Trump’s New Tax Proposal Could Have Substantial Impact on Seattle Homeowners

Trump Real Estate Deduction Seattle Tax Property Mortgage Interest

Trump’s Plan & the Seattle Market

President Donald Trump has developed a proposal to rewrite the tax code in such a way that it may render the mortgage interest deduction meaningless for all but a small minority of wealthy homeowners. Opponents argue that this provision would take away an important incentive of homeownership; supporters contend that the change benefits the majority of Americans and would expand homeownership opportunities for middle income earners.

Let’s examine Trump’s proposal in greater detail and highlight how the changes could impact the Seattle real estate market.

Proposed Revisions

The proposal contains a number of changes; perhaps the most important one is the raising of the standard deduction from its current level of $12,700 (for married couples filing jointly) to $24,000. On its face, Trump’s proposal does not eliminate the mortgage interest deduction, but its goal of substantially raising the standard deduction would mean that millions would cease to itemize their write-offs and consequently fail to deduct the interest from their home loan.

Trump’s plan also modifies existing deductions for state and local taxes, including property taxes. Opponents contend that the property tax deduction is another important perk of homeownership which should not be removed.

The Trump administration states that the changes will actually stimulate home purchases for low to middle income Americans because the higher standard deduction will enable greater savings. The proposal is also likely to trigger a measurable decline in average home pricings across the country which will increase access to homeownership.

Possible Impact

Currently, the Seattle real estate market has a median home price of approximately $722,250. This figure undoubtedly places Seattle among the most expensive real estate market in the country. Assuming the Seattle buyer puts down twenty percent, this median price means that the typical Seattle homeowner will pay roughly $2,735 per month in mortgage costs over a 30-year loan. Given its status, there’s no question that the Seattle real estate market will be impacted by the Trump proposal very heavily. A large number of our homeowners will suddenly be in a situation in which itemizing will no longer make financial sense. Trulia – the well-known property data provider – determined that the number of households eligible for the mortgage interest deduction in Seattle would drop from 56 percent down to 26 percent.

Whether Trump’s changes increase or decrease homeownership across the country obviously remains to be seen; what is certain is that the real estate industry as a whole is lined up in opposition to Trump’s proposal. Supporters and opponents both appear to have facts and figures which bolster their respective positions. Perhaps only a fair trial will determine whether Mr. Trump’s plan will be beneficial to the nation.

Source

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To learn more about the mortgage interest deduction and other tax benefits of homeownership, see this presentation by our CPA Jessica Chisholm

Hylton v. United States & the Practical Difficulties of Apportionment

In early June of 1794, Congress passed a “carriage tax” aimed at carriages used for business purposes. The tax was to be collected annually for as long as the carriage owner maintained ownership of the carriage. The original Constitution of the U.S. recognized a distinction between direct taxes and indirect taxes, but it did not establish definitive guidelines for determining whether a new tax is direct or indirect. At the time of the adoption of the Constitution, it was established that poll taxes (or “capitation” taxes) and land taxes were direct taxes, but there was no formal mechanism for sorting a given tax into either category. Hence, though the authority of Congress to pass the carriage tax was never brought into question, what category the tax should be assigned was unclear.

Carriage Tax Constitution Law Amendment

Carriage Tax

In Hylton v. United States (1796), a suit was brought to collect a debt which was derived from the carriage tax. Hylton (the defendant in the original case) claimed that the carriage tax statute was unconstitutional. Hylton reasoned that the carriage tax was a direct tax and because the statute did not follow the rule of apportionment the tax had to be struck down under the Constitution. At the time of the suit, Hylton was in possession of 125 carriages.

The justices of the Supreme Court – who all wrote their own opinion of the case – determined that the carriage tax was an indirect tax and that, consequently, Hylton was liable for the debt. The justices decided that there was no compelling reason to suppose that the carriage tax fell within the meaning of a direct tax as understood by the framers of the Constitution. The framers understood that poll taxes and taxes on land were “direct” taxes; this classification had a basis in the conditions present among the states at that time. Although the carriage tax may have been superficially dissimilar from other indirect taxes in some ways, the justices could not find that this level of dissimilarity warranted classification as a direct tax.

Hylton entered the case with one critical disadvantage: the practical difficulties of apportioning the carriage tax by population were such that classifying the tax as a direct tax would have led to absurd results. Carriage ownership varied greatly from state to state, and so the carriage tax would have imposed an unfair burden on certain states if it were apportioned as a direct tax. The federal government would have been compelled to adopt new and unusual measures in order to artificially correct the unfair burden created by such a tax. The justices all concurred that the unfair results and practical difficulties of apportionment provided sufficient grounds for classification as an indirect tax.

Because the carriage tax was a tax on personal property, the Hylton decision came to the fore nearly one hundred years after it was made during the case of Pollock v. Farmers’ Loan & Trust Co. (1895). The Pollock case ruled that a tax on income from personal property (and real property) was a direct tax and must follow the rule of apportionment; this ruling effectively overturned the decision made in Hylton. Those who objected to the Pollock decision predicated their objection on the fact that the decision made the imposition of a federal income tax a near impossibility. Implementing a federal income tax which followed the apportionment rule would have been excessively burdensome for the federal government for a number of reasons. The sixteenth amendment was drafted in order to bypass the sort of practical difficulties associated with apportionment which was discussed in Hylton.

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The Sixteenth Amendment & the Issue of State Sovereignty

Sixteenth Amendment Income Tax State Sovereignty

The Sixteenth Amendment

In the next several installments of Huddleston Tax Weekly, we will discuss in great detail some of the controversies which were stirred by the sixteenth amendment. As we’ve noted in previous installments of HTC, the sixteenth amendment to the U.S. Constitution was an act of awesome importance. Through this amendment, the Congress was freed of the various constraints on its taxing power which had existed since the founding of the country. The original U.S. Constitution expressly gave Congress the power to tax, but it also set certain restrictions on this taxing power; excise (indirect) taxes had to be uniformly imposed, and direct taxes had to be properly apportioned among the several states. Prior to the sixteenth amendment, judicial opinions on tax law often dealt with determining whether a given tax should be classified as either direct or indirect. The sixteenth amendment removed the necessity of making such determinations.

The full text of the sixteenth amendment is as follows: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.” Clearly, this amendment was directly responsive to a number of judicial decisions which, through their treatment of certain forms of taxation, had curtailed the taxing function of Congress. For instance, the Pollock case ruled that taxes on income derived from real property and personal property (such as stocks and bonds) were direct and therefore subject to the apportionment requirement. Pollock and other judicial opinions made the imposition of a federal income tax a practical – though not theoretical – impossibility. By removing the apportionment requirement, the sixteenth amendment made the implementation of such a tax an exceedingly simple matter.

The potential impact of the sixteenth amendment on state sovereignty was an issue immediately recognized by both the legal profession and the political establishment. Since it allowed Congress to collect taxes on incomes from any conceivable source, it apparently encompassed state securities; and by taxing state securities the Congress would be effectively lessening the power of the states in relation to the federal government. In his 1919 essay entitled “Power of Congress to Tax State Securities Under the Sixteenth Amendment,” Albert Ritchie argued that the amendment did not actually extend to state securities because the amendment was never intended to grant any new taxing powers to the Congress; the amendment was merely designed to consolidate Congress’ existing taxing powers, and since the power to tax state securities had historically been considered unconstitutional, and the authors of the amendment were themselves wary of the taxing of state securities, it follows that the amendment could not have granted a new power to tax state securities.

At the time of its publication, this essay by Mr. Ritchie must’ve had a great appeal. If taken solely on its words, the sixteenth amendment undoubtedly encompassed state securities, and it certainly raised the sovereignty of the federal government in relation to the states. But Mr. Ritchie’s reasoning involves looking behind the plain text of the amendment and considering the larger historical context in which this amendment was birthed. Given the conclusions to which it led, this reasoning certainly would’ve found plenty of open ears in 1919.

But Mr. Ritchie’s argument had at least one major weakness: it failed to recognize that the limited nature of state sovereignty has always been an established constitutional principle. As Mr. Harry Hubbard pointed out in his Harvard Law Review article entitled “The Sixteenth Amendment” in 1920, there is no constitutional basis for the notion that either the states or the federal government must have a certain degree of sovereignty. The Constitution provides that state sovereignty may be reduced if the people so desire with the power of amendment. The only principle which cannot be amended is the right of each state to have equal political representation. Thus, if the states choose to enlarge the role of the federal government through a constitutional amendment there is no higher authority which can be invoked to bar such a choice.

Mr. Hubbard argued that, given this reality, the sixteenth amendment was intended to cover state securities. The text did not need to specifically mention state securities in order to address any sort of historical trend against this type of taxation; if the amendment reduced state sovereignty simultaneously at the time that it consolidated Congress’ taxing power then this would have been a natural extension of the will of the people. We may like to suppose that, past a certain point, state sovereignty may not be encroached upon. But there is actually no constitutional foundation for this supposition. State sovereignty may be an ideal, but it is not unassailable and is very much subject to transformation depending on the whims of the public. In the end, the authors must have been aware of the amendment’s impact on state sovereignty, and it follows that any reduction in state sovereignty was fully permissible because these authors were merely acting as instruments of the people.

References

Hubbard, Harry. “The Sixteenth Amendment.” Harvard Law Review, Vol. 33, No. 6 (April, 1920), 794-812.

Ritchie, Albert C. “Power of Congress to Tax State Securities Under the Sixteenth Amendment.” American Bar Association Journal, Vol. 5, No. 4 (October, 1919), 602-613.

Pollock v. Farmers’ Loan & Trust Co., 157 U.S. 429 (1895)

Hylton v. United States, 3 U.S. 171 (1796)

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Mercantile Trust Co. v. Commissioner & the Limited Importance of Contingencies

Real Estate Property Transaction Exchange

Real Property Exchange

Nearly every legal concept presently in use in these United States has an established pedigree. Very few of our concepts are recent inventions. This observation holds true not just in one or two areas of law but for quite literally our entire legal edifice. Section 1031 is no exception to this rule. Section 1031 is derived from a number of earlier tax acts which addressed the non-recognition of gains (or losses) when real property held for business or investment purposes is exchanged for like-kind property. Today, courts utilize the judicial opinions made in previous eras which were informed by one of these earlier tax acts. The case of Mercantile Trust Co. v. Commissioner (1935) is among the most significant of these opinions.

As we will see, Mercantile Trust Co. set an important precedent for viewing complex real property exchange transactions. Like the parties in Alderson v. Commissioner, the parties of Mercantile Trust Co. engaged in a complex transaction which involved multiple independent contracts, the use of an intermediary and a cash payment as “boot” on top of the exchange. In its opinion, the court emphasized that non-recognition depends primarily on what actually occurred, rather than on the various methods and motives which ultimately led to the transaction. Simply because a contingency could have given rise to a sale – and therefore would have created a taxable gain – does not necessarily bar non-recognition; the most important fact is whether an exchange of like-kind property actually transpired.

Facts

The representatives for Mercantile Trust Co. (the petitioners) appealed a judgment for a tax deficiency arising from a transaction involving Mercantile Trust Co., an intermediary (known as Title Guarantee & Trust Co.) and Emerson Hotel Co. The Commissioner of Internal Revenue (the respondents) claimed that the transaction amounted to a sale and that the petitioners had a recognized gain of $179,621 (approximately $2,521,070.02 when adjusted for inflation in 2016). The petitioners argued that the transaction had been an exchange of real property of like-kind within the scope of existing statutory provisions.

Title Guarantee & Trust Co., the intermediary, developed separate contracts with Mercantile and Emerson. To conclude certain of these contracts Title Guarantee made cash payments to the other party, and to conclude other contracts Title Guarantee accepted cash payments. Mercantile Trust Co. ultimately received the deed to the property (known as Lexington Street) originally held by Emerson Hotel Co. as well as a total of $24,426.90 in cash. Emerson Hotel Co. received the deed to the property originally held by Mercantile Trust Co. (known as Baltimore Street). Title Guarantee received commissions and title fees which added up to $8,573.10.

The respondents assessed the tax deficiency on the premise that Mercantile Trust Co. acquired the Lexington Street property in a separate transaction which should be considered a sale. The question before the court was whether the evidence on record supported this premise.

Law

The statutory provisions which applied to the case arose from section 112 of the Revenue Act of 1928. Section 112 (of the act of 1928) is the predecessor of section 1031 and includes many of the same provisions as the current law.

Ruling

The court (the U.S. Tax Court, known as the Board of Tax Appeals in 1935) ruled in favor of the petitioners and declared that the deficiency assessed by the Commissioner was without basis. The Commissioner argued that what had occurred was a “fictitious” exchange and that the Lexington Street property was acquired by Mercantile Trust Co. in an independent sales transaction. The tax court rejected this argument. The contract made between Mercantile Trust Co. and Title Guarantee included a contingency whereby Title Guarantee would pay $300,000 in cash in the event that the deed to the Lexington Street property could not be transferred. The court determined that this contingency did not negate non-recognition treatment given that an exchange of like-kind property did occur.

The reasoning employed by the tax court in Mercantile Trust Co. influenced later decisions, including the decision made in Alderson. The determination of non-recognition treatment depends heavily on the end result and not as much on the methods used to reach that result.

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Readers who enjoyed this piece about the famous case of Mercantile Trust Co. should check out our video on the tax perks of real estate ownership given by CPA Jessica Chisholm

Essential Points of the Principal Residence Exclusion

Real Estate Property Capital Gains Exclusion Residence

Excluded Capital Gains

In our first essay on section 1031 we promised to explore other sections of the tax code – namely, 1033 and 121 – which may be of interest to our readers. As always with HTC, we are true to our word. In this essay we will discuss some of the basic facts of section 121.

Section 121 is referred to as the “principal residence exclusion” because it allows gains derived from the sale of one’s primary residence to be excluded from taxable income (up to certain limits). Under 121, real property owners are permitted to exclude up to $250,000 in capital gains from the sale of their principal residence; married couples intending to file jointly may exclude up to $500,000.

In order to qualify for section 121 treatment, property owners must prove that they have owned and lived in the property for at least 24 months during the last 60 month period. It is not necessary that these 24 months be consecutive. Hence, under current law, it is theoretically possible to utilize section 121 once every 2 years.

Real property owners who wish to take advantage of section 121 have to keep a close eye on the market trends which affect the value of their property. As we know, property values tend to fluctuate throughout the course of ownership, and if the value rises too high then the property owner may end up having a significant tax liability even after section 121 is invoked. If a property’s value rises too high, converting the residence into a rental property and then utilizing section 1031 after a certain period of time has passed may be an optimal strategy.

In later installments we will cover section 121 in greater detail by examining legal cases and viewing examples of how section 121 has been utilized in real-world scenarios.

*It is worth mentioning that section 121 is the successor to section 1034. Section 1034 allowed taxpayers to defer 100 percent of the capital gain derived from the sale of their primary residence provided that they subsequently acquired another residence of equal or greater value. This section was replaced with the provisions of section 121 in 1997.

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Tracing the Bounds of Section 1031 through Alderson v. Commissioner

Real Estate Property Exchange 1031 Tax

Real Estate

In our previous installment, we learned that whether a transaction falls under section 1031 of the Internal Revenue Code is an extremely important determination. Section 1031 enables taxpayers to receive non-recognition of capital gains when they exchange their real property for another property of like-kind. Real estate transactions can often result in gains of many thousands – and even millions – of dollars, and so receiving non-recognition of this sort under section 1031 can potentially remove very large tax liabilities. For this reason, the qualifications of section 1031 are narrowly construed by courts and so real property owners must carefully observe these qualifications to receive non-recognition treatment.

As with other areas of law, tax law is shaped by judicial opinions. Though the provisions of section 1031 originally emanate from the language of the tax code, the precise contours of these provisions are nonetheless informed and guided by the opinions issued in cases. This is the main reason Huddleston Tax Weekly has focused so heavily on highlighting tax, contract and property cases: it is important that our readers be aware not only of the various laws which may affect them, but also of how these laws apply in real-world scenarios.

The case of Alderson v. Commissioner (1963) gives us a sense of the level of conscientiousness required from the parties of a real estate exchange. As we will explore in detail below, Alderson shows that whether a cash payment is included as a contingency within an agreement is immaterial; the critical factor in determining 1031 treatment is whether an exchange of property of like-kind actually occurred. Alderson also demonstrates that property may be acquired specifically for the purpose of exchanging it as part of a 1031 transaction.

Facts

Alderson (the appellant) agreed to sell his property – referred to as Buena Park in the opinion – to a company known as Alloy Die Casting Company. Before the sale was concluded, Alderson decided he would prefer to exchange his property for another property which he discovered after the original agreement was made. This newly discovered property – Salinas – was then acquired by Alloy and transferred to Alderson in exchange for Buena Park.

The amended agreement between Alderson and Alloy included a contingency clause which stated that Alloy would pay cash for the Buena Park property in event that it could not furnish the Salinas property by a specific date.

Law

To receive section 1031 treatment, a transaction must involve the exchange of properties which are of like-kind. The transaction must also be reciprocal and involve a present transfer of ownership, the transfer cannot occur gradually or incrementally over a period of time.

Ruling

The court (U.S. Court of Appeals for the Ninth Circuit) overturned the opinion of the Tax Court and ruled in favor of Alderson. As noted above, the transaction between Alderson and Alloy was a bit convoluted and involved a formal amendment to the original agreement; two escrow accounts were created as a consequence of the decision made by Alderson to acquire the Salinas property. The Commissioner of Internal Revenue (the respondent) argued that the contingency clause provided evidence for the classification of the transaction as a sale rather than an exchange; the Commissioner also felt that the separate accounts provided evidence for this same conclusion. These arguments ultimately failed to persuade the court.

When determining whether a given transaction falls within the 1031 statute, the court considers the transaction as a whole and bases its decision on the true “substance” of the transaction. Though Alderson did initially agree to a cash sale, and the exchange was complicated by the opening of separate accounts, the substance of the transaction clearly reveals an intention to make an exchange of properties of like-kind. The court does not opine on hypothetical scenarios; the critical fact of Alderson was that the deeds for Buena Park and Salinas were exchanged, not that such an exchange may not have occurred if Salinas were not acquired.

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Property owners should view this video by Jessica Chisholm to learn more about the tax perks of homeownership

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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Bailey v. Drexel Furniture Co. & the Child Labor Tax Law of 1919

Drexel Child Labor Tax Law Constitutional Penalty

Supreme Court

To most contemporary Americans, exploitative child labor practices seem like an ancient, prehistoric phenomenon far removed from the context of advanced civilization. But, crazy though it sounds to modern ears, such practices sadly occurred on a fairly regular basis in the not too distant past of our society. In fact, our society was grappling for ways to combat this problem less than 100 years ago. In 1919, Congress addressed this issue through its Child Labor Tax Law. The law imposed a tax of 10 percent on the net profits of companies which employed children (as defined by the age limits of the law).

With the Child Labor Tax Law, the Congress was attempting to curtail child labor by regulating business through its taxing power. In effect, Congress was “punishing” businesses for exploiting the labor of children through the tax.

One curious result of constitutional restrictions on government power is that occasionally good laws are thrown out. Obviously, no one in 1919 disputed the desirability of a law which aimed to prevent abusive child labor practices; the issue which arose in Bailey v. Drexel Furniture Co. (1922) was whether the Congress went beyond the bounds of its constitutionally delineated authority by using a “tax” to stop unethical behavior. As we will see, the Bailey case illustrates the difficulty involved with maintaining restrictions on government power even when such power is being tailored for good ends.

Facts

Drexel (plaintiff in original suit and respondent in appellate case) was a furniture manufacturing company which employed a child under the age of 14 during the 1919 tax year. In agreement with the Tax Law, Bailey (the tax collector for the government) assessed a tax of $6,312.79 for such behavior. Drexel paid the full amount and then sued for recovery.

Drexel argued that the tax was a covert “penalty” designed to punish undesirable behavior and that the law was therefore an unconstitutional attempt to regulate business. The government argued that the levying of the tax was fully consistent with its broad taxing powers as prescribed by Article One of the Constitution.

Law

The Congress has the power to lay and collect taxes as outlined by the Constitution. However, this power is not unlimited and when the Congress attempts to step beyond its bounds such attempts must be struck down.

Ruling

The Supreme Court ruled in favor of Drexel (as did the lower court). Although no issue was raised as to the desirability of the Tax Law, the court reasoned that the tax created by the law was in fact a disguised penalty and it was therefore impermissible. The court defined a “tax” as a source of revenue for the government, while a penalty is a punishment intended to deter certain behavior. Penalizing unethical behavior is not a function of the taxing power of the Congress but should be addressed through the criminal law of individual states.

The decision in Bailey was controversial in part because other taxes aimed at curtailing (or in some sense penalizing) certain behavior had been upheld. For instance, excise taxes on drugs and firearms have not been regarded as improper attempts by the Congress to regulate business. But the court in Bailey recognized that an overly broad reading of Congress’ taxing power could result in the obfuscation of its proper function and unfairly reduce the power of the states.

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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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A Note on Direct & Indirect Taxes

Money Tax System Direct Indirect

Direct & Indirect Taxes

In recent installments, we have discussed some of the legal and political issues surrounding the income tax. Upon reviewing these installments, there can be little doubt that the history of taxation in these United States is quite complex. Though the Congress has always had a power to tax, the precise scope of its taxing power has evolved in tandem with various social, economic and military events. The taxing power of the Congress was clarified a great deal by the sixteenth amendment – by way of this amendment, the Congress gained the power to tax income “from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

Before the sixteenth amendment, the Congress was limited in its ability to lay and collect “direct” taxes. Article 1, Section 2, Clause 3 of the U.S. Constitution states that direct taxes must be apportioned among the states according to their respective numbers; the rationale of this provision was to ensure that no state was disproportionately – and therefore unfairly – burdened by an oppressive tax system.

Every type of tax can be classified as being either a direct or indirect tax. Broadly speaking, a direct tax is one paid by the individual (or business entity) to the government; it is aimed specifically at the person who is paying the tax. By contrast, an indirect tax is one levied upon a transaction, it is not targeted to a specific individual. Sales tax, use tax and value added tax are all examples of indirect taxes. Historically, U.S. tax law regarded tax on labor (or wages) as an indirect tax.

Prior to the opinion made in Pollock v. Farmers’ Loan & Trust Co. (1895), tax on income derived from property (i.e. from real estate, stocks, bonds, etc.) was not considered a direct tax. The Pollock case overturned this consideration and ruled that such a tax was a type of direct tax and that therefore the income tax provision of the Wilson-Gorman act was unconstitutional. In effect, the Pollock decision made it essentially impossible for the government to impose a federal income tax without a constitutional amendment. The sixteenth amendment, which was ratified in 1913, was a direct response to the Pollock ruling: the politicians in the Congress came to understand the full implications of Pollock and so the sixteenth amendment simply did away with the longstanding requirements concerning direct taxes.

When viewed in proper historical context, the sixteenth amendment was a political act of truly monumental significance. Through this act, the dichotomy of direct and indirect taxes – a dichotomy which had shaped our system of taxation throughout our nation’s entire history – was suddenly made to have no meaning at all. Immediately subsequent to this act, the Revenue Act of 1913 was passed, and the progressive income tax system which we have come to know so well was implemented.

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