Federal Income Tax Outline

I. Introduction to Federal Income Taxation
A. A Glimpse Backward
1. The nation had few taxes in its early history. From 1791 to 1802 (tax was abolished), the United States government was supported by internal taxes on distilled spirits, carriages, refined sugar, tobacco and snuff, property sold at auction, corporate bonds, and slaves. The high cost of the War of 1812 brought about the nation’s first sales taxes on gold, silverware, jewelry, and watches. In 1817, however, Congress did away with all internal taxes, relying on tariffs on imported goods to provide sufficient funds for running the government.
2. In 1862, in order to support the Civil War effort, Congress enacted the nation’s first income tax law. It was a forerunner of our modern income tax in that it was based on the principles of graduated, or progressive, taxation and of withholding income at the source. During the Civil War, a person earning from $600 to $10,000 per year paid tax at the rate of 3%. Those with incomes of more than $10,000 paid taxes at a higher rate. Additional sales and excise taxes were added, and an “inheritance” tax also made its debut. In 1866, internal revenue collections reached their highest point in the nation’s 90-year history—more than $310 million, an amount not reached again until 1911.
i) The Act of 1862 established the office of Commissioner of Internal Revenue. The Commissioner was given the power to assess, levy, and collect taxes, and the right to enforce the tax laws through seizure of property and income and through prosecution. The powers and authority remain very much the same today.
3. In 1868, Congress again focused its taxation efforts on tobacco and distilled spirits and eliminated the income tax in 1872. It had a short-lived revival in 1894 and 1895. In the latter year, the U.S. Supreme Court decided that the income tax was unconstitutional because it was not apportioned among the states in conformity with the Constitution.
4. In 1913, the 16th Amendment to the Constitution made the income tax a permanent fixture in the U.S. tax system. The amendment gave Congress legal authority to tax income and resulted in a revenue law that taxed incomes of both individuals and corporations. In fiscal year 1918, annual internal revenue collections for the first time passed the billion-dollar mark, rising to $5.4 billion by 1920. With the advent of World War II, employment increased, as did tax collections—to $7.3 billion. The withholding tax on wages was introduced in 1943 and was instrumental in increasing the number of taxpayers to 60 million and tax collections to $43 billion by 1945.
5. Prior to 1874, U.S. statutes were not codified. That is, they were not set forth in one comprehensive subject matter title, but were instead contained in the various acts passed by Congress. Codifications of statutes (including tax statutes) undertaken in 1873 resulted in the Revised Statutes of the United States, approved June 22, 1874, effective for the laws in force as of December 1, 1873 (title 35 of which was the internal revenue title). Another codification was undertaken in 1878. In 1919, a committee of the U.S. House of Representatives began a project to recodify U.S. statutes which eventually resulted in a new code in 1926 (including tax statutes).
6. The tax statutes were re-codified by an Act of Congress on February 10, 1939 as the “Internal Revenue Code” (later known as the “Internal Revenue Code of 1939”). The 1939 Code was published as volume 51, Part I, of the United States Statutes at Large and as title 26 of the United States Code. Subsequent permanent tax laws enacted by the United States Congress updated and amended the 1939 Code.
7. On August 16, 1954, in connection with a general overhaul of the Internal Revenue Service, the IRC was greatly reorganized by Congress and expanded. To prevent confusion with the 1939 Code, the new version was thereafter referred to as the Internal Revenue Code of 1954 and the prior version as the Internal Revenue Code of 1939. The lettering and numbering of subtitles, sections, etc., was completely changed. For example, section 22 of the 1939 Code (defining gross income) was roughly analogous to section 61 of the 1954 Code. The 1954 Code replaced the 1939 Code as title 26 of the United States Code.
8. On Oct. 22, 1986, President Reagan signed into law the Tax Reform Act of 1986, one of the most far-reaching reforms of the United States tax system since the adoption of the income tax. The top tax rate on individual income was lowered from 50% to 28%, the lowest it had been since 1916.
B. The Income Tax and the United States Constitution
1. Article 1, Section 8: Constitution of the United States confers on Congress the “power to lay and collect taxes, duties, imposts and excises…”
2. 16th Amendment: The 16th Amendment took effect in 1913 and gave Congress the power to impose income taxes.
3. Apportionment Among the States
i) Article I, Section 2, clause 3 and Section 9, clause 4 require that “direct” taxes be apportioned among the several states in accordance with their respective populations
A) Direct tax v. Indirect tax
1) A direct tax is demanded from the very person intended to pay it while an indirect tax is paid primarily by a person who can shift the burden of the tax to someone else or who at least is under no legal compulsion to pay the tax
ii) The Rule of Apportionment says that after Congress has established a sum to be raised by direct taxation, the sum must be divided among the states in proportion to their respective populations
iii) In Pollock v. Farmers’ Loan and Trust, the Supreme Court invalidated an income tax statute that included as income rents from real estate because they felt that the intention of the drafters of the Constitution was to prevent the imposition of tax burdens on accumulations of property, except in accordance with the rule of apportionment
4. Uniformity Among the States
i) Article 1, Section 8, clause 1 reads: “all duties, imposts, and excises shall be uniform throughout the United States”
A) By uniform, it is well settled that the Constitution requires only geographic uniformity
ii) Whenever some manner or mode of taxation is used somewhere in the US, the same manner or mode must be used everywhere throughout the US
iii) Notwithstanding the Constitutional fiat of uniformity, in the practical application of the income tax laws some lack of uniformity creeps in, even in the geographical sense, because there are always uncertainties in the interpretation of statutes
5. Due Process
i) It has been long settled that Congress may impose an income tax measured by the income of a prior year or by income of the year of the enactment before the enactment date
ii) If questions can be raised about retrospective taxation, the 5th Amendment seems the likely weapon, but the Supreme Court has held that it “is not a limitation upon the taxing power conferred upon Congress by the Constitution”
A) Although the 5th Amendment may not limit the taxing power, it can vitiate a statute that, while masquerading as a tax, in reality amounts to confiscation
6. Self-Incrimination
i) It is well settled that requiring a taxpayer to file an income tax return does not violate the 5th Amendment privilege against self-incrimination; rather, the proper place to raise the objection is in the return itself
C. Sources of Federal Income Tax Law
1. Internal Revenue Code of 1986 (IRC): Title 26 of the United States Code (USC) is the primary source of authority for the federal tax law.
2. Treasury Regulations: Regulations are drafted by the United States Treasury Department under authority from Congress.
i) Legislative: The regulations are drafted to cover specific provisions of the IRC. They carry the force of law unless they are drafted so broadly as to fall outside of their specific mandates.
ii) Interpretative: Some regulations are interpretative. These are issued under general authority granted by Congress, and are given a strong presumption of correctness by the courts. Regulations can be held invalid.
3. Revenue Rulings and Procedures: Rulings and procedures are written by IRS attorneys and are not official pronouncements. They respond to a limited factual setting, accordingly, their scope is limited. Essentially, “an indication that you’re going to get hassled if you go through with the transaction.”
4. Rulings and Determination Letters: Letters of ruling or determination are written for taxpayers’ inquiries sent to the IRS national office or a district director. These are issued only if a clear determination can be made from the IRC, a treasury regulation, or court decision. These letters cannot be cited as authority, but guide in determining the IRS position with regard to an issue.
5. Judicial Opinions: Tax controversies are heard by the United States Supreme Court, US Court of Appeals, US District Court and the United States Claim Court. In addition, the United States Tax Court is specifically set aside for tax issues.
D. Income Tax Terminology
1. Tax Computation
E. The Big Picture
1. Gross Income (§61) (all income from whatever sources derived-except for statutorily excluded)
i) Less: Certain Deductions (i.e.Business Expense (§61)
2. =Adjusted Gross Income
i) Less: Personal Exemptions
ii) Less: Standard or Itemized Deductions
3. = Taxable Income
i) Multiplied by Tax Rate (from tables in §1)
4. =Tax Due on Taxable Income
i) Less: Credits
5. = Tax Due/Refund
i) Filing Categories and Rate -§1
A) Progressive: Proportional tax rate.
B) Marginal: Rate at which the last dollar is taxed at the top tax rate to which the taxpayer is exposed.
C) Effective: Average tax rate applied to every dollar.
F. Tax Ethics
1. A taxpayer has a responsibility to file an accurate tax return, and a lawyer may advise a client to take a particular return position only if it has a “realistic possibility of success on the merits if litigated.” Certain civil and criminal penalties attach to an inaccurate tax return.
G. The Road Ahead
1. Relevant Questions to Consider in Working Tax Problems
i) What is gross income?
ii) Who pays tax on it?
iii) What deductions are allowed on that gross income?
A) “Above the line” deductions are subtracted from gross income and are available to all taxpayers whether they choose to itemize or not
1) Common deductions: Contributions to IRA, non-employee trade or business expenses, employee expenses paid by the taxpayer under a reimbursement arrangement with her employer, losses from the sale or exchange of property, expense related to the production of rents or royalties, employer contributions to the taxpayer’s pension or profit-sharing plan, contributions to qualified retirement savings plans, alimony payments made by the taxpayer, employment-related moving expenses that were not reimbursed by the taxpayer, qualified contributions to medical savings accounts, and interest paid on qualifying education loans.
B) “Below the line” deductions are subtracted from adjusted gross income to arrive at taxable income. These include the standard deductions, regular itemized deductions, and miscellaneous itemized deductions. The TP may choose either the standard below-the-line deduction or itemized deductions, but not both.
1) Common itemized deductions: Interest paid §163, taxes paid to state and local governments §164, charitable contributions §170, business and investment losses §165, personal casualty losses, medical expense §213, moving expenses, education §222
2) Common miscellaneous itemized deductions: §67 Unreimbursed employee expenses, expenses related to generating investment income, and tax preparation fees. The key fact to remember about these deductions is this: only that amount of miscellaneous itemized deductions, added together, which exceeds 2% of AGI may be deducted from AGI. The 2% floor does not apply to pass through entities such as partnerships.
iv) For what year is an item income or deductible?
v) What is the character of various items?
vi) Is a gain or loss to be immediately recognized?
vii) What is the taxpayer’s tax liability?
viii) Are any credits available?
ix) Have any mistakes been made and what would happen in the event that one was?

————————————————–GROSS INCOME———————————————————-

II. Identification of Income Subject to Taxation
A. Gross Income Definition – §61: “Gross income means all income from whatever source derived.” Broad interpretation. Compensation for services, rents, royalties, interest and dividends is explicitly included. §71-87 mention additional items included in gross income. However, this list is not considered exhaustive. There are also numerous exclusions such as interest on state and municipal bonds.
B. Receipt of Financial Benefit
1. Realization and Recognition: A gain or loss is said to be “realized” when there has been some change in circumstances such that a gain or loss might be taken into account for tax purposes. Realization requires the accrual or receipt of cash, property, or services, or change in the form or nature of an investment. A realized gain is then said to be “recognized” when the change in circumstances is such that the gain or loss is actually taken into account. Therefore, a realization of gain does not necessarily bring forth immediate gain recognition.
i) Pure Income: Tax immediately.
ii) Capital Investment: Tax when owner pulls the realizati