US Income Tax/Introduction
Who's who in the tax system
Income taxes in the United States are levied by the federal government and by state and local governments. The federal income tax, upon which this text focuses, is collected by the Internal Revenue Service (IRS), part of the Department of the Treasury. The rules for collecting income taxes are set in the Internal Revenue Code (IRC), Title 26 of the United States Code. The IRC is a statute written and regularly revised by Congress. Treasury Regulations are more detailed rules written by the IRS to effectuate the implementation of the IRC. Code provisions, which are statutory, always trump contrary regulatory provisions. Regulations can be of two types: legislative and interpretive. With legislative regulations, Congress says, for example, that depreciation will be an allowable expense "in accordance with regulations to be established by the IRS." It gives the IRS the power to make the rules. Interpretive regulations are those in which the IRS says how it will interpret and apply a given statute.
Disputes over tax rules are generally heard in the United States Tax Court before the tax is paid, or in a United States District Court or United States Court of Federal Claims after the tax is paid. Appeals from the Tax Court go to the United States Court of Appeals for the circuit in which the taxpayer resides, or was domiciled when the tax return in controversy was originally filed. From the Court of Appeals the taxpayer may file a writ of certiorari with the Supreme Court, which may or may not be granted. The IRS also periodically issues Revenue Rulings when taxpayers have questions about how to declare certain transactions. These rulings are only opinions, and are trumped by court rulings or contrary legislation. Revenue Rulings should not be confused with Private Letter Rulings. A Private Letter Ruling is a request by a specific taxpayer to the IRS to rule on the tax consequences of a specific transaction before the action is taken. A Private Letter Ruling is directed only towards the requesting taxpayer, and therefore can not be relied upon by other taxpayers considering the exact action. Private Letter Rulings are released every Friday by the IRS
How tax is calculated
The actual computation of tax is a straightforward process that can be performed by hand using IRS worksheets, or by computer using special tax software. The basic steps are as follows:
- The taxpayer computes their gross income, including ordinary gains and losses.
- The taxpayer subtracts capital gains which are taxed separately from other income.
- The taxpayer subtracts business deductions and other above the line deductions to find their adjusted gross income.
- The taxpayer subtracts their personal exemption.
- The taxpayer adds up itemized deductions, and either subtracts that sum or their standard deduction, whichever is greater, to find their taxable income.
- The taxpayer multiplies their taxable income by various percentages to compute their tentative tax liability.
- The taxpayer subtracts tax credits to find their final tax liability.
Accounting is important to discussions of tax law, because it determines when a receipt becomes taxable income and when a payment becomes deductible. Individuals and corporations generally compute their taxable income on a cash method or an accrual method and it is on this taxable income that the tax liability is based.
The cash method
The cash method is primarily used by individuals and small businesses. Under a cash system, generally, transactions count as income in the year of actual receipt, and count as deductions in the year of actual payment. There are some exceptions:
- Some transactions are counted as income before they are actually received because of the doctrine of prior constructive receipt.
- Amortized capital expenditures, deductions on certain business assets, are not deducted immediately.
- Interest is deductible when paid, but prepaid interest is not.
The accrual method
The accrual method is primarily used by large businesses which want to keep their income statements and their actual cash flow separate. Goods inventories are generally tracked using the accrual method, so any retail business is likely to use accrual accounting, and many businesses selling goods ancillary to their services may have to use accrual accounting as well.
In addition to the foregoing two methods there are also "Special methods of accounting for certain items of income and expenses" and "Combination (hybrid) methods using elements of two or more of the foregoing." For a non-authoritative but more extensive discussion of all these methods, including when they may and may not be used, and who may and may not use them, see IRS Publication 538, Accounting Periods and Methods. It should be noted that this discussion of the various methods is for the purpose of income taxes and not for the purpose of preparing financial statements in accordance with generally accepted accounting principles (GAAP).
An accrual-based taxpayer has income when:
- all events have occurred that fix the right to the income and
- the amount of the income can be determined with reasonable accuracy.
Charles Schwab Corp. v. Commr., 107 T.C. 282 (1996), dealt with this question in the context of securities brokerage, where parties become bound to a transaction on the "trade date" but do not actually perform the transaction until a "settlement date" a few days later. Schwab and the IRS disputed whether the "all events" test was satisfied on the trade date. The court ruled that Schwab had to accrue its income on the trade date, because the execution of the trade was a condition precedent fixing Schwab's right to receive its commission on the settlement date.
Under the claim of right doctrine, a taxpayer has income whenever they receive an amount under a claim of right and without restriction to its use. This means that in some transactions, where an accrual-based taxpayer receives a payment before their right to the payment has been fixed (a "pre-payment"), they recognize income when they actually receive the payment. The main exception to this rule is for security deposits, which are generally not received under a claim of right. Another exception is for non-profit membership organizations such as AAA, which receive prepayments for services: under Section 456, they are allowed to defer their income across the period of liability to perform the services.
An accrual-based taxpayer has a deduction when:
- all events have occurred that fix the liability for the deduction and
- the amount of the deduction can be determined with reasonable accuracy and
- economic performance has occurred with respect to the liability.
One well-known contest regarding the "all events" test was Mooney Aircraft v. U.S., 420 F.2d 400 (1969). Mooney sold each of its aircraft with a "Mooney Bond" promising to pay the bearer $1,000 when the aircraft was retired from service. Mooney tried to deduct the value of each bond in the year of issue; the IRS argued that the value of a bond could only be deducted when the aircraft was retired. The court sided with the IRS, noting that "the longer the time the less probable it becomes that the liability, though incurred, will ever in fact be paid... the very purpose of the 'all events' test is to make sure that the taxpayer will not deduct expenses that might never occur."
The "economic performance" requirement applies to deductions, but not to income. The rationale of the requirement, which was added in 1984, is that many business liabilities do not require actual payment until a distant point in the future, and many such liabilities can be easily overstated to reduce (or eliminate) tax liability. Under Section 461, economic performance occurs when property or services are provided or used, or when payments are made in the case of workers' compensation and tort claims.
Regardless of whether they use a cash or accrual method, all taxpayers follow a system of annual accounting. Income taxes are always levied on a year-by-year basis, and each year is "compartmentalized" from the previous year and the next year. This means that if a taxpayer loses money in year 1 but has a higher income in year 2, they must still pay taxes on their income in year 2 even if the income is only enough to offset their previous loss. This is a general rule, and like most general rules, it has many exceptions.
Tax benefit doctrine
When a taxpayer has an expense, takes a deduction for that expense, but then recovers the expense later, they have income in the year they recover the expense. This principle is known as the tax benefit doctrine. A corollary to the tax benefit doctrine is Section 111, which establishes that recovery of an expense is not income if the taxpayer did not get a tax benefit from the expense.
Income under semblance of unrestricted right
What if a taxpayer receives something and believes they have a right to it, but later has to pay it back? In some situations, Section 1341 allows the taxpayer to deduct their previous income when it was received with a "semblance" of an unrestricted right.
Net operating losses
Businesses also have an option to "carry back" and "carry over" their net operating losses for the year. Under Section 172, carrybacks are available to the two years preceding the loss year, and carryovers are available to the next twenty years. This allows operating losses to offset income in other years, "flattening" the business's tax liability. Generally, the losses must be applied against income in the earliest year possible (i.e. the earliest year where there is income), but a business can elect to waive its carryback and save losses for carryover only.