"Taxable Income"
by Larken Rose
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Section 861 Issues
The second erroneous "interpretation" which tax professionals have regarding Section 861 is that it is relevant to everyone, but that it does show the income of most people to be taxable. This is due in large part to the general language used in Section 861, which reads:
"Sec. 861. Income from sources within the United States
(a) Gross income from sources within United States
The following items of gross income shall be treated as income from sources within the United States: (1) Interest - Interest from the United States... (2) Dividends... (3) Personal services - Compensation for labor..." [26 USC § 861](Interestingly, most tax professionals are aware that the application of this section is not as broad as it appears to be at first glance.)
As shown above, this section of the statutes applies only in determining taxable income from "specific sources," which are all related to international and foreign commerce. The history of the regulations and statutes, as shown above, make this point clear. However, certain sections of the regulations (taken out of context) are used to try to support the claim that the tax is not limited to the "specific sources."
(The entire issue of "residual groupings" mentioned below is settled easily using the older regulations, but for the sake of completeness it will also be dealt with using the current regulations. The following explanation deals with an issue intended to be confusing; it is included for the purpose of being thorough in documenting and refuting anything likely to be used to try to refute the conclusions of this report.)
The regulations define a "statutory grouping" of gross income as income from a specific source, while "residual grouping of gross income" means income from anywhere else.
"…the term ‘statutory grouping of gross income’ or ‘statutory grouping’ means the gross income from a specific source or activity... (See paragraph (f)(1) of this section.) Gross income from other sources or activities is referred to as the ‘residual grouping of gross income’ or ‘residual grouping.’" [26 CFR § 1.861-8(a)(4)]
The argument is that income from somewhere other than the "specific sources" may also be taxable. The idea is that "gross income" must constitute "taxable income" (after deductions are subtracted), since the definition of "taxable income" is "gross income" minus deductions. However, the regulations often use the term "gross income" in a more general way, meaning any income, whether taxable or not. In fact, the regulations specifically state that the "residual grouping" may be excluded from federal taxation.
"…the residual grouping may include, or consist entirely of, excluded income. See paragraph (d)(2) of this section with respect to the allocation and apportionment of deductions to excluded income." [26 CFR § 1.861-8(a)(4)]
A clear example of tax-exempt income being referred to as "gross income" in a "residual grouping" is shown below. As stated in 26 USC § 882(a)(2), foreign corporations are only taxable on "gross income which is effectively connected with the conduct of a trade or business within the United States." The following example therefore shows that any regulation which discusses "gross income" (not "taxable income") from the "residual grouping" in no way shows that the residual grouping must be taxable.
"(iii) Apportionment Since X is a foreign corporation, the statutory grouping is gross income effectively connected with X's trade of business in the United States, namely gross income from sources within the United States, and the residual grouping is gross income not effectively connected with a trade or business in the United States, namely gross income from countries A and B." [26 CFR § 1.861-8(g), Example 21]
The fact that the regulations refer to income as "gross income" does not mean it is taxable. In discussing an item of income, the regulations state the following:
"Gross income from sources within the United States includes compensation for labor or personal services performed in the United States..." [26 CFR § 1.861-4]
In the generic sense, compensation for labor within the United States is "gross income." However, as the current regulations repeatedly explain, it can only be "taxable income" if it comes from a "specific source." The older regulations dealt with this "item" of income in a very similar way, and the context of the surrounding regulations made it perfectly clear in what situations this "item" could be taxable.
"Sec. 29.119-1. Income from sources within the United States.
Nonresident alien individuals, foreign corporations, and citizens of the United States or domestic corporations entitled to the benefits of section 251 are taxable only upon income from sources within the United States...The Internal Revenue Code divides the income of such taxpayer into three classes:
(1) Income which is derived in full from sources within the United States;
(2) Income which is derived in full from sources without the United States;
(3) Income which is derived partly from sources within and partly from sources without the United States...Sec. 29.119-2. Interest...
Sec. 29.119-3. Dividends...
Sec. 29.119-4. Compensation for labor or personal services. - Except as provided in section 119(a)(3), gross income from sources within the United States includes compensation for labor or personal services performed within the United States...
Sec. 29.119-5. Rentals and royalties...
Sec. 29.119-6. Sale of real property...Sec. 29.119-10. Apportionment of deductions.
From the items specified in sections 29.119-1 to 29.119-6, inclusive, as being derived specifically from sources within the United States there shall, in the case of nonresident alien individuals and foreign corporations engaged in trade or business within the United States, be deducted [allowable deductions]. The remainder shall be included in full as net income from sources within the United States..."The fact that income is referred to in the regulations as "gross income" certainly doesn’t mean it is taxable. In fact, after stating that the "residual grouping of gross income" may or may not be taxable, the regulations refer the reader to "paragraph (d)(2)" regarding "excluded income." As shown above, the only types of income listed as not exempt are:
"(A) In the case of a foreign taxpayer…
(B) In computing the combined taxable income of a DISC or FSC…
(C) For all purposes under subchapter N of the Code… the gross income of a possessions corporation…
(D) Foreign earned income as defined in section 911 and the regulations thereunder…" [26 CFR § 1.861-8T(d)(2)(iii)]Deductions must be divided between the "statutory grouping" (income from a specific source) and the "residual grouping" (income from anywhere else). This does not mean that the "residual grouping" is taxable. The regulations show in several places that there must be an "operative section" which applies in order to determine taxable income.
"A taxpayer to which this section applies is required to allocate deductions to a class of gross income and, then, if necessary to make the determination required by the operative section of the Code, to apportion deductions within the class of gross income between the statutory grouping of gross income (or among the statutory groupings) and the residual grouping of gross income." [26 CFR § 1.861-8(a)(2)]
The regulation which states that the "residual grouping" may be exempt from taxation also shows that there must be an "operative section" applicable.
"In some instances, where the operative section so requires, the statutory grouping or the residual grouping may include, or consist entirely of, excluded income." [26 CFR § 1.861-8(a)(4)]
This is only logical, based on the simple fact that the section "for determining taxable income from sources within the United States" (26 CFR § 1.861-8) states over and over again that it is for determining taxable income from "specific sources," not the "residual groupings."
"The rules contained in this section apply in determining taxable income of the taxpayer from specific sources and activities under other sections of the Code, referred to in this section as operative sections…" [26 CFR 1.861-8(a)(1)]
"The operative sections of the Code which require the determination of taxable income of the taxpayer from specific sources or activities and which give rise to statutory groupings to which this section is applicable include the sections described below…"
[26 CFR 1.861-8(f)(1)]"A taxpayer to which this section applies is required to allocate deductions to a class of gross income and, then, if necessary to make the determination required by the operative section of the Code, to apportion deductions…" [26 CFR § 1.861-8(a)(2)]
The regulations (and statutes) are not about determining taxable income from anywhere other than the "specific sources." Part of the confusion is from the fact that, in stating that the "residual grouping" may consist of excluded income, the regulations imply that it also may be taxable. This is correct, but deceptive. The possibility of the "residual grouping" being taxable could easily lead to the erroneous conclusion that income from somewhere other than the "specific sources" might be taxable. The assumption is that the "residual grouping" cannot be from one of the listed "specific sources." This is not the case.
If person ‘A’ gets taxable income from two "specific sources" (taxable activities described in "operative sections"), the regulations state that all the calculations must be done for each "specific source" separately. Paragraph (f)(1) lists the "specific sources" under the "operative sections," and then the next paragraph states the following:
"(i) Where more than one operative section applies, it may be necessary for the taxpayer to apply this section separately for each applicable operative section." [26 CFR § 1.861-8(f)(2)]
While person ‘A’ is calculating all the deductions, etc. for the first "specific source," his income from the second "specific source" falls in the category of "residual grouping." Likewise, when he is doing the calculations for the taxable income from the second "specific source," the income from the first is in the "residual grouping." The temporary regulations at 26 CFR § 1.861-8T demonstrate this.
"Thus, in determining the separate limitations on the foreign tax credit imposed by section 904(d)(1) or by section 907, the income within a separate limitation category constitutes a statutory grouping of income and all other income not within that separate limitation category (whether domestic or within a different separate limitation category) constitutes the residual grouping." [26 CFR § 1.861-8T(c)(1)]
(The same thing is said again in 26 CFR § 1.861-8T(f)(1)(ii).)
Even an example in the regulations showing that the "residual grouping" may be taxable therefore does not imply that income from somewhere other than the "specific sources" may be taxable. The "operative sections" involving individuals receiving income from within federal possessions also makes it possible for a taxpayer to have "taxable income" from within and without the United States.
The "residual grouping" argument relies on making assumptions based on something that complex deduction allocation examples might seem to suggest, but do not state (that income not from the "specific sources" can be taxable), while at the same time ignoring several sections of regulations which contradict this theory. The over-complexity of these regulations seems designed to cause confusion and uncertainty. But even if the current complicated regulations by themselves, combined with some "creative interpretation," allowed for the "residual grouping" argument to have some credibility, the older regulations (as shown above) erase that credibility entirely.
The 1945 regulations made no mention of "operative sections," "specific sources," "statutory groupings" or "residual groupings," and didn’t take dozens of pages to create a jumbled, confusing mess. Since there was nothing about "residual groupings" back then to base an argument on, to use the argument now would require the claim that since 1945 there must have been a massive expansion of what income is taxable, from international and foreign commerce to all commerce, and that the Secretary decided to inform the public of this by innuendos hidden in confusing examples about deduction allocation related to the per-country limitation on the foreign tax credit. (And, as shown before, Congress stated that "no substantive change" was made anyway.)
The common "interpretation" of the income tax laws relies on multiple assumptions, as well as simply ignoring various sections which contradict those assumptions. Some may wish to imagine that some other "sources" of income which the law does not mention must also be taxable. Some may like to assume that everything is taxable unless the law specifically says it is not. And some may say that if there is some uncertainty about what the law requires, then the government by default "wins." All of these are in direct conflict with a basic principle of tax law, which has been explained on numerous occasions by the Supreme Court.
"In the interpretation of statutes levying taxes it is the established rule not to extend their provisions, by implication, beyond the clear import of the language used, or to enlarge their operations so as to embrace matters not specifically pointed out. In case of doubt they are construed most strongly against the government, and in favor of the citizen." [Gould v. Gould, 245 U.S. 151 (1917)]
"In view of other settled rules of statutory construction, which teach that... if doubt exists as to the construction of a taxing statute, the doubt should be resolved in favor of the taxpayer..." [Hassett v. Welch, 303 U.S. 303 (1938)]
The extensive evidence of the correct, limited application of the income tax leaves little room for doubt. But even if the IRS, or others who would challenge the conclusions of this report, could obfuscate and confuse matters to the point where "it could go either way," the Supreme Court makes it clear that such a disagreement is to be settled in favor of the citizen, not the government.
Strange Links
In various sections of the statutes, Section 911 is referenced where it does not seem to fit in (if one accepts the common, overly-broad interpretation of the Code). One example exists in Section 1 itself (the section imposing the income tax on individuals). Subsection (g) of Section 1 deals with certain income of children being treated as income of that child’s parents, and shows that the term "earned income" is defined in 26 USC § 911(d)(2).
"(g) Certain unearned income of minor children taxed as if parent's income…
(4) Net unearned income
For purposes of this subsection--
(A) In general
The term "net unearned income" means the excess of--
(i) the portion of the adjusted gross income for the taxable year which is not attributable to earned income (as defined in section 911(d)(2))…" [26 USC § 1(g)]This section (26 USC § 1(g)) is referred to later in Section 59(j), and Section 911(d)(2) is again mentioned as the section which defines "earned income." Other sections, such as 26 USC § 66(d) and 26 USC § 469(e), also refer to Section 911(d)(2) for the definition of "earned income." There is nothing peculiar about the definition in 26 USC § 911(d)(2) itself, which states:
"(d) Definitions and special rules
For purposes of this section--
(2) Earned income
(A) In general
The term "earned income" means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered, but does not include…" [26 USC § 911(d)]What is interesting is the location of the definition:
Subchapter N -- Tax based on income from sources within or without the United States
Part III -- Income from sources without the United States
Subpart B -- Earned income of citizens or residents of United States
Sec. 911. Citizens or residents of the United States living abroadWhile it is true that the location of such a definition does not legally change the meaning of the definition, it is still somewhat telling that the definition is found in Subchapter N, rather than in Subchapters A and B (which impose the tax, and define "gross income" and "taxable income"). It is also telling that the definition itself (even though the definition is also "borrowed" by other sections) says that the definition is "for purposes of this section," meaning Section 911, which deals exclusively with the "foreign earned income" of United States citizens.
Another strange connection occurs in the section regarding "community income," which comes shortly after Section 63 defining "taxable income."
"Sec. 66. Treatment of community income
(a) Treatment of community income where spouses live apart
If- (1) 2 individuals are married to each other…;
(2) such individuals-- (A) live apart… (B) do not file a joint return…;
(3) one or both of such individuals have earned income for the calendar year which is community income; and
(4) no portion of such earned income is transferred (directly or indirectly) between such individuals before the close of the calendar year,
then, for purposes of this title, any community income of such individuals for the calendar year shall be treated in accordance with the rules provided by section 879(a)." [26 USC § 66]Note that this is giving the rules applicable to all of Title 26 regarding "community income." But the section it refers to for such rules reads:
"Sec. 879. Tax treatment of certain community income in the case of nonresident alien individuals
(a) General rule - In the case of a married couple 1 or both of whom are nonresident alien individuals and who have community income for the taxable year, such community income shall be treated as follows:…" [26 USC § 879(a)]The text here specifically states that it applies only where one or both are nonresident aliens. To use the same rules for two citizens of the United States, Section 66 would have to say something similar to "shall be treated in accordance with the rules provided by 879(a) regarding nonresident aliens, notwithstanding the fact that the individuals may be citizens or residents of the United States." But it says no such thing, implying that "community income" applies only if at least one partner is a nonresident alien.
Following Instructions
Form 1040 is divided into several categories, such as personal information, "Filing Status," "Exemptions," "Income," etc. In the instruction booklet for that form, there is a section that gives line-by-line instructions. The general category of "Income" begins:
"Foreign-Source Income
You must report unearned income, such as interest, dividends, and pensions, from sources outside the United States unless exempt by law or a tax treaty. You must also report earned income, such as wages and tips, from sources outside the United States.
If you worked abroad, you may be able to exclude part or all of your earned income. For details, see Pub. 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, and Form 2555, Foreign Earned Income, or Form 2555-EZ, Foreign Earned Income Exclusion.
Community Property States... *
Rounding Off to Whole Dollars..." [1996 Instruction Booklet for Form 1040](* - This concerns "community income," which is dealt with above. This would apply only to a United States citizen married to a nonresident alien.)
That is all it has to say about the general subject of income. The booklet then tells where the listed "items" (interest, dividends, wages, etc.) should be entered on Form 1040. While there is a statement specifically saying that "you must report" these items if from sources outside the United States, there is no statement that these items must be reported if they come from within the United States.
This admission in the booklet is very easy for most readers to simply disregard as irrelevant to them. If there was the need to say that foreign-source income must be reported, why was there no need to say that any other income must be reported? Why did the statement not say that foreign source income "as well as domestic income" must be reported? One is left free to make the incorrect assumption that all income must be reported, when this is not the case.
A similar situation exists with IRS Publication 525, "Taxable and Nontaxable Income." The first thing this publication says concerning taxes, which appears on the cover, is:
"Important Reminder
Foreign Source Income
If you are a U.S. citizen, you must report income from sources outside the United States (foreign income) on your tax return unless it is exempt by U.S. law."Then, in the introduction (which follows the above "reminder"), the publication states that the publication "discusses many kinds of income and explains whether they are taxable or nontaxable." Other than the "foreign source income" reminder, the publication deals only with "items" of income, not "sources." Again, one is left free to assume that income from within the United States is taxable to U.S. citizens, but it is not stated.
Treasury Decision 2313
The Supreme Court’s decision in the Brushaber case in 1916 (240 U.S. 1) is often cited by the IRS as demonstrating that the income tax is Constitutional (which it is, because of its very limited legal application). What the IRS fails to mention, and what is not apparent from looking at the court’s ruling in the case, is that the case concerned income from within the United States accruing to a nonresident alien, which is subject to the income tax. Treasury Decision 2313 makes this apparent.
"Under the decision of the Supreme Court of the United States in the case of Brushaber v. Union Pacific Railway Co., decided January 24, 1916, it is hereby held that income accruing to nonresident aliens in the form of interest from the bonds and dividends on the stock of domestic corporations is subject to the income tax imposed by the act of October 3, 1913." [Treasury Decision 2313]
Note how in this case an "item" of income (interest) is subject to the income tax when paid to nonresident aliens, because that is one of the legal "sources" of taxable income. The decision also states a proper use of Form 1040.
"The responsible heads, agents, or representatives of nonresident aliens, who are in charge of the property owned or business carried on within the United States, shall make a full and complete return of the income therefrom on Form 1040, revised, and shall pay any and all tax, normal and additional, assessed upon the income received by them in behalf of their nonresident alien principals." [Treasury Decision 2313]
While this in itself does not prove that Form 1040 should not be used in any other situation, something telling appears later in the decision. Speaking of the responsibility of fiduciaries of domestic entities, it states:
"[W]hen there are two or more beneficiaries, one or all of whom are nonresident aliens, the fiduciary shall render a return on Form 1041, revised, and a personal return on Form 1040, revised, for each nonresident alien beneficiary."
This both implies that a Form 1041 is not required if there are no nonresident alien beneficiaries (only citizens and residents), as well as implying that a Form 1040 is not to be issued for the citizen and resident beneficiaries.
Other Clues
As mentioned above, the only form ever approved for use with section 26 CFR § 1.1-1 of the regulations (under the Paperwork Reduction Act) was Form 2555, "Foreign Earned Income." In addition, the only form approved by the Office of Management and Budget for 26 CFR § 1.861-2 and -3 (which deal with interest and dividends from within the United States) is Form 1040NR, "U.S. Nonresident Alien Income Tax Return." Similarly, the only form approved under 26 CFR § 1.861-8 itself is Form 1120-F, "U.S. Income Tax Return of a Foreign Corporation."
Below each section of regulations in the CFR there is a citation of the legal authority under which the regulations are made. The statutory authority for 26 CFR § 1.861-8 is listed as 26 USC § 7805 (which is the general rule-making authority for the Secretary, as shown in the first citation of this report), as well as 26 USC § 882(c), which reads:
"Tax on income of foreign corporations connected with United States business…
(c) Allowance of deductions and credits
(1) Allocation of deductions
(A) General rule... the proper apportionment and allocation of the deductions for this purpose shall be determined as provided in regulations prescribed by the Secretary." [26 USC § 882(c)]This matches the fact that only the income tax return for a foreign corporation has been approved for use with this section of regulations by the OMB. The newer, temporary regulations in 26 CFR § 1.861-8T cite no statutory authority, but instead cite Treasury Decision 8228, which states that the authors of the regulation both work in the "Office of the Associated Chief Counsel (International)." The scope of the regulations is identified in the first paragraph of Treasury Decision 8228:
"Summary: This document provides temporary Income Tax Regulations relating to the allocation and apportionment of interest expense and certain other expenses for purposes of the foreign tax credit rules and certain other international tax provisions." [Treasury Decision 8228]
So the authorities cited as the legal basis for the regulations for "determining taxable income from sources within the United States" (temporary and final) show that the regulations are about international commerce.
Another legal resource which demonstrates the true applicability of the "income tax" is the annotated index of the United States Code. While there are different versions which vary somewhat in exact wording, under "Income tax, citizens," only things such as citizens "living abroad" or "about to depart from U.S." are listed.
Both the indexes and the contents of "Internal Revenue Bulletins" (which contain rulings and decisions by the IRS regarding interpretation of the law) reinforce the conclusions of this report. For example, the 1957-1960 cumulative bulletin has nine listings under "Citizens," every one of which deals with citizens being outside of the United States. This same bulletin, under "Income - Source," has 35 listings, all of which deal with specific issues related to international commerce, with one exception; and that exception again reinforces the significance of Part I of Subchapter N, and the related regulations:
"Within and without United States; determination. - Rules are prescribed for determination of gross income and taxable income derived from sources within and without the United States... §§ 1.861-1 through 1.864. (Secs. 861-864; ’54 Code) T.D. 6258, C. B. 1957-2, 368."
The bulletins show similar patterns year after year, from 1913 (when the basis of the current federal income tax was written) to the present.
Another resource which indicates the true nature of the "income tax" is the Internal Revenue Manual, which is the instruction manual for all divisions of the Internal Revenue Service. The Criminal Investigation Division of the IRS is the division which deals with criminal violations of the federal "income tax" laws, including tax evasion and failure to file a return. Section 1132.55 of the Internal Revenue Manual (entitled "Criminal Investigation Division") begins as follows:
"The Criminal Investigation Division enforces the criminal statutes applicable to income, estate, gift, employment, and excise tax laws… involving United States citizens residing in foreign countries and nonresident aliens subject to Federal income tax filing requirements…" [IRM, Section 1132.55 (1991 Ed.)]
Similarly, the federal regulations found in 26 CFR § 601.101(a) describe in general the functions of the Internal Revenue Service. The only specific mention in these regulations of who or what is subject to taxes administered by the Internal Revenue Service reads as follows:
"The Director, Foreign Operations District, administers the internal revenue laws applicable to taxpayers residing or doing business abroad, foreign taxpayers deriving income from sources within the United States, and taxpayers who are required to withhold tax on certain payments to nonresident aliens and foreign corporations…" [26 CFR § 601.101(a)]
In keeping with the deceptive structure used throughout the statutes and regulations, the reader is left to assume that some other matters are also under IRS jurisdiction, but nothing else is specifically mentioned.