Income Tax Myths
"Section 861 shows that the domestic income of U.S. citizens is not taxable."
My basic 861 page explains the error in the 861 argument. Section 861 and the following sections tell which part of a person's income is considered to be from sources within the United States and which part is considered to be from sources without the United States. But a United States citizen is taxed on income from all sources, so section 861 doesn't matter for most taxpayers.
That's the key point, but this page provides some more detail, which may be particularly useful for those readers who have seen this video or other material by one Larken Rose, who is a big proponent of the 861 argument (and, not coincidentally, a convicted tax criminal). The video is long, complicated, and tedious, and it keeps suggesting that the key information is just around the corner. It keeps one hanging for so long that I can see how a viewer might get confused (although it does have impressive graphics). In the end, though, the critical error in the argument is simple.
Rose considers the case of a hypothetical United States citizen named "Andy Green," who lives in the United States, performs work for his neighbors (mostly yard work, it would seem from the video), and gets paid in cash for it. Does Andy have taxable income?
First, let's review the tax code basics. The basic rules of taxable income comes from sections 1, 61, and 63 of the tax code.
Section 1 is the section that actually imposes the income tax. It’s very simply written. If you are unmarried (as Andy appears to be), the relevant provision is § 1(c), which states:
followed by a table specifying the tax rates on various income amounts. If you are married, you are covered by the similar provision at § 1(a). There are also a couple of other possible filing statuses covered elsewhere in § 1 (such as “head of household”), but the basic point is that section 1 imposes an income tax.
Section 1, it will be observed, imposes the tax on your “taxable income.” How do you know what that is? Section 63 of the Code, 26 U.S.C. § 63, defines “taxable income” to mean “gross income minus the deductions allowed” by chapter 1 of the Code, so now we need to know what “gross income” is. So we turn to section 61 of the Code, 26 U.S.C. § 61, which provides the critical definition:
There are 15 items in the full list (I’ve only quoted the first seven), but the key part of the definition is that gross income means “all income from whatever source derived.”
So Andy, who performs services for his neighbors and who gets paid for it, has "compensation for services" income. This income is part of Andy's gross income, and, to the extent Andy's gross income exceeds his allowable deductions, he has taxable income. It is not necessary to determine the geographic source of this income because gross income includes income "from whatever source derived."
But there's certainly no harm in determining the geographic source of this income if one wants to. To do so, one would turn to section 861 of the code, 26 U.S.C. § 861. The section is long and complicated, but for a simple case like Andy's, the relevant part of section 861 is simple:
So, because the hypothetical "Andy" lives in the United States, the income that he gets from doing yard work for his neighbors would be "[c]ompensation for labor or personal services performed in the United States," and therefore this income would be "treated as income from sources within the United States." Similarly, if Andy keeps his money in a locally incorporated bank and earns interest on it, that interest would be "[i]nterest from . . . [a] domestic corporation," and so also treated as income from sources within the United States.
So Andy's income is treated as income from sources within the United States. But so what? That doesn't add to our knowledge that the income is includable in Andy's gross income (and therefore in his taxable income to the extent Andy's gross income exceeds his allowable deductions). We already knew that, because section 61 provides that Andy's gross income means his income "from whatever source derived."
Section 61 stands in sharp contrast to section 871, which imposes the tax on foreigners, which provides that "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." The rule is clear: foreigners are taxed on "the amount received from sources within the United States," but citizens are taxed on "all income from whatever source derived."
Thus, the bottom line, as explained on my basic 861 page, is that section 861 doesn't matter for most U.S. citizens. If we don't take section 861 into account, we conclude that Andy's yard work income is part of his gross income, because section 61 defines gross income as including "all income from whatever source derived." If we do take section 861 into account, we still conclude that Andy's yard work income is part of his gross income. Section 861 tells us that Andy's yard work income is "treated as income from sources within the United States," which is nice to know, but it has no effect on the determination that it is part of his gross income under section 61. And in either case, we further conclude that, to the extent that Andy's gross income exceeds his allowable deductions, his yard work income is also part of his taxable income under section 63.
Thus, the result is the same whether or not one considers section 861.
Even Larken Rose recognizes this. Readers who saw this video will recognize most of the above information as Steps One, Two, and Three in Rose's argument (in the video I saw -- the steps are different in some of Rose's other presentations of the argument). Even Rose concludes, at the end of Step Three in the above video, that the above information shows that Andy's taxable income apparently includes his income from his yard work for neighbors.
So what more is there to the argument? Rose's key error comes in what he calls Step Four. After much tedious buildup, the whole thing comes down to a misunderstanding of an income tax regulation. The regulation, 26 C.F.R. § 1.861-8, provides additional guidance on how to apply the source rules of code section 861 and following. The regulation states that its rules "apply in determining taxable income of the taxpayer from specific sources and activities under other sections of the Code, referred to in this section as operative sections." The regulation provides:
I've omitted a lot of detail here, but, as you can see, the "operative sections" all involve situations with some connection to foreign activities. From this, Rose concludes that the income a United States citizen gets from performing services within the United States is not taxable.
Nonsense. That's just not what the regulation says.
As noted earlier, because a United States citizen is taxed on all his or her income, from whatever source derived (see section 61), for most purposes it doesn't matter whether a citizen's income is from sources within or without the United States. But sometimes it does matter. The "operative sections" of regulation 1.861-8(f) are just a list of those situations in which it does matter (for more on when it does matter, see the basic 861 page). That's all subsection (f)(1) does: it lists the code sections as to which it matters whether income is from sources within or without the United States. Section 61 is not listed, because, for the purpose of determining what constitutes a U.S. citizen's gross income, it doesn't matter whether the income is from sources within or without the United States.
This is also clear from subsection (a) of the regulation, which states that the regulation "provides specific guidance . . . by prescribing rules for the allocation and apportionment of expenses, losses, and other deductions . . . of the taxpayer." That is, the regulation does not determine whether income is included in gross income. It provides rules for allocating deductions. It does so for the purpose of those codes sections for which this allocation matters (the "operative sections"). It just has nothing to do with figuring out whether anything is part of a U.S. citizen's gross income.
In the end, that's what it all comes down to. The 861 argument, as articulated by Larken Rose, contains endless buildup, but at bottom it's all based on a misunderstanding of this regulation. The regulation just provides a list of the situations in which it matters whether income is from foreign sources or not. The regulation does not show that domestic income is not taxable. The above references, and particularly code section 61's definition of gross income as "all income from whatever source derived" (as opposed to section 871's limitation to "the amount received from sources within the United States"), shows that the domestic income of a U.S. citizen is subject to the income tax.
By the way, the notion that the whole thing turns on a regulation is somewhat ironic: most tax protestors are particularly insistent that they want the government to rely on laws (which have to be passed by Congress), not just regulations (which come from a government agency such as the IRS).
But if there were even the slightest doubt as to the meaning of Regulation 1.861-8 (which there isn't), it would all be cleared up by the IRS's other regulations. Once you are relying on the regulations and not just the Code itself, it's only fair to rely on all the regulations, and the regulations as a whole make the matter perfectly clear. Most notably, consider this regulation:
That's clear, isn't it? There's no point fooling around with an absurd misinterpretation of regulation 1.861-8(f) when regulation 1.1-1(b) is utterly, 100% clear.
In sum, the laws and the regulations clearly show that U.S. citizens are taxed on all their income, without regard to whether it comes from inside or outside the United States.