Federal Income Tax on Individuals in the U.S. Series
I. What is “federal income tax” on “individuals”? <This Article>
IV. Above-the-line Deductions <Still in plan>
V. Below-the-line Deductions <Still in plan>
VI. Ordinary Tax Rates v. Capital Gains Tax Rates <Still in plan>
VII. Alternate Minimum Tax <Still in plan>
VIII. Planning for tax avoidance <Still in plan>
Disclaimer: While the Author believes that the information here is accurate in general, the Author does not represent that the information here may be literally relied upon to make tax calculations or legal conclusions. The U.S. income tax code is complex and contains thousands of sections. This article should be used to grasp the basic concept, but should not be used to calculate your actual amount of tax obligations. Please use available tax software, a tax accountant, or a tax attorney for such purposes. Notwithstanding such limitations, this article should be helpful for understanding the big picture and for planning for your overall tax strategies.
I. What is “federal income tax” on “individuals”?
1.1. What is a “tax”?
A tax is a financial charge on entities legally imposed by a state or an entity with state-derived powers.
In general, a non-financial levy is not considered a tax by modern standards. For example, a Roman male may have been required to serve in the military for the republic or the empire 2,000 years ago. While this is certainly a levy on personal services, this is not a tax in modern terms. Thus, military draft is not a tax.
A tax must be legal. An illegal financial charge is not a tax. For example, the protection money a pimp pays to a local chapter of Mafia is not a tax because it is illegal (let alone Mafia not being a state or a legal entity). The money a mugger exacts from a victim with a threat for physical violence is not a tax. Even Robin Hood cannot claim that he “taxed” the Sheriff of Nottingham.
A tax can be imposed only by a state or a legal entity with sate-derived powers. In other words, the tax must be backed by the administrative power of a sovereign entity. Per-capita tax in the Roman times was legal because the Roman emperor made it legal by his declaration. The U.S. government can tax U.S. citizens because the U.S. government has the legal authority to do so. But the U.S. government cannot tax the aborigines living in Australia because the administrative power and the jurisdictional power of the U.S. government does not reach Australia. (note: What happens to the obligation to pay taxes during a revolution would be an interesting topic. If you pay both governments, one payment would turn out to have been a tax, and the other would turn out to have been just a protection money. One would know the answer only after a legitimate government is established after the war.)
Not only can a state levy a tax, but state-derived powers may also levy a tax. Thus, each of the 50 states of the U.S. may levy state taxes, and each county can levy taxes. In fact, most counties impose various taxes such as school tax, library tax, police tax, fire prevention tax, garbage disposal tax, town highway tax, zoning board tax, etc, etc…. A charge for supplying city water is likely to be a tax because a government agency manages the supply of water. A charge for use of electricity is not likely to be a tax because a non-governmental entity, i.e., a private company supplies electricity most of the time. The difference is whether a government is directly involved in the imposition of the charge.
The rational for paying taxes is not necessarily that one can get corresponding services back from the government or a governmental entity. In the case of various local taxes, there is a one-to-one correspondence between the taxes you pay and the benefit you receive. You get fire protection coverage of a local fire department for paying the fire prevention tax. What about school taxes on the elderly residents. Because their children have all grown up, there is no apparent one-to-one correspondence between the payment and the benefit. In general, the benefit you get for paying taxes is not proportional to the amount of tax you pay. The lack of proportionality between the amount of paid tax and received benefits becomes more apparent at federal level. Most of one-year old babies do not pay taxes because they do not earn money. Yet they receive the same protection as adults.
The rational for paying taxes is better justified by necessity. If the society is to function in any decent manner, a government need to perform some activities. Nominally electing unpaid officials who exhort people to perform voluntary unpaid services for the country out of patriotism is not likely to produce a prosperous country. While some people might claim that they are living in the mountains without using public road and without reaping the benefit of the government, it is questionable whether they would continue their peaceful life if the U.S. government disappeared tomorrow and an anarchy follows. If we are to “secure the Blessings of Liberty to ourselves and Posterity” as recited in the U.S. constitution, some kind of taxation scheme is absolutely necessary. Because most people would consent to such arrangement, people agree to pay various taxes. Besides, do we have any other practical option of operating the government and its entities without imposing taxes? Thus, one can say that taxation is a collective voluntary arrangement based on necessity and practicality.
1.2. What is an “income” tax?
An income tax is a tax imposed on income. There are many taxes that are not imposed on income, but is based on other tax-triggering events. A list below for non-income taxes illustrates many such possibilities (and the creativity of those who invented them).
property tax: The tax-triggering event is that you own a property (a house, a boat, an airplane, a car, etc.)
sales tax: The tax-triggering event is a sale of a product or a service. This tax is proportional to the sale price.
excise tax: The tax-triggering event is a sale of a product. This tax is proportional to the quantity of goods sold. For example, the U.S. federal government imposes an excise tax on gasoline per liter sold.
value added tax (V.A.T.): The tax-triggering event is a useful economic activity that creates value. (The U.S. does not have this tax.) For example, a corporation manufactures goods worth $100.00 after spending $80.00 for the manufacturing activity (including wages, raw material, and expenses). The corporation is taxed on the value increase of $20.00.
transfer tax: The tax-triggering event is a transfer of an ownership interest in an asset through a contract. For example, some states charge 1% of the sales price of a house upon the “transfer” of title to the purchaser.
tariff (customs duty, impost): The tax-triggering event is the transport of goods across a political border. This can be applied to imports and/or exports.
gift tax: The tax-triggering event is an exercise of the privilege of transferring an asset to anyone as a gift. There is a federal gift tax over an amount of a lifetime exemption ($1,000,000.00 in 2009) and an annual exemption ($13,000,00 per year in 2009) in the U.S. Also, some states impose a state gift tax. There is no gift tax between spouses
estate tax: The tax-triggering event is the death of a person and subsequent creation of his estate (if he/she left any money). While some theorized that the estate tax is triggered upon exercise of the privilege of transferring an asset upon the death of a person, courts have imposed estate tax on the estates of criminals whose property was confiscated (think of a drug dealer who dies in a dangerous transport operation). In this sense, the triggering event is really the death.
inheritance tax: The tax-triggering event is the inheritance of an estate (After the deceased’s estate pays the estate tax, a living heir pays the inheritance on what is left). The tax is imposed upon the privilege of receiving an asset as an inheritance. Some states impose inheritance taxes above an exemption amount if the relationship between the decedent and the recipient is not close enough (e.g., a third cousin twice removed).
wealth tax: The tax-triggering event is that one is wealthy enough! (The U.S. does not have this tax.) Some other countries tax individuals or corporations based on the net worth. In other words, you pay because you have so much money in net worth!
poll tax (per capita tax, capitation tax): The tax-triggering event is that one is alive! (The U.S. does not have this tax.) This is a very old tax from biblical times and practiced in Rome and England (only in the past, not now).
If an income tax is a tax imposed on income, then what is income? This is indeed a very important question. To address this question, the U.S. tax law employs the concept of “gross income.” A financial gain that falls in the category of “gross income” is subjected to income taxation according to the U.S. tax law. A financial gain that falls outside the category of “gross income” (which is rare) is exempt from income taxation according to the U.S. tax law. A non-financial gain cannot be taxed. For example, the joy you share with your spouse upon marriage cannot be taxed because the gain is non-financial. Because the concept of “gross income” is such an important concept, this subject is examined in detail in Chapter III. What counts as gross income.
1.3. What is a “federal” income tax?
In theory, when the U.S. declared independence from Britain in 1976, all the power of the British crown over the colonies was transferred to the 13 states. This transfer was validated when the 13 colonies won the American war of independence
and the treaty of Paris
was concluded. Among the powers transferred to the 13 states included the power to impose taxes. The constitution of the United States was ratified by the 13 states after its adoption by the Constitutional Convention on September 17, 1787. According to the terms of the agreement, the federal government of the United States began its operation on March 4, 1789 under the Constitution of the United States.
However, the original constitution did not allow federal taxation on income. Article 2, Section 9, Clause 4 of the U.S. constitution states:
No capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.
In other words, the original constitution prohibited a poll tax and any other direct tax on individuals unless the taxed levied through the states in proportion to the population of each state. An income tax is a direct tax, and was therefore constitutionally banned in the U.S. before! See a U.S. Supreme Court case of Pollock v. Farmers’ Loan & Trust Company (1895). Thus, the original federal taxation scheme was a population-based taxation through the states irrespective of the wealth of each state.
To remove the ban on direct taxation on individuals, the Congress of the United States passed the 16th amendment on February 3, 1913. The 16th amendment states:
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.
The 16th amendment negates the effect of Article 2, Section 9, Clause 4 of the U.S. constitution so long as the direct tax is “on incomes.” (The constitutional ban on a poll tax is still valid.) In order to emphasize that the states collectively intended to empower the U.S. federal government to impose income taxes on any type of income, the Congress used the phrase “from whatever source derived.” Thus, the federal government can legally impose an income tax. While some people allege that the U.S. government is without power to impose the income tax, the text of the constitution including the amendments says otherwise. The federal income tax is legal!
The 16th amendment merely empowers the U.S. government to collect taxes on income “from whatever source derived,” but it does not mean that the U.S. government will actually collect taxes on all types of income. The U.S. government provides select few categories of income that is not taxed. Also, the U.S. government controls when a tax is collected and how much tax is collected as taxes on income. In other words, the U.S. government has a very broad power as to how to collect income taxes.
1.4. What is a federal income tax on “individuals”?
“Individuals” mean individual natural persons that are born, live, breath, eat, and die. The opposite concept is a legal person, or a corporation, which is a legal entity that does not exist in a biological form.
The 16th amendment did not list entities that may be taxed. It just recites “power to lay and collect taxes on incomes,” and the taxed entity may be individuals or corporations. There is no limitation on which entity may be taxed as long as there is any type of income. Of course, corporations are also taxed on income.
When an individual owns a stock of a corporation, the corporation pays income tax on the profit that corporation makes through business activities and pays dividend from the post-taxation profit. The individual stockholder pays taxes on the dividend he receives because this is income to her. This is not double taxation because the first income tax is on the corporation, and the second income tax is on the stockholder. If an individual A pays an individual B for B’s merchandise, and B pays an individual C for C’s service, and C pays corporation D for D’s merchandise, each of B, C, and D pays income tax irrespective of the nature of their entity. Income tax on corporations are usually called “corporate tax.”
The reason we discuss federal income tax on “individuals” here as opposed to federal income taxation on “corporations” is that the rules of taxation are different between individuals and corporations. Federal income taxation of corporations would be a topic deserving a dedicated discussion. We will discuss only federal income taxation of individuals in this article.
What type of individuals are subjected to federal income taxation? Obviously, only people under the administrative power of the federal government of the U.S. can be possibly subjected to federal income taxation. Can the U.S. impose taxes on a U.S. citizen living abroad and earning income from foreign sources? The theoretical answer is a definite “yes” irrespective of where that U.S. citizen lives because the administrative power of the U.S. could extend to citizens living abroad in some circumstances (through the embassy, for example). For practical difficulties associated with enforcing the collection of taxes, however, the U.S. government has concluded tax treaties with almost all other nations in the world so that U.S. citizens residing in foreign countries pay taxes to the government of that country. Likewise, the tax treaties allow imposition of U.S. income tax on foreigners residing in the U.S. and its territories. International treaties as well as domestic laws explicitly prohibit treating foreigners any worse than the U.S. citizens, i.e., the U.S. government cannot tax foreigners on the U.S. soil at a higher rate than the U.S. citizens. In general, one follows the tax law of the land in which he is residing, although there are some explicit exceptions to this rule. If one is a citizen or a permanent resident of the country that she is living in, she is residing in that country. What about visiting? This is a harder question. The world is divided into two parts. In one part, the residency of the taxpayer determines to which government he owes a tax. In another part, the source of income of the taxpayer determines to which government he owes a tax. Either way, one gets to pay an income tax only to one government most of the time through the operation of international tax treaties, although in principle, it is possible that an unfortunate person becomes liable for income taxes to two governments.
The 16th amendment does not alleviate any tax burden of individuals imposed by the individual states. Thus, U.S. residents (or even aliens that receive an income within the U.S.) are liable to taxation from the state of residency, taxation from the local governments (cities, counties, etc.), and taxation from the federal government. Also, states and local governments have power to impose an income tax based on residency and/or source of income (e.g., the location of your workplace).