"Taxable Income"
by Larken Rose
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16) The Other Side
As most tax professionals believe that most Americans have taxable income, their position regarding Section 861 and other matters should be explained. The incorrect readings of Section 861, and related regulations, fall into two main categories. The two approaches are in direct conflict with each other, and both approaches are provably incorrect.
Pay No Attention
The first erroneous "interpretation" which tax professionals have regarding Section 861 is that it is entirely irrelevant to most people, and should therefore be ignored by most people. This approach rests on the misreading of "from whatever source derived" (as used in 26 USC § 61) to mean "no matter where it comes from." This interpretation requires the reader to ignore all of the evidence presented in part 4 ("Sources of Income") and part 5 ("Determining Taxable Income") of this report; most notably, the sections of regulations which state that Section 861 and following, and the regulations thereunder, "determine the sources of income for purposes of the income tax," and the sections which state that "determining taxable income from sources within the United States" is to be done using 26 USC § 861(b) and 26 CFR § 1.861-8.
This position is the result of backwards logic. The tax professionals start with the incorrect assumption that most people receive taxable income. Therefore, when they discover that (for example) 26 CFR § 1.861-8 does not show most income to be taxable income, they incorrectly conclude (based on a false premise) that that section should not be used by most people, even though the regulations clearly state otherwise. This is usually stated as "that section doesn’t apply to you." The following analogy demonstrates the logical flaw with this half-truth.
As shown above (see "English vs. Legalese"), one section of the statutes of Subtitle E states that the Secretary shall maintain a central registry of "all firearms." But a separate section defines the term "firearm," and the legal meaning is far more restrictive than the meaning of the word in common English. For example, a basic hunting rifle is obviously a "firearm" in common English, but is not considered a "firearm" for purposes of Section 5841. An individual who owns one hunting rifle could, therefore, correctly state that Section 5841 does not impose any obligation on him.
Now imagine someone arguing to him the following: "The definition of ‘firearms’ doesn’t apply to your firearm, so you should just ignore the definition in Section 5845. Just look at Section 5841, where it says ‘all firearms.’ That includes your rifle." Such an argument would be ludicrous, and yet this is precisely the logic (or lack of logic) used by the tax professionals regarding 26 USC § 861.
Section 61 defines "gross income" generally as "all income from whatever source derived," and Part I of Subchapter N (Section 861 and following) and related regulations "determine the sources of income for purposes of the income tax." Many tax professionals will argue that Section 861 "doesn’t apply" to most people, and therefore most readers should ignore the sections which "determine the sources of income for purposes of the income tax." This is entirely illogical, but it is the only way for the tax professionals to avoid coming face-to-face with their monumental error. Contrary to the evidence, they continue to claim that most citizens receive taxable income.
The main citation used in an attempt to justify this misinterpretation is found in the regulations related to Section 1 of the statutes (which imposes the income tax).
"Sec. 1.1-1 Income tax on individuals.
(a) General rule. (1) Section 1 of the Code imposes an income tax on the income of every individual who is a citizen or resident of the United States and, to the extent provided by section 871(b) or 877(b), on the income of a nonresident alien individual… The tax imposed is upon taxable income (determined by subtracting the allowable deductions from gross income).
(b) Citizens or residents of the United States liable to tax. In general, all citizens of the United States, wherever resident, and all resident alien individuals are liable to the income taxes imposed by the Code whether the income is received from sources within or without the United States." [26 CFR § 1.1-1]This section is a masterpiece of deception. While being literally correct (as the law must be), it is likely to give the wrong impression. Stating that a tax is imposed "on the income of every individual who is a citizen or resident" of the U.S. gives the impression that all income of these individuals is taxable. But anyone even slightly familiar with tax law knows this is not the case. The section goes on to specify that the tax is not on all income, but on "taxable income" (which is "gross income" minus deductions). As shown above, 26 CFR § 1.861-8 is the section for determining "taxable income" from within the United States. The language could just as easily (and just as correctly) stated that "everyone on earth, no matter where he is and no matter where his income comes from, is taxable upon his taxable income." The meaning of the statement is, of course, totally dependent upon the meaning of "taxable income."
Subsection "(b)" also gives a false impression at first glance, while being literally correct. It doesn’t matter where someone lives, provided that he receives income from "sources" within or without the United States. And Part I of Subchapter N and related regulations "determine the sources of income for purposes of the income tax."
It is a word game, where what may be inferred differs from what is actually stated. If someone does not have "taxable income," and if someone does not receive "income from sources" (as defined by law), then 26 CFR § 1.1-1 becomes irrelevant. Nothing in the section has any effect on the legal meaning of "taxable income" or "sources of income." Instead, the section uses these terms in a context which makes them sound less restricted.
(As a reminder, the only form ever approved for use with the above regulations under the Paperwork Reduction Act was Form 2555, "Foreign Earned Income.")
The predecessors of the current regulations were worded slightly differently.
"19.11-1 Income tax on individuals
Chapter 1 of the Internal Revenue Code [*]... imposes an income tax on individuals, including a normal tax (section 11), a surtax (section 12), and a defense tax [*]... The tax is upon net income which is determined by subtracting the allowable deductions from the gross income. (See generally 21 to 24, inclusive.)"[ * - Words omitted related only to which years the law was applicable.]
"19.11-2 Citizens or residents of the United States liable to tax
In general, citizens of the United States, wherever resident, are liable to the tax, and it makes no difference that they may own no assets within the United States and may receive no income from sources within the United States. Every resident alien individual is liable to the tax, even though his income is wholly from sources outside the United States."The wording of these regulations (from 1945), while deceptive, does not give quite as persuasive a deception as the current regulations. The only solid conclusion which can be inferred from these older regulations is that income from outside of the United States can be taxable to United States citizens and residents.
17) Conclusion
Because of the Constitution, Congress could not impose a tax on all income earned in the United States. What Congress did instead was to impose a tax on matters which they could tax (international and foreign commerce), and write the law in such a way that it would give the impression that it also applied to the income of most Americans. The Secretary of the Treasury wrote corresponding regulations with a similar goal: to tell a truth while implying a lie. Despite a longstanding and ongoing effort by some in government to confuse and obfuscate, the literal truth has remained in the law. Though it is a complex process, the current statutes and regulations by themselves do reveal the limited application of the federal income tax laws. The older statutes and regulations then add extensive reinforcement and clarity to the conclusions reached by deciphering the current law. The historical documents also give ample evidence to justify an accusation, against the legislators in Congress and the authors of the regulations at the Department of the Treasury, of intent to defraud the American people of money not legally owed.
Aside from arguments about specific details, there is one giant hurdle for those who would still insist that most Americans receive taxable income: what is the alternate conclusion that accounts for every citation in this report? There is extensive documentation, not only in the current statutes and regulations, but throughout 87 years of statutory and regulatory history, which supports the conclusions of this report. It would be absurd to claim that a tax was imposed on the income of most Americans, and that by mistake or coincidence Congress and the Secretary put into the statutes and regulations such an enormous amount of information, spanning nearly a century, which indicates that the tax applies only to those engaged in international or foreign commerce. Quite simply, there is no conclusion other than the conclusion of this report which explains all of the evidence.
(Question for Doubters #7: Is there some other "interpretation" of the statutes and regulations which would show domestic income of United States citizens as taxable, and also explain the meaning of all of the citations in this report?)
Part I of Subchapter N, and the regulations thereunder:
STATUTES REGULATIONS
Subchapter N - Tax based on income from sources within or without the United States
Part I - Source rules and other general rules relating to foreign income
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…
(2) Dividends…
(3) Personal services - Compensation for labor or personal services…
(4) Rentals and royalties…
(5) Disposition of United States real property interest…
(6) Sale or exchange of inventory property…
(7) …underwriting income…
(8) Social security benefits…
(b) Taxable income from sources within United States
From the items of gross income specified in subsection (a) as being income from sources within the United States there shall be deducted the expenses, losses, and other deductions properly apportioned or allocated thereto and a ratable part of any expenses, losses, or other deductions which cannot definitely be allocated to some item or class of gross income. The remainder, if any, shall be included in full as taxable income from sources within the United States…
(c) Foreign business requirements…
(d) Special rule for… subsection (a)(2)(B)…
(e) Income from certain railroad rolling stock…
(f) Cross reference…
Part I - Income taxes
Determination of sources of income
Sec. 1.861-1 Income from sources within the United States.
(a) Categories of income. Part I (section 861 and following), subchapter N, chapter 1 of the Code, and the regulations thereunder determine the sources of income for purposes of the income tax… The statute provides for the following three categories of income:
(1) Within the United States. The gross income from sources within the United States, consisting of the items of gross income specified in section 861(a)… [plus part of 863 income] See Secs. 1.861-2 to 1.861-7, inclusive, and Sec. 1.863-1. The taxable income from sources within the United States… shall be determined by deducting therefrom, in accordance with sections 861(b) and 863(a), [allowable deductions]… See Secs. 1.861-8 and 1.863-1.
(2) Without the United States…
(3) Partly within and partly without…
(b) Taxable income from sources within the United States. The taxable income from sources within the United States shall consist of the taxable income described in paragraph (a)(1) of this section… [plus part of (a)(3) income]
(c) Computation of income… [deals with income from both within and without U.S.]
Sec. 1.861-2 Interest.
Sec. 1.861-3 Dividends.
Sec. 1.861-4 Compensation for labor or personal services.
Sec. 1.861-5 Rentals and royalties.
Sec. 1.861-6 Sale of real property.
Sec. 1.861-7 Sale of personal property.
Sec. 1.861-8 Computation of taxable income from sources within the United States and from other sources and activities.
(a) In general--(1) Scope. Sections 861(b) and 863(a) state in general terms how to determine taxable income of a taxpayer from sources within the United States after gross income from sources within the United States has been determined… 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. See paragraph (f)(1) of this section for a list and description of operative sections. The operative sections include, among others, sections 871(b) and 882…
(2) Allocation and apportionment of deductions…
(3) Class of gross income. For purposes of this section, the gross income to which a specific deduction is definitely related is referred to as a "class of gross income" and may consist of one or more items… of gross income enumerated in section 61, namely:… [lists items]
(4) Statutory grouping of gross income and residual grouping of gross income. For purposes of this section, the term "statutory grouping of gross income" or "statutory grouping" means the gross income from a specific source or activity which must first be determined in order to arrive at "taxable income" from which specific source or activity under an operative section. (See paragraph (f)(1) of this section.)…
(5) Effective date…
(b) Allocation… [defines "class of gross income" again] See… paragraph (d)(2) of this section which provides that a class of gross income may include excluded income.
(c) Apportionment of deductions…
(d) Excess of deductions and excluded and eliminated income…
(2) Allocation and apportionment… [Reserved] For guidance, see Sec. 1.861-8T(d)(2).
(e) Allocation and apportionment…
(f) Miscellaneous matters--(1) Operative sections. 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.
(i) Overall limitation to the foreign tax credit… [26 USC 904]
(ii) [Reserved]
(iii) DISC and FSC taxable income… [26 USC 925, 994]
(iv) Effectively connected taxable income. Nonresident alien individuals and foreign corporations engaged in trade or business within the United States, under sections 871(b)(1) and 882(a)(1)…
(v) Foreign base company income… [26 USC 954]
(vi) Other operative sections. The rules provided in this section also apply in determining--
(A) The amount of foreign source items…; (B) The amount of foreign mineral income…; (C) [Reserved]; (D) The amount of foreign oil and gas…; (E) [about Puerto Rico]; (F) [about Puerto Rico]; (G) [about Virgin Islands]; (H) The income derived from Guam…; (I) [about China Trade Act]; (J) [about foreign corporations]; (K) [about insurance income of foreign corporations]; (L) The international boycott factor…; (M) [about Merchant Marine Act]…
(2) Application to more than one operative section….
(3) Special rules of section 863(b)
(i) In general…
(ii) Relationship of sections 861, 862, 863(a), and 863(b). Sections 861, 862, 863(a), and 863(b) are the four provisions applicable in determining taxable income from specific sources…
(g) General examples. The following examples illustrate the principles of this section. In each example, unless otherwise specified, the operative section which is applied and gives rise to the statutory grouping of gross income is the overall limitation to the foreign tax credit under section 904(a)…
Sec. 1.861-8T Computation of taxable income from sources within the United States and from other sources and activities (temporary).
(a) In general… (b) Allocation… (c) Apportionment of deductions…
(d) Excess of deductions and excluded and eliminated items of income.
(1) [Reserved]
(2) Allocation and apportionment to exempt, excluded or eliminated income--
(i) In general…
(ii) Exempt income and exempt asset defined--(A) In general. For purposes of this section, the term exempt income means any income that is, in whole or in part, exempt, excluded, or eliminated for federal income tax purposes…
(iii) Income that is not considered tax exempt. The following items are not considered to be exempt, eliminated, or excluded income and, thus, may have expenses, losses, or other deductions allocated and apportioned to them:
(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… the gross income of a possessions corporation…
(D) Foreign earned income as defined in section 911 and the regulations thereunder…
(iv) Prior years….
(e) Allocation and apportionment of certain deductions…
(f) Miscellaneous matters--(1) Operative sections… [no list yet]… (g) [Reserved]…
Sec. 1.861-9T through 1.861-18 [allocation & special rules, income from aircraft & vessels, research, computer programs, etc.]
Sec. 862. Income from sources without the United States... Sec. 1.862-1 Income specifically from sources without the United States. (a) Gross income… [lists items of income]
(b) Taxable income. The taxable income from sources without the United States, in the case of the items of gross income specified in paragraph (a) of this section, shall be determined on the same basis as that used in Sec. 1.861-8 for determining the taxable income from sources within the United States.
(c) Income from certain property…
Sec. 863. Special rules for determining source… [deals with income from sources partly within and partly without the United States] Sec. 1.863-0 Table of contents… Sec. 1.863-1 Allocation of gross income under section 863(a).
(a) In general. Items of gross income other than those specified in section 861(a) and section 862(a)…
(b) Natural resources…
(c) Determination of taxable income. The taxpayer's taxable income from sources within or without the United States will be determined under the rules of Secs. 1.861-8 through 1.861-14T for determining taxable income from sources within the United States.
(d) Scholarships, fellowship grants, grants, prizes and awards--
(e) Effective dates…
Sec. 1.863-2 through 1.863-5 [about allocation and apportionment, income from sales, transportation services, etc.]
Sec. 1.863-6 Income from sources within a foreign country or possession of the United States.
The principles applied in Secs. 1.861-1 to 1.863-5, inclusive, for determining the gross and the taxable income from sources within and without the United States shall generally be applied, for purposes of the income tax, in determining the gross and the taxable income from sources within and without a foreign country, or within and without a possession of the United States.
Sec. 1.863-7 Allocation of income attributable to certain notional principal contracts under section 863(a).
Sec. 864. Definitions and special rules... Sec. 1.864-1 through 1.864-8T [definitions] Sec. 865. [personal property sales] Sec. 1.865-1T through 1.865-2T [Loss with respect to personal property] Predecessor of Part I of Subchapter N, and related regulations (1945)
STATUTES REGULATIONS
Sec. 119. Income from sources within the United States (a) Gross Income from Sources in 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, any Territory, any political subdivision of a Territory, or the District of Columbia, and interest on bonds, notes, or other interest-bearing obligations of residents, corporate or otherwise, not including:…(2) Dividends…
(3) Personal services. - Compensation for labor or personal services…
(4) Rentals and royalties…
(5) Sale of real property…
(6) Sale of personal property...
(b) Net Income from Sources in United States. - From the items of gross income specified in subsection (a) of this section there shall be deducted [allowable deductions]. The remainder, if any, shall be included in full as net income from sources within the United States.
(c) Gross Income from Sources Without United States…
(d) Net Income from Sources Without United States…
(e) Income from Sources Partly Within and Partly Without United States…
(f) Definitions…
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. Citizens of the United States and domestic corporations entitled to the benefits of section 251 [*] are, however, taxable upon income received within the United States, whether derived from sources within or without the United States. (See sections 212(a), 231(c), and 251.)
The Internal Revenue Code divides the income of such taxpayers into three classes:
(a) Income which is derived in full from sources within the United States;
(b) Income which is derived in full from sources without the United States;
(c) Income which is derived partly from sources within and partly from sources without the United States.The taxable income from sources within the United States includes that derived in full from sources within the United States and that portion of the income which is derived partly from sources within and partly from sources without the United States which is allocated or apportioned to sources within the United States.
Sec. 29.119-2. Interest. There shall be included in the gross income from sources within the United States, of nonresident alien individuals, foreign corporations, and citizens of the United States or domestic corporations which are entitled to the benefits of section 251 [*], all interest received or accrued, as the case may be, from the United States, any Territory, any political subdivision of a Territory, or the District of Columbia, and interest on bonds, notes, or other interest-bearing obligations of residents of the United States, whether corporate or otherwise, except:…
Sec. 29.119-3. Dividends…
Sec. 29.119-4. Compensation for labor or personal services…
Sec. 29.119-5. Rentals and royalties…
Sec. 29.119-6. Sale of real property…
Sec. 29.119-7. Income from sources without the United States…
Sec. 29.119-8. Sale of personal property…Sec. 29.119-9. Deductions in general.
The deductions provided for in chapter 1 shall be allowed to nonresident alien individuals and foreign corporations engaged in trade or business within the United States, and to citizens of the United States and domestic corporations entitled to the benefits of section 251 [*], only if and to the extent provided in sections 213, 215, 232, 233, and 251.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…
[* - One can be entitled to the benefits of section 251
only if he receives a certain percentage of his income
from within federal possessions.]