxes depend on location, transaction type, product category, and the taxpayer’s business activities.

– Sales and Use Tax Differences

You pay sales tax when you buy something. You owe use tax when you buy it without sales tax but use it in your state.

Sales and use taxes are state-imposed consumption taxes, and each state determines:

• Which goods and services are taxable
• Sales tax rates
• When out-of-state sellers must collect tax
• When consumers owe use tax

Key Differences:

• Sales tax → collected at checkout by the seller
• Use tax → owed by the buyer when sales tax was not collected

– Excise Taxes by Category

Excise tax applies to specific products like fuel, alcohol, tobacco, or air travel. It’s built into the price.

Excise taxes are imposed at either the federal or state level on specific goods or activities. They often apply per unit (e.g., per gallon, per pack, per flight segment).

Common excise categories include:

• Fuel
• Alcohol
• Tobacco
• Firearms and ammunition
• Airline passenger transportation
• Heavy truck and highway usage

What CPAs Monitor for Clients

CPAs watch for sales tax nexus, wrong product classifications, and missing excise filings.

Key CPA oversight areas include:

• Identifying nexus in multiple states
• Determining whether digital goods or services are taxable
• Reviewing vendor exemption certificates
• Checking if the business sells items subject to excise tax
• Filing Form 720 when required
• Ensuring proper remittance schedules for each jurisdiction

Misclassification risk is high because states vary widely in how they tax:

• Software and SaaS
• Digital services
• Professional services
• Bundled transactions

Sales, use, and excise taxes apply to transactions—what businesses sell or purchase.
The next category focuses on taxes tied to what people and businesses own: property, vehicles, and inherited wealth.

Property Tax

Real property tax is based on the value of land and buildings you own. Local governments set the rate. Real property taxes are assessed by local governments—cities, counties, or school districts. The tax is based on:

• Assessed value of land and improvements
• Local millage or tax rate
• Classification rules (residential, commercial, agricultural)
• Periodic revaluation cycles

These taxes fund local services such as schools, infrastructure, and emergency services. Rules vary significantly across states and counties.

Personal Property Tax

Some states tax personal property, like vehicles or business equipment. Personal property tax applies to movable assets and is often imposed on:

• Business machinery and equipment
• Office furniture
• Computers and tools
• Vehicles (in certain states)

This tax generally applies at the local level, though rules vary:

• Some states tax only business personal property
• Some tax vehicles annually
• Some have exemptions based on asset value or business size

A manufacturing company may owe annual personal property tax on $280,000 of machinery located at its production site.

Estate and Gift Taxes

Estate tax applies to large estates when someone dies. Gift tax applies when you give away property during your lifetime. Wealth transfer taxes include:

Important Mechanics:

• Estate tax applies to the fair market value of all assets as of the date of death
• Gift tax uses an annual exclusion (e.g., gifts under a certain yearly limit may be tax-free)
• Unified credit covers lifetime gift + estate transfers
• Executors must file Form 706 for taxable estates

Tax Planning Touchpoints for CPAs

For CPAs, property and wealth taxes matter for planning — especially when clients own businesses, real estate, or large estates.

Key CPA planning activities include:

• Tracking depreciation vs assessed property value differences
• Reviewing property tax assessments for accuracy
• Planning gifting strategies around annual exclusion limits
• Coordinating basis step-up strategies for inherited assets
• Preparing valuation documentation for estate filings
• Reviewing state estate/inheritance tax thresholds for relocation planning

CPAs also collaborate with estate attorneys to align tax strategies with client wealth-transfer goals.

Property and wealth taxes affect what taxpayers own or transfer.

The next section focuses on how taxes apply to different profiles, such as W-2 employees, self-employed workers, investors, retirees, business owners, and cross-border taxpayers — giving CPAs a clear mapping of which tax types affect each group.

Which Taxes Apply to Who? (Profiles and Scenarios)

Profile	Key Tax Types
W-2 Employee	Income, Payroll, Capital Gains, Property
Retiree	Income (pensions/IRA), Social Security taxability, Capital Gains, Property
Self-Employed	Income, SE Tax, Sales Tax, Estimated Tax
Small-Business Owner	Income, Payroll, Entity Tax, Property
Investor	Capital Gains, Dividends, Interest
Green Card Holder	Worldwide Income
Nonresident Alien	U.S.-Source Income Only

Conclusion – Turning Complexity into Compliance

Navigating U.S. taxes means understanding how income, payroll, business, property, and wealth taxes overlap across federal, state, and local systems. Each taxpayer profile—whether W-2 employee, self-employed, business owner, investor, or cross-border filer—faces a unique mix of obligations, forms, and planning opportunities. With the right guidance, these complexities become manageable, predictable, and optimized for better financial outcomes.

Whether you’re a CPA, firm owner, or business leader, CPA Pilot helps you research faster, avoid costly errors, and deliver accurate, client-ready tax insights in seconds – not hours.

👉 Take your next step:  Optimize your tax workflow with CPA Pilot today. Let’s turn complexity into clarity—and compliance into confidence.

U.S. Tax System FAQs 

What is the difference between tax deductions and tax credits?

Tax deductions reduce taxable income, while tax credits reduce tax owed directly

How does the IRS determine whether income is passive or active?

The IRS classifies income as passive when the taxpayer does not materially participate in the activity.

What taxes apply when hiring your first employee?

Hiring an employee triggers payroll tax, withholding, and employment reporting duties.

How do U.S. tax treaties help reduce double taxation? 

U.S. tax treaties allocate taxing rights between countries to prevent double taxation. 

What records should individuals and businesses keep for tax compliance?

Taxpayers should keep income statements, receipts, payroll records, bank logs, and asset documents for at least three years. 

Disclaimer: This article is provided by CPA Pilot for educational purposes. While we may offer tax software/services, the information here is general and may not address your specific facts and circumstances. It does not constitute individual tax, legal, or accounting advice. U.S. federal and State Tax laws change frequently; please consult a qualified tax professional before acting on any information.