Some people argue that section 861 of the tax code shows that U.S. citizens are taxed only on foreign-source income. This argument is mistaken.

Section 861 of the tax code (plus some of the following sections and the attendant regulations) determines whether income is considered to be from a source within the United States or from a source outside the United States. But the rest of the tax code (especially sections 1, 61, and 63) shows that U.S. citizens are taxed on their income from all sources, whether from within or outside the United States. So anyone can use section 861 to determine whether their income is from foreign or domestic sources, but for most U.S. citizens, the source simply doesn’t matter, because U.S. citizens are taxed on their income from all sources.

It’s as though section 861 said that some of your income shall be considered red income and some blue income, but then the rest of the code said that you are taxed on all your income regardless of color. You could use section 861 to determine the color of your income, but it wouldn’t matter.

So why does section 861 exist, if it doesn’t matter? The answer is that section 861 doesn’t matter to most U.S. citizens, but it matters a lot to some people. Without going into all the situations where section 861 matters, here are the two most important:

1. Foreigners (unless admitted to the U.S. for permanent residence) are not subject to U.S. income tax on their foreign-source income, but only on their U.S.-source income. This is only natural: the U.S. could hardly expect to tax a billion Chinese people on the income they earn in China! But if a foreigner earns income from a U.S. source (for example, by maintaining a bank account in the U.S., which earns interest), then the U.S. government can tax that income. So section 861 is very important to foreigners, because it tells them what part of their income is subject to U.S. income tax.

This is made clear by section 2(d) of the tax code, 26 U.S.C. § 2(d), which provides that "In the case of a nonresident alien individual, the taxes imposed by sections 1 and 55 shall apply only as provided by section 871 or 877," and by section 871, 26 U.S.C. § 871, which provides, "there is hereby imposed for each taxable year a tax of 30 percent of the amount received from sources within the United States by a nonresident alien individual . . . "

Notice the difference from section 61. Section 61 defines gross income as "all income from whatever source derived," but section 871 provides that foreigners are taxed only on "the amount received from sources within the United States."

The contrast between the two sections makes the rule particularly clear. Foreigners need to know whether their income is from sources within or without the United States, because they are taxed only on their U.S.-source income, but U.S. citizens are taxed on all income from whatever source derived, so for the basic purpose of determining gross income it doesn't matter whether a U.S. citizen's income is from within or without the United States.

2. U.S. citizens who have income from foreign sources (e.g., from working abroad, receiving dividends from foreign companies, or interest on foreign bank accounts) may have paid tax on that income to a foreign government. Double taxation is usually considered bad, so the U.S. tax code allows a credit for taxes paid to foreign governments. But determining the credit requires apportionment of income and deductions into foreign and domestic sources. So section 861 is important to U.S. citizens who have foreign source income and who want to claim the foreign tax credit. (This is provided in tax code sections 27 and 901.)

But to repeat, for a typical U.S. citizen, section 861 is irrelevant. Anyone can go ahead and use it to characterize their income as from U.S. sources or foreign sources, but, because U.S. citizens are taxed on all income from all sources, the characterization simply won’t matter for most U.S. citizens.

That's really all one needs to know, but readers who have seen this video or other material by one Larken Rose, a big proponent of the 861 argument, may want more detail. For more detail, please click here:

Click for More Detail On The 861 Argument

Readers might also be interested to know that Mr. Rose served a substantial jail term following his conviction on tax charges. In seeking trustworthy tax law information, no sensible person would turn to a convicted tax criminal who has no training in law.

(Also, Rose's conviction was affirmed by the U.S. Court of Appeals for the Third Circuit in August 2008, and it appears from the court's opinion that Rose did not even make the 861 argument to the court. If he really believed the argument, one would have expected him to make it in his own case.)

Like other tax protestor arguments, the 861 argument has been to court many times and has a batting average of zero. Every court to consider the argument has rejected it. A representative sampling (from among dozens of cases that have considered the argument):

"Bell's main rationale for avoiding the income tax is known as the 'U.S. Sources argument' or the 'Section 861 argument.' This method has been universally discredited." United States v. Bell, 414 F.3d 474 (3d Cir. 2005). "Carmichael asserts that, under I.R.C. § 861, only the domestic income of those engaged in certain activities relating to foreign commerce are taxable . . . . This argument has been uniformly rejected by courts that have considered it, . . . and we reject it as well." Carmichael v. United States, 128 Fed. Appx. 109 (Fed. Cir. 2005). "Rayner insists that he owed no tax in 1998 because all his income that year . . . derived from sources within the United States and therefore (so he says) is not taxable income under 26 U.S.C. § 861 and the regulations construing that statute. This absurd argument is patently frivolous." Rayner v. Commissioner, 70 Fed. Appx. 739 (5th Cir. 2003). "While the plaintiffs have attached a 12-page supplement to their 1040X, explaining that they did not have to pay income taxes as wage earners in the United States pursuant to 26 U.S.C. § 861, this argument is simply frivolous and has been uniformly rejected by other courts." Deyo v. I.R.S., 2004 WL 2051217 (D. Conn. 2004). "Loofbourow . . . [argues] that his compensation does not constitute gross income because it is not an item of income listed in 26 C.F.R. § 1.861- 8(f). Loofbourrow's argument, however, is misplaced and takes the regulations out of context." Loofbourrow v. Commissioner, 208 F. Supp. 2d 698 (S.D. Tex. 2002).

Somewhat amusingly, you can read a scathing critique of the 861 argument on the web page of Irwin Schiff, who is a leading tax protestor himself.