Federal payroll taxes in the United States are primarily collected by employers, for the U.S. Internal Revenue Service. The Federal income tax uses a system of direct withholding. Employers pay part of a taxpayer’s income tax directly from their payrolls. The amount of withholding is calculated based on an employee’s expected annual salary and the employee’s living situation (married or unmarried, number of dependents, other factors). Withholding does not perfectly calculate an individual’s tax each year.
The U.S. government rewards certain behavior with tax deductions or tax credits. The most famous reduction in taxes is that income used to pay mortgage interest on a personal home is exempted from taxes, if the taxpayer elects to itemize. Taxpayers who do not participate in an employer-sponsored pension plan may contribute up to $3,000 ($3,500 if age 50 or above) into an individual retirement account, and deduct that contribtion from their gross income. The Earned Income Tax Credit benefits low- to moderate-income working families.
There are two ways to calculate Income Tax. The regular way is based on the gross income minus any applicable deductions and then a marginal tax percentage is applied according to the taxpayer’s income bracket. From this result, any applicable tax credits are subtracted and the result is the income tax owed. If the result is a negative number due to refundable tax credits and/or if the Federal Withholding Tax was greater than the income tax that was actually owed, the taxpayer is entitled to a tax refund.
The second way, the Alternative Minimum Tax (AMT) is based on the gross income, computed without regard to certain tax preference items (such as tax-exempt interest on certain private activity bonds) and with a reduced number of exemptions and deductions. This higher income base is taxed in two rate brackets, 26% and 28%, depending on taxpayer income.
The AMT was designed to prevent people from using loopholes in the tax law to avoid tax. However, the inclusion of unrealized gain on incentive stock options imposes difficulties for people who cannot come up with cash to pay tax on gains that they have not realized yet. As a result, Congress has taken action to modify the AMT regarding incentive stock options. In 2000 and 2001, people exercised incentive stock options and held onto the shares, hoping to pay long-term capital gains taxes instead of short-term capital gains taxes.  Many of these people were forced to pay the AMT on this income, and by the end of the year, the stock was no longer worth the amount of AMT tax owed, forcing some individuals into bankruptcy. In the Nortel example given above, the individual would receive a credit for the AMT paid when the individual did eventually sell the Nortel shares.