Early history

The first attempt to tax income

Income tax

An income tax is a tax levied on the income of individuals or businesses . Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate...

 in the United States

United States

The United States of America is a federal constitutional republic comprising fifty states and a federal district...

 was in 1643 when several colonies instituted a “faculties and abilities” tax. Tax collectors would literally go door to door and ask if the individual had income during the year. If so, the tax was computed on the spot. The income tax raised little revenue, and was viewed as a supplement to more traditional forms of property taxation.

Constitutional provisions

Article I, Section 8, Clause 1 of the United States Constitution (the "Taxing and Spending Clause

Taxing and Spending Clause

Article I, Section 8, Clause 1 of the United States Constitution, is known as the Taxing and Spending Clause. It is the clause that gives the federal government of the United States its power of taxation...

"), specifies Congress

United States Congress

The United States Congress is the bicameral legislature of the federal government of the United States, consisting of the Senate and the House of Representatives. The Congress meets in the United States Capitol in Washington, D.C....

's power to impose "Taxes, Duties, Imposts and Excises," but Article I, Section 8 requires that, "Duties, Imposts and Excises shall be uniform throughout the United States."

In addition, the Constitution specifically limited Congress' ability to impose direct taxes, by requiring Congress to distribute direct taxes in proportion to each state's census population. It was thought that head taxes and property tax

Property tax

A property tax is an ad valorem levy on the value of property that the owner is required to pay. The tax is levied by the governing authority of the jurisdiction in which the property is located; it may be paid to a national government, a federated state or a municipality...

es (slaves could be taxed as either or both) were likely to be abused, and that they bore no relation to the activities in which the federal government had a legitimate interest. The fourth clause of section 9 therefore specifies that, "No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or enumeration herein before directed to be taken."

Taxation was also the subject of Federalist No. 33

Federalist No. 33

Federalist No. 33 is an essay by Alexander Hamilton, the thirty-third of the Federalist Papers. It was published on January 2, 1788 under the pseudonym Publius, the name under which all the Federalist Papers were published. This is the fourth of seven essays by Hamilton on the then-controversial...

 penned secretly by the Federalist Alexander Hamilton

Alexander Hamilton

Alexander Hamilton was a Founding Father, soldier, economist, political philosopher, one of America's first constitutional lawyers and the first United States Secretary of the Treasury...

 under the pseudonym

Pseudonym

A pseudonym is a name that a person assumes for a particular purpose and that differs from his or her original orthonym...

 Publius. In it, he explains that the wording of the "Necessary and Proper" clause should serve as guidelines for the legislation of laws regarding taxation. The legislative branch is to be the judge, but any abuse of those powers of judging can be overturned by the people, whether as states or as a larger group.

Early colonial and state income taxes

In the early 18th century and well into the 19th century, a number of the southern colonies and states adopted an income tax modeled on the tax instituted in England. The British theory was that you tax the income from property, and not the property itself; thus, sales of property were not subject to taxation.

First income tax law

In order to help pay for its war effort in the American Civil War

American Civil War

The American Civil War was a civil war fought in the United States of America. In response to the election of Abraham Lincoln as President of the United States, 11 southern slave states declared their secession from the United States and formed the Confederate States of America ; the other 25...

, the United States government imposed its first personal income tax, on August 5, 1861, as part of the Revenue Act of 1861

Revenue Act of 1861

The Revenue Act of 1861, formally cited as , included the first U.S. Federal income tax statute . The Act, motivated by the need to fund the Civil War , imposed an income tax to be "levied, collected, and paid, upon the annual income of every person residing in the United States, whether such...

. Tax rates were 3% on income exceeding $600 and less than $10,000, and 5% on income exceeding $10,000. This tax was repealed and replaced by another income tax in the Revenue Act of 1862

Revenue Act of 1862

The Revenue Act of 1862 , was passed by the United States Congress to help fund the American Civil War. The Act was signed into law by President Abraham Lincoln, introducing the first progressive rate income tax to the country....

.

After the war when the need for federal revenues decreased, Congress (in the Revenue Act of 1870) let the tax law expire in 1873. However, one of the challenges to the validity of this tax reached the United States Supreme Court in 1880. In Springer v. United States

Springer v. United States

Springer v. United States, 102 U.S. 586 , was a case in which the United States Supreme Court upheld the Federal income tax imposed under the Revenue Act of 1864.- Background :...

, the taxpayer contended that the income tax on his professional earnings and personal property income violated the “direct tax” requirement of the Constitution. At this time, it was difficult for the Supreme Court to be interested in a case involving a tax that expired seven years earlier. To avoid the chaos that a decision for the taxpayer would generate, the Court unanimously sided with the government. In effect, the Supreme Court concluded that the income tax was an “excise tax”, and was neither a capitation tax (based on population) nor a property tax.

Second income tax law

In 1894, a Democratic-led Congress passed the Wilson-Gorman tariff. This imposed the first peacetime income tax. The rate was 2% on income over $4000, which meant fewer than 10% of households would pay any. The purpose of the income tax was to make up for revenue that would be lost by tariff reductions. This was a controversial provision, and the law actually passed with the signature of President Grover Cleveland

Grover Cleveland

Stephen Grover Cleveland was the 22nd and 24th president of the United States. Cleveland is the only president to serve two non-consecutive terms and therefore is the only individual to be counted twice in the numbering of the presidents...

"Direct" income tax unconstitutional: Pollock v. Farmers' Loan Trust Company

Once again, a taxpayer challenged the legality of the income tax. In Pollock v. Farmers’ Loan and Trust Company (1895), a taxpayer sued the corporation in which he owned stock, contending that they should never have paid the income tax because it was unconstitutional. In this case, the tax was paid on income from land, and Pollock argued that since a tax on real estate is a direct tax, then a tax on the income from such property must be a direct tax as well. Since the Constitution prohibited a “direct tax

Direct tax

The term direct tax generally means a tax paid directly to the government by the persons on whom it is imposed.-General meaning:In the general sense, a direct tax is one paid directly to the government by the persons on whom it is imposed...

” unless certain conditions are met, Pollock argued that the income tax should be declared unconstitutional. The “direct tax” argument had also been used by Springer in 1880, but now the Court focused more closely on the wording in the Constitution.

The provisions were Article I, Section 8, Clause 1, which provides that “all duties, imposts, and excises shall be uniform throughout the United States” and Article I, Section 9, Clause 4, which provides that “no capitation, or other direct tax shall be laid, unless in proportion to a census or enumeration herein before to be taken.”

In effect, the latter clause requires any direct tax to be based on a census. For example, if the government desired to raise $10 million and New York had 20% of the total U.S. population at that time, then New York would be required to raise $2 million. If New York had 1 million residents, each resident would owe $2 in taxes. Obviously, a tax based on income could not achieve such proportionality, since incomes differed across individuals.

This time, the Supreme Court took the argument seriously and in a 5-4 decision, ruled that the income tax was unconstitutional. A few days after the initial vote, the Court re-voted and reached the same result.

The Court held an unapportioned tax based on receipts from the use of property to be unconstitutional. The Court held that taxes on rent

Economic rent

Economic rent is typically defined by economists as payment for goods and services beyond the amount needed to bring the required factors of production into a production process and sustain supply. A recipient of economic rent is a rentier....

s from real estate, on interest

Interest

Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....

 income from personal property and other income from personal property (which includes dividend

Dividend

Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...

 income) were treated as direct taxes on property, and therefore had to be apportioned. Since apportionment of income taxes is impractical, this had the effect of prohibiting a federal tax on income from property. The power to tax real and personal property, or that such was a direct tax, was not denied by the Constitution. Due to the political difficulties of taxing individual wages without taxing income from property, a federal income tax was impractical from the time of the Pollock decision until the time of ratification of the Sixteenth Amendment (below).

Thus, the tax law was ruled unconstitutional and was effectively repealed.

Modern income tax

In 1909, fifteen years after Pollock, Congress took two actions to deal with their increasing revenue needs.

1. Corporate income ("excise") tax. First, they passed a corporate income tax, but labeled it an “excise tax.” The tax was set at 1% on all incomes exceeding $5,000. In 1911, the U.S. Supreme Court upheld this corporate “excise tax” as constitutional in Flint v. Stone Tracy Company, in which the court ruled that the tax was a special excise tax on the privilege of doing business.

2. Sixteenth Amendment. More importantly, in 1909 Congress passed the Sixteenth Amendment

Sixteenth Amendment to the United States Constitution

The Sixteenth Amendment to the United States Constitution allows the Congress to levy an income tax without apportioning it among the states or basing it on Census results...

, which would do away with the apportionment requirement of the Constitution if enacted. This amendment reads 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.

By 1913, the required three-fourths of the states ratified the Sixteenth Amendment, thus adding the amendment to the constitution.

Congress immediately enacted the first “constitutional” tax law, The Revenue Act of 1913

Revenue Act of 1913

The United States Revenue Act of 1913 also known as the Tariff Act, Underwood Tariff, Underwood Tariff Act, or Underwood-Simmons Act , re-imposed the federal income tax following the ratification of the Sixteenth Amendment and lowered basic tariff rates from 40% to 25%, well below the Payne-Aldrich...

. The tax ranged from 1% on income exceeding $3,000 to 7% on incomes exceeding $500,000. In effect, this statute introduced for the first time the notion of a progressive tax rate structure; the tax rate increases as the base, income in this case, increases.

Subsequently, the U.S. Supreme Court in 1916 upheld the progressive income tax as constitutional in Brushaber v. Union Pacific Railroad Company, . The Supreme Court

Supreme Court of the United States

The Supreme Court of the United States is the highest court in the United States. It has ultimate appellate jurisdiction over all state and federal courts, and original jurisdiction over a small range of cases...

 indicated that the amendment did not expand the federal government's existing power to tax income (meaning profit or gain from any source) but rather removed the possibility of classifying an income tax as a direct tax on the basis of the source of the income. The Amendment removed the need for the income tax to be apportioned among the states on the basis of population. Income taxes are required, however, to abide by the law of geographical uniformity.

Initial attempts to define “income”

The concept of “income” is never really defined in the Internal Revenue Code. The closest that Congress comes to defining income is found in IRC Section 61, which is largely unchanged from its predecessor, the original Section 22(a) definition of income in the Revenue Act of 1913:

Sec. 22(a). “Gross income” includes gains, profits, and income derived from salaries, wages or compensation for personal service (including personal service as an officer or employee of a State, or any political subdivision thereof, or any agency or instrumentality of any one or more of the foregoing), of whatever kind and in whatever form paid, or from professions, vocations, trades, businesses, commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property; also from interest, rent, dividends, securities, or the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatsoever.

Eisner v. Macomber

One of the earliest attempts to define income occurred in the case of Eisner v. Macomber

Eisner v. Macomber

Eisner v. Macomber, , was a tax case before the United States Supreme Court. It is notable for the following holdings:*a pro rata stock dividend, where a shareholder received no actual cash or other property, and retained the same proportionate share of ownership of the corporation as was held...

, in which the U.S. Supreme Court addressed the taxability of a proportionate stock dividend. This case provided the Court with a forum to try to interpret exactly what Congress intended to include in the sparse Section 22 definition of “income.” This was not the first time the Court had addressed the issue: the case had been argued in the previous term of the court, and was being reargued with additional oral and written briefs.

The Court stated that it needed to examine the boundaries of the definition of income for several reasons.

• First, the Revenue Act of 1916
  Revenue Act of 1916
  The United States Revenue Act of 1916, raised the lowest income tax rate from 1 % to 2 % and raised the top rate to 15 % on taxpayers with incomes above $2 million...
  
   expressly stated that a “stock dividend shall be considered income, to the amount of the cash value.” However, in a previous case, Towne v. Eisner
  Towne v. Eisner
  Towne v Eisner is an early United States income taxation case before the Supreme Court. It held that:Congress passed a new law in reaction to Towne v Eisner, and as a result the case was soon overturned by the Supreme Court in Eisner v Macomber....
  
  , the Court had ruled that a stock dividend made in 1914 against surplus earned prior to January 1, 1913 was not taxable under the Act of October 3, 1913, which provided that net income included “dividends.” The district court in that case had noted that: “It is manifest that the stock dividend in question cannot be reached by the Income Tax Act, and could not, even though Congress expressly declared it to be taxable as income, unless it is in fact income.” It had held, however, that the stock dividend was the equivalent of income. The Supreme Court in Towne v. Eisner then reversed the lower court, finding that the dividend was not income because the “proportional interest of each shareholder remains the same … and the stockholder is no richer than they were before.”

As a result, the Court decided in Eisner v. Macomber to address the larger constitutional question of whether or not a stock dividend was gross income within the meaning of “income” as used in the Sixteenth Amendment. As noted by the Court:

In order, therefore, that the clauses cited from Article 1 of the Constitution may have proper force and effect, save only as modified by the Amendment, and that the latter also may have proper effect it becomes essential to distinguish between what is and what is not “income” as the term is there used; and to apply the distinction, as cases arise, according to truth and substance, without regard to form. Congress cannot by any definition it may adopt conclude the matter, since it cannot by legislation alter the Constitution, from which it derives its power to legislate, and within whose limitations alone that power can be lawfully exercised.

As a starting point, the Court defined income succinctly by reference to the dictionary and to two earlier cases as follows: “Income may be defined as the gain derived from capital, from labor, or from both combined, provided it be understood to include profit gained through a sale or conversion of capital assets.” The Court then went into a lengthy and somewhat convoluted discussion as to how this definition applies to a stock dividend. In the end, the Court decided that the stock dividend was not taxable because it was merely a book adjustment and not “severable” from the underlying stock. In other words, income would not be realized until the stock dividend was sold, that is, severed from the underlying original security investment.

Refinements in the definition of income

A number of commentators contended that the Court in Eisner v. Macomber

Eisner v. Macomber

Eisner v. Macomber, , was a tax case before the United States Supreme Court. It is notable for the following holdings:*a pro rata stock dividend, where a shareholder received no actual cash or other property, and retained the same proportionate share of ownership of the corporation as was held...

 had gone too far in overturning a statute taxing stock dividends (the 1916 Act) that many perceived as being fair and equitable. Henry Simons, a noted tax scholar of the time, in his treatise, observed the following:

Actually, an utterly trivial issue was made the occasion for injecting into our fundamental law a mass of rhetorical confusion which no orderly mind can contemplate respectfully, and for giving constitutional status to nave and ridiculous notions about the nature of income and the rationale for income taxes.

Despite this criticism, a number of decisions subsequent to Eisner v. Macomber relied on this simplistic definition of income. This in turn led to the question of whether or not this formulation was an “exclusive” definition of income, with any income not clearly covered by its terms deemed to be nontaxable.

In Hawkins v. Commissioner, the IRS sought to tax compensatory damages received by the taxpayer by way of settlement of a suit for injury to personal reputation and health caused by defamatory statements constituting libel or slander. While noting that “there may be cases in which taxable income will be judicially found although outside the precise scope of the description already given,” the Court found that such damages would not be taxable. The court noted that the injury was “wholly personal and nonpecuniary,” and that the remedy simply attempts to make the individual whole. Thus, even though the payment was “severable” and lead to a demonstrable increase in net wealth, the Court nonetheless concluded that the payment was not income.

Other commentators noted that if “severability” is a touchstone for the definition of income, it followed that a number of sales or exchanges of property that did not involve immediate realization through severance would not be taxable. Realizing that the “one size fits all” definition of income in Eisner v. Macomber was too broad, the U.S. Supreme Court reconsidered the idea of severability in Helvering v. Bruun

Helvering v. Bruun

Helvering v. Bruun, , was an income tax case before the Supreme Court of the United States. It is notable for the following holding:-Facts:...

. In this case, the Court addressed the question of whether or not a lessor recognizes income from the receipt of a leasehold improvement made by a lessee during the lease when the improvement reverts to the lessor at the end of the lease. In ruling that the value of the improvement was taxable, the Court noted that every gain need not be realized in cash to be taxable. There was a clear increase in the taxpayer’s wealth, and this increase did not have to be severed to measure such increase for tax purposes.

In subsequent cases, the Court distanced itself further from the overly-simplistic Eisner v. Macomber definition of income and its dependence on the concept of severability. For example, in Commissioner v. Glenshaw Glass Company, the Court ruled that punitive damages recovered under a violation of anti-trust laws were included in gross income, and that the language of Section 22 (now IRC Section 61) clearly intended that Congress exert “the full measure of its taxing power.” And in referencing its previous definition of income in Eisner v. Macomber, the Court noted that “in distinguishing gain from capital, the definition had served a useful purpose. But it was not meant to provide a touchstone to all future gross income questions.”