Towne v. Eisner & the Definition of Income

Income Tax Rule Gain Financial

Income Tax

As counter-intuitive as it may seem, many of the most basic terms in tax law were being argued and debated as recently as one century ago. We tend to think of many terms in tax law – particularly very elementary terms such as “property” and “income” – as things which simply emerged with fixed definitions, presenting little or no controversy since their inception. Here at HTW, we know better: in fact, oftentimes the most elementary terms have been fraught with the greatest level of uncertainty. The average person may not realize it today, but the clarity of many of our essential tax law concepts is the result of an immense amount of mental energy on the part of our legal and political establishment.

The case of Towne v. Eisner (1918) is one example of such mental energy being expended to settle a seemingly simple term. In this case, the full breadth of the term “income” came under contention when a shareholder challenged the tax authorities on the issue of the taxability of stock dividend transactions. This case is significant for a number of reasons, but one reason for its significance stands out among others: through this case, the basic principle that income places someone in an advantageous position was firmly pinned down. This “principle of advantageous position,” to coin a phrase, is still at the heart of our definition of income today.

Let’s look at the (relatively simple) factual scenario of this case in greater detail.

Facts

After a company transferred $1.5 million in profits to its capital account, the taxpayer received a stock dividend consistent with his preexisting ownership stake in the company. The newly received stock had a value of roughly $417,450. The authorities contended that this stock dividend was income within the meaning of the tax law of 1913 – and that this construction of the term “income” within the tax law of 1913 was also consistent with the construction of the same term in the sixteenth amendment – and assessed a tax liability on the taxpayer. Though the taxpayer received additional shares, he did not take a cash dividend, and so the question before the court was whether a valid tax liability could be assessed given that the taxpayer was not actually placed in a financially superior or advantageous position following the stock dividend.

Law

The applicable law was the Revenue Act of 1913. This act contained an income tax provision which was freed from the traditional rule of apportionment present in previous eras. The taxpayer claimed that stock dividends fell outside of the definition of “income” as construed within this act.

Ruling

The court (the Supreme Court of the U.S.) ruled in favor of the taxpayer and threw out the tax liability assessed by the tax authorities. The court cited several earlier cases involving corporate stock dividends in its decision; the essential fact which decided the matter was that the taxpayer was not placed in a financially superior position by way of the transaction. What had occurred was merely a reissuing of stock certificates in order to properly reflect the proportional interests of the shareholder. The taxpayer did not actually “gain” anything from the transaction, he was not placed in a more advantageous position, and so the court ruled that it would be incorrect to say that the taxpayer had received taxable income.

As mentioned above, this basic principle has endured up to the present day and continues to inform our conception of taxable income. This principle informed the construction of the term “income” in various other contexts as well; for instance, the provisions of section 1031 of the tax code follow from the idea that gain should not be taxable if it were merely theoretical rather than actual. Again, though we may see this principle as self-evidently true today, this was not always so, and the case of Towne v. Eisner contributed mightily to the development of this principle.

Source

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Helvering v. Brunn & the Issue of Taxable Gain

Taxable Gain Income Tax Amendment

Taxable Gain

After a great deal of suspense, drama and record-breaking levels of nail-biting on the part of our readers, Huddleston Tax Weekly is proud to announce that we will be picking up our XVI Amendment series. We will contribute a few more articles to this series before we move on to other things. The purpose of our XVI Amendment series is twofold: firstly, our aim is to show how important this political act was to American society; and secondly, by examining some of the issues which were sparked by this amendment, our other goal is to provide our readers with a sense of the complexity of tax law as a field. This latter goal, if realized, should confer significant benefits to our readers: if you’re familiar with some of the essential issues in the field of tax law, the likelihood is strong that you’ll be more effective in how you handle your own tax situation.

One of the things which makes tax law such a fascinating field is that it forces you to formally analyze many terms which are casually – and often carelessly – used in everyday conversation. In common parlance, terms such as “income,” “gain” and “property” are understood intuitively and require little or no clarification. But tax law does not operate in this same way. In tax law, these terms, along with many others, have much more narrow and occasionally shifting meanings which must be carefully examined in whatever context they originally appeared in order to produce a sustainable legal result. Though they may appear simple, these terms can create all sorts of complexity in tax litigation.

The case of Helvering v. Brunn (1940) is a good example of a case which involved formal analysis of a term which is typically grasped very rapidly. The judicial officers had to determine whether the events which occurred in the case could be construed as “taxable gain.” The XVI Amendment only removed the restrictions on the taxing power of Congress, it did not contribute to the issue of what constitutes taxable gain. The case of Helvering v. Brunn explored this issue, and it added an important layer to our understanding of taxable gain. In a sense, it helped to clarify the full scope of the amendment by showing what can – and what cannot – be taxed.

Let’s look at this case more closely to get a sense of its full significance.

Facts

The respondent (a landowner) executed a lease with a tenant which provided, among other things, that any improvements or buildings added to the land during the time of the lease would be surrendered back to the respondent when the lease expired. The tenant destroyed an existing building on the land and then developed a new building in its place. The difference in value between the old building and the new one was approximately $51,434.25. The tenant forfeited the lease when he was unable to keep up with rent and taxes. Subsequently, the IRS claimed that the respondent realized a gain of $51,434.25 as a consequence of the new building which had been added to the land. The respondent disputed this claim and contended that any value conferred by the new building did not qualify as taxable gain under the prevailing construction of this term.

Law

The prevailing definition of “gross income” derived from the Revenue Act of 1932. The central question of the case was whether the value conferred by the new building should be treated as a taxable gain under the bounds established by this act.

Ruling

The court (the Supreme Court of the U.S.) ruled that the respondent had in fact realized a taxable gain when the tenant added the new building to the land. The respondent highlighted the importance of transferability (or exchangeability) to the definition of taxable gain in certain contexts. The new building was not “removable” or “separable” from the land in the sense that it could not be taken off the land and still maintain its current market value. The respondent argued that this lack of transferability made the value bestowed by the new building nontaxable. In support of this of position, the respondent cited a number of cases which apparently held that transferability was a key component of taxable gain in stock dividend transactions. The court stated that the logic underlying the importance of transferability was limited to those types of transactions and did not apply to the present situation.

The key point to gather from Helvering v. Brunn is that gain can be taxable even outside of a traditional business transaction. And the gain needn’t be transferable, at least not in most contexts. Taxable gain can be triggered whenever value has been added or an event places someone in a financially superior position. Forgiveness of a liability or exchange of property, for instance, can trigger taxable gain even though cash isn’t involved and no sale has occurred.

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Owning real estate often brings up tax issues. If you’re a current or future real estate owner and you’d like to learn about the tax perks of real estate ownership, check out our presentation on this topic by our CPA, Jessica Chisholm

Kornfeld v. Commissioner and the Step Transaction Doctrine

Step Transaction Doctrine Legal Theory Tax Deduction

The Step Transaction Doctrine

We will look at one more case before returning to our article series on the sixteenth amendment. This is a case every HTW reader should become very well acquainted with: Kornfeld v. Commissioner (1998). Though it’s primarily an income tax case, it contains a plethora of other important topics and subtopics, and it presents a message which every HTW reader should commit to memory.

In the past, we’ve learned that whether a transaction be taxable is dependent on its substance, and that courts apply the “substance over form” doctrine to determine the true nature of a business transaction. The substance over form doctrine is not the only tool utilized by courts to review a transaction, however; the so-called “step transaction doctrine” is another tool commonly used by courts to clarify the nature of a transaction for tax purposes. Under the step transaction doctrine, multiple “steps” may be classed together and regarded as a single transaction; in this way, steps which may have been taken simply for the specific goal of altering tax liability can be overturned. The step transaction doctrine does not exist to create tax liabilities where none should exist, but to assess tax liability properly by viewing a transaction with the greatest level of accuracy.

In other words, the step transaction doctrine imposes a sort of coherence to a multistep transaction so that it can be properly adjudicated. This is very common in law: legal theories often condense or codify reality so that it can be interpreted using preexisting categories. But the rationale for theories such as the step transaction doctrine is not only about simplicity; there is also the aim of viewing a matter according to its true nature. Even though the step transaction doctrine may “condense” things for the sake of simplicity, many contend that this theory (and other similar theories) portrays matters in a more accurate way, that it provides a clearer sense of what actually occurred. Let’s look at the details of the Kornfeld case to get a better sense of this doctrine and its rationale.

Facts

The facts of this case are a bit complicated. Kornfeld, a highly experienced tax attorney, established a revocable trust which he intended to use to purchase bonds. He entered into an agreement with his daughters in order to claim an amortization deduction on the bonds; the agreement was that Kornfeld would transfer funds (from the trust) to the bond issuing institution equal to the value of a life estate in the bonds and then the daughters would pay the balance on the bonds. The agreement also held that Kornfeld would deliver checks to the daughters for the exact amount which they paid to cover the balance.

Kornfeld and his daughters executed this initial agreement and Kornfeld obtained the bonds. Subsequently, the tax code was changed so that the amortization deduction sought by Kornfeld was made unavailable in situations involving related parties. In response, Kornfeld and his daughters made another agreement which included Kornfeld’s secretary; the second agreement held that the daughters would take a second life estate interest in the bonds following Kornfeld’s death, and that the secretary would have the final remainder interest upon the death of the daughters. Importantly, Kornfeld used IRS valuation tables to create his estimates for the value of his life estate interest. Kornfeld claimed amortization deductions on the bonds and then the IRS assessed a deficiency after they declared that the transaction had failed to produce a genuine life estate in the bonds.

Law

Under U.S. code – specifically section 167 – taxpayers may claim a depreciation deduction of a reasonable amount based on wear and tear for property held primarily for the production of income (such as a bond). IRC subsection 167(d) pertains to life tenants and beneficiaries of trusts. Under these rules, life estate interests in bonds – or “term interests” or limited interests – are considered amortizable (or depreciable) and thus taxpayers may claim a deduction for such an interest. Also see 26 CFR 1.167(a)-1.

Ruling

Applying the step transaction doctrine, the court rejected the argument made by Kornfeld that the payments made to his daughters (and secretary) had no real connection to the bond transaction, and that a genuine life estate interest had been created for tax purposes. The court based its decision on the fact that the seemingly disparate actions of the case were patently interdependent and all served to produce a single, underlying purpose. Kornfeld thought that he had devised a near foolproof scheme to completely avoid any tax liability on the bond transaction, but the court realized that a genuine limited interest had not been created and that Kornfeld had acquired total ownership of the bonds.

The Kornfeld case is a prime example of the step transaction doctrine at work. All HTW readers need to be aware of how the step transaction can affect their tax liabilities; if you aim to acquire a particular kind of tax treatment, you need to understand that your actions preceding any given transaction, as well as your actions which occur after a given transaction, can impact the tax treatment you ultimately receive. In the future – after a few more installments on the sixteenth amendment – we will look at a few more examples of how the step transaction doctrine has been used to alter the tax classification of a series of events.

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How Trump’s Tax Plan Will Affect Individuals

Trump Tax Plan Bracket System

Trump Tax Plan

The election of Donald Trump to our nation’s highest political office is undoubtedly one of the most surprising developments in U.S. history. This is a purely factual observation, completely removed from any sort of partisan bias. Many reliable polls taken just prior to the election showed Clinton with a firm advantage. And the fact that Mr. Trump is essentially a political outsider, having no prior political offices on his resume, seemed to cast serious doubt on the viability of his candidacy. Trump’s success has triggered a mass of heated reaction, both of a supportive and antagonistic nature. No matter how much the perception of his electoral success varies at the individual level, however, what is certain is that his victory will be regarded as one of the most unlikely in our nation’s history.

Trump’s staunchly pro-American standpoint captivated his followers and played a large role in building his base of voters. He repeatedly claimed that he would utilize the powers of the presidency to protect the American people – especially working and middle-class people – from internationalist economic policies and improve the American standard of living.

But how will these things be achieved? Trump has devised a tax plan which forms one part of his overall agenda for substantive change. But will his plan actually benefit the majority of American taxpayers? Let’s take a closer look at how the Trump tax plan will affect individual taxpayers.

New Tax Bracket System

Trump intends to reduce the total number of tax brackets from the current number of seven down to three. The three (ordinary) rates would be: twelve percent for individuals earning $37,500 or less; twenty-five percent for those earning between $37,500 and $112,500; and thirty-three percent for individuals earning above $112,500. Again, these thresholds apply to single filers, the income thresholds are doubled for married couples filing jointly.

This new bracket system may result in either a tax cut or a tax increase for middle income earners depending on which bracket they fell into the preceding year.

This system would give a substantial tax cut for high income earners as it would reduce the top rate of 39.6 percent down to thirty-three percent.

The full impact of the Trump tax bracket system is still impossible to determine because we currently are unaware of what sort of credits, limitations and qualifications the system will be coupled with. But at this point it appears that the new system will provide mixed results for middle income earners and generally positive results for very high income earners.

Increased Federal Deficit

Though Trump’s new tax bracket system may benefit quite a number of individual taxpayers, when combined with his corporate tax cuts this new system will add to the national deficit. If these cuts remain in place for the next ten years, projections show that federal revenue will decrease between $4.4 trillion and $5.9 trillion. Trump has stated that he plans to cut spending by approximately $1.2 trillion over the next decade; if these figures remain the same, they would result in an increase to the national deficit of around $5.3 trillion.

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Taxation in the Confederacy

Confederate Tax Act Revenue Taxation

Taxation in the Confederacy

Taxation in the Confederate States of America is a subject not often studied by either professional academics or laypeople. This is not at all surprising: there is a natural tendency to avoid giving deep attention to things considered deplorable, and since the legacy of the Confederacy is construed as wretched by so many people, it follows that a great many are ignorant of the details of Confederate society. Today, we will go against natural tendency and take a look at the tax acts passed by the rebel government in its attempt to raise revenue for the war.

Revenue derived from taxation made up only a very small part of the war fund for the South. In total, taxes constituted roughly 8.2 percent of the war account; this is less than half of the percentage contributed by taxes for the Union. Compared to the North, the Confederacy was slow to impose a “direct” tax on its population in large part because of its strong commitment to state’s rights and opposition to centralized government. As we will explore in detail below, the Confederate Congress passed two tax measures during the course of the war; neither of these measures generated sufficient income, and by the end of the war it was evident that financial trouble had played a substantial role in the demise of the South.

War Tax of 1861

At the beginning of the war, the Confederate government relied on tax revenue derived from international trade (i.e. tariffs and taxes on exports) and financial contributions from private citizens. These sources of funding started off well, but by the close of 1861 both had dried up almost entirely. The collapse of these sources prompted the Confederacy to impose a “War Tax” which was passed in August of 1861. The War Tax consisted of taxes on a number of items identified by the Treasury and a tax on real property greater than $500 in value.

In its first year (1862) of operation, the War Tax contributed a measly 5 percent of total war revenue. Not only was the tax relatively gentle in its basic terms, collection proved to be much more difficult than Confederate lawmakers had anticipated.

Agricultural Produce Tax of 1863

In response to the lackluster performance of the tax act of 1861, the Confederate Congress passed the Tithe Act – otherwise known as the Tax-in-Kind – in April of 1863. On top of the taxes imposed by the War Tax, the Tithe Act placed a tax of 10 percent on agricultural produce. The Tithe Act was referred to as the “tax-in-kind” because it was not paid in currency but with physical goods; under this act, 10 percent of the actual produce of plantation owners was handed over directly to the government, not 10 percent of their profits. Though it was plagued by implementation difficulties of its own, the produce tax was relatively successful and contributed a substantial portion of overall tax revenue in the remaining years of the conflict.

Controversy surrounded the tax-in-kind because it was interpreted as a direct tax by the Confederate Congress. Though they were in rebellion against the Union, the lawmakers of the Confederate Congress still adhered to the constitutional principle of apportionment for direct taxes and so many felt the Tithe Act unacceptable on this principle. The financial condition of the South ultimately tipped the scales and the act was passed out of sheer necessity.

References

Richard Burdekin and Farrokh Langdana, “War Finance in the Southern Confederacy, 1861-1865,” Explorations in Economic History, Vol. 30, No. 3, July 1993.

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How War Shaped Modern U.S. Taxation

War Taxes Taxation United States Tax Policy Income

War & Taxes

The idea that war has in some sense impacted tax policy throughout our nation’s history should strike no one as being controversial. War and taxes have always had a close relationship, not only within the United States but across the whole globe. In fact, it is probably the case that taxes have played a role in just about every military conflict in history, though the role may not have always been overt and openly recognized. War is essentially a dispute over power, and since money is often a source of power it should surprise nobody that taxes are frequently looming in the background of such disputes.

What fewer people realize, however, is that war has arguably been the single greatest engine behind the development of U.S. tax structure since the outbreak of the War Between the States. As we will see, without war, our tax structure would likely be radically dissimilar from what it is today. The federal income tax may not have been established, and certainly the size of our government would be much smaller by comparison to what we have now.

The Birth of the Income Tax

The founders of the U.S. wished to limit the taxing power of their government and the Constitution was drafted in a fashion consistent with this desire. Up to 1861, the government of the United States had only collected excise taxes and taxes on foreign imports (tariffs); there was no controversy surrounding the income tax because no such tax had yet been imposed. This state of affairs, a state which had carried on stably for over seven decades after the writing of the Constitution, was disrupted by the War Between the States. Soon after the war broke out the Revenue Act of 1861 was passed and the first income tax was implemented on the American population. Two additional acts were passed subsequent to the act of 1861 which made modifications to the rate structure of the tax.

Though they were (supposedly) only intended as strictly wartime measures, the acts passed during the war produced an indelible precedent, and by 1894 the income tax had reemerged as part of the Wilson-Gorman Tariff Act. Whether the income tax would have been created in the absence of the War Between the States is a matter open to speculation. What is certain is that the war had a tremendous impact on the course of U.S. tax policy.

The First World War

The income tax provision of the Wilson-Gorman Tariff Act of 1894 was ruled unconstitutional by the Supreme Court with its decision in Pollock v. Farmers’ Loan & Trust Co. (1895). That ruling marked the beginning of a near two decade long hiatus during which the income tax disappeared. The income tax made its reappearance with the Revenue Act of 1913 which was developed after the taxing powers of the Congress were expanded through the sixteenth amendment.

Now, it may be untrue that the income tax itself did not reemerge as a direct consequence of the First World War; but there can be no questions of any sort that this war provided the impetus for the massive increases made to the rate structure of the income tax when it did return. When the U.S. entered the war the top rate of the income tax was changed from seven percent to an astounding sixty-seven percent; by the close of the war the top rate had been further increased to seventy-seven percent. Tax rates for individuals fluctuated after the war during the 1920s; by the end of the 1920s the top rate for individuals reached a low of 25 percent.

Rates for individuals were increased following the Great Depression and they would continue to remain high both during and long after the conclusion of the Second World War. The top rate for individuals would not fall below 30 percent until the late 1980s.

Again, we can only speculate about how U.S. tax policy would have developed without war. Was a federal income tax a historical inevitability? Would the rate structure of the income tax look dramatically different if war had not caused us to lean heavily on our wealthiest citizens and corporations? These questions can never be answered given how events have unfolded. One thing which is not open to speculation, however, is that our tax policy looks unrecognizably different than the way it looked at the time of the founding.

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The Rise of the Progressive Federal Income Tax System

Income Tax Federal Progressive Revenue

Progressive Federal Income Tax

Before we dive into the details of the Revenue Act of 1913 and the progressive tax system, let’s briefly go over what we’ve learned about the history of the income tax. During the War Between the States, the U.S. government imposed the first income tax in order to fund the Union army. This tax – which was brought about through the Revenue Act of 1861 – was conceived as an emergency measure and was not intended to continue after the war. Following the surrender at Appomattox, the income tax lingered around until about 1872, but it then disappeared for over twenty years. The income tax made its reappearance with the Wilson-Gorman Tariff Act of 1894, but the tax provision of this act was quickly struck down with the opinion stated in the case of Pollock v. Farmers’ Loan & Trust Co. (1895). This second hiatus was interrupted by the sixteenth amendment to the U.S. Constitution which consolidated the taxing power of the Congress by eliminating the rule of apportionment which had applied to direct taxes.

With the sixteenth amendment, the Congress was transformed into a monstrously powerful entity, a taxing giant free of traditional legalistic constraints. When historians of the future assess the relative importance of the many amendments to the Constitution, their assessment can be said to be accurate only if it includes the sixteenth amendment near the very top of the list.

On October 3, 1913, President Woodrow Wilson signed the Revenue Act of 1913 into law. Along with reducing tariff rates, the act instituted a progressive tax structure in which higher earning individuals had a greater tax liability. Just as the sixteenth amendment allowed, the tax could be collected on income derived from any source, no matter whether it be direct or indirect, without any requirement to apportion among the states according to population.

Original Tax Table

By current standards, the tax table created by the act of 1913 was remarkably gentle. Single filers who earned less than $3,000 were exempt, as were married filers who earned $4,000; adjusted for inflation, in 2016 these amounts would translate to approximately $73,100 for single filers and $97,500 for married filers. Single filers were required to pay one percent on earnings above $3,000 ($4,000 for married filers); income above $20,000 but below $50,000 was taxed at a rate of two percent; income above $50,000 but below $75,000 was taxed at a rate of three percent; income above $75,000 but below $100,000 was taxed at a rate of four percent; income above $100,000 but below $250,000 was taxed at a rate of five percent; income above $250,000 but below $500,000 was taxed at a rate of six percent; and all incomes above $500,000 were taxed at a rate of seven percent.

Subsequent Tax Acts

This tax table created by the Revenue Act of 1913 only lasted for three years. It was replaced by a new table contained in the Revenue Act of 1916. The tax table of the act of 1916 (which can be viewed in full here) doubled the lowest income tax rate from one percent to two percent, and it increased the highest tax rate to fifteen percent. The 1916 tax table lasted for only a single year as it was replaced by the War Revenue Act of 1917. Prompted by America’s entry into World War I, the act of 1917 greatly increased tax rates across all income levels in order to support the war effort. The 1917 act imposed a top rate of sixty-seven percent on income above $2,000,000.

The act of 1917 was superseded by the Revenue Act of 1918. This act saw a top rate of seventy-seven percent and this applied to all incomes above $1,000,000. The revenue derived from these wartime acts contributed approximately one-third of the total fund for World War I; eye-catching of itself, this fact is made all the more impressive considering that only about five percent of the population paid income taxes in 1918.

After the Great War, the Congress continued to make revisions to the tax structure. In the 1920s, four different tax acts were passed – the acts were passed in 1921, 1924, 1926 and 1928. The act of 1921 was noteworthy as it implemented a tax on corporate income of ten percent. This rate on corporate income was likewise revised and by the 1928 act the rate was increased to twelve percent. Though the scourge of war formed the basis for the transformation of the income tax, little interest was shown by the politicians in Washington in reducing the tax to pre-war rates.  And the decades following the 1920s would see a steady increase in the share of Americans filing tax returns. The federal income tax was firmly in place, supported by our nation’s political leaders and fully backed by constitutional law.

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Brushaber v. Union Pacific Railroad Co. & the Rise of the Federal Income Tax

Congress Tax Power Constitution Law

U.S. Congress

As we have learned in previous installments, for most of its history, the United States has recognized a distinction between direct taxes and indirect taxes, and this distinction informed our law prior to the adoption of the sixteenth amendment. After the sixteenth amendment, the Congress was no longer bound to ensure that direct taxes follow the rule of apportionment outlined by Article 1, Section 9, Clause 4 of the U.S. Constitution. And given that this rule of apportionment was the main reason behind the distinction between direct and indirect taxes, it follows that subsequent to the sixteenth amendment such a distinction was essentially meaningless.

Immediately after the rule of apportionment had been lifted, the Congress passed the Revenue Act of 1913 (also referred to as the Underwood-Simmons Act). In addition to lowering tariff rates, this act implemented a progressive federal income tax system. This income tax was originally intended to compensate for the deficit created by the reduced tariff rates, but soon after its implementation it became the chief source of revenue for the U.S. government. Consistent with the language of the sixteenth amendment, the tax on income could be derived from any source (wages, dividends, interest, rents, etc.). Amazingly, in its first several years of application, the federal income tax only applied to roughly 1 percent of the population as the other 99 percent did not meet the income threshold to qualify.

Even though the language contained in the sixteenth amendment was quite clear, not much time passed before the validity of the Revenue Act of 1913 was challenged. As we will see, the case of Brushaber v. Union Pacific Railroad Co. (1916) upheld the ability of the Congress to tax income (whether direct or indirect) without the traditional constraint of apportionment.

Facts

Mr. Frank Brushaber (plaintiff) owned stock in Union Pacific Railroad Company (defendant). The railroad attempted to pay a tax on Brushaber’s income and Brushaber brought a suit to prevent the railroad from doing so. Brushaber based his suit on several grounds: he argued that (1) the Revenue Act of 1913 violated the due process clause of the Constitution, (2) that the act was unconstitutional because it exempted specific types of income, and (3) that the act was unconstitutional because it failed to follow the rule of apportionment put forth by Article 1, Section 9, Clause 4.

Law

The Congress has always had the power to tax income. This power is derived from the Constitution and consequently there cannot be any conflict between this constitutionally conferred power and the due process clause.

The sixteenth amendment removes the requirement that direct taxes must be properly apportioned among the states according to population. Hence, the Congress is able to lay and collect taxes, both direct and indirect, without regard to the apportionment rule laid out by Article 1, Section 9, Clause 4.

Ruling

The Supreme Court threw out all three arguments made by Brushaber and ruled that the federal income tax created by the Revenue Act of 1913 was fully valid and did not violate the Constitution. In essence, the court in Brushaber simply reaffirmed the clear language of the sixteenth amendment. Following Brushaber, challenging the validity of the Revenue Act would have been a pointless endeavor.

The early twentieth century saw two extremely important developments in U.S. taxation: the consolidation of the taxing power of the Congress by way of the sixteenth amendment and the creation of the federal progressive income tax system. In our next installment, we will look more closely at the provisions of the Revenue Act of 1913 and discuss how the federal income tax system evolved up to its present form.

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The Birth & Growth of the Income Tax in the United States

Income Tax Congress Revenue Act

Income Tax

Most people are oblivious of the fact that the United States has not always consistently imposed an income tax. Most people assume that the Internal Revenue Service has existed in its current form forever. Though it is false, this assumption is not without reason: national governments have a well-earned reputation of being tax hungry entities. In reality, however, the U.S. has only consistently collected a tax on income since the passing of the sixteenth amendment in 1913. But though the U.S. has only regularly collected an income tax since after the sixteenth amendment, this does not mean that the U.S. government never collected such a tax earlier.

After the eruption of the Civil War, President Lincoln and the Congress passed the Revenue Act of 1861, and this act allowed the government to impose a tax on income to fund the war effort for the Union. The Revenue Act gave birth to a federal office in charge of collecting the tax, and this office was the embryonic form of the IRS.

The Revenue Act of 1861 grew out of necessity. The Union army needed additional funds in its struggle against the Confederacy. The 1861 act first put forth a rate of 3 percent on income above $800. This rate was subsequently discarded when the Revenue Act of 1862 was passed. The act of 1862 imposed a rate of 3 percent on income between $600 and $10,000, and 5 percent on income over $10,000. These rates were also later discarded and in 1864 a new act (the Revenue Act of 1864) imposed rates of 5 percent on income between $600 and $5,000, 7.5 percent on income between $5,000 and $10,000 and 10 percent on income above $10,000. These multiple acts provided the Union with a large source of its revenue: approximately 21 percent of Union funds were raised from income taxes.

Though it was only intended as a temporary measure during wartime, the income tax lingered for a bit after the Union declared victory. The various public projects associated with the Reconstruction era required funding, and so an income tax was collected until roughly 1872. But even though the tax expired around this time, a precedent was established, and in 1894 a peacetime income tax was included as a provision of the so-called Wilson-Gorman Tariff Act. The Wilson-Gorman act reduced the tariff rates set by a previous act, and proposed a 2 percent tax on income above $4,000 in order to cover the deficit. The income tax provision of the Wilson-Gorman measure was ruled unconstitutional by the Supreme Court in its opinion of Pollock v. Farmers’ Loan & Trust Co. in 1895, but the income tax eventually made its return with the sixteenth amendment.

To this day, opponents of the income tax continue to make arguments against its constitutionality, but none of these arguments have passed legal scrutiny. No matter what your position on the income tax, it is important to remember that even if this tax disappeared tomorrow we can be certain another one would take its place in double quick time.

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Huddleston Tax CPAs of Seattle & Bellevue
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