A Brief History of “Income” (Tax)

I just finished this fascinating book, The Oxford Introductions to U.S. Law: Income Tax Law. It really opened my eyes to the notion that tax is not simply a massive set of random rules encoded in one of the largest legal documents, but that tax does have a conceptual and theoretical foundation beyond what most people are aware of. As the author points out, most people miss the forest for the trees when it comes to tax.

Income Taxed

The United States did not have an income tax at all until the early twentieth century, except briefly during periods of war. In 1895, the courts actually viewed an income tax as unconstitutional (Pollock v. Farmers’ Loan & Trust Company, 157 U.S. 429). But in 1913, the 16th amendment to the Constitution was passed:

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.

That’s some really broad phrasing there, baked right into the United States constitution.

So now, we have an income tax. What does that mean? What is income? We know our paychecks are much smaller than the salary we were promised, and that sucks. But let’s go back to the basics and take a look at the concept of income.

Broadly, there are two sources of income: wages, and capital returns. The distinction is crucial.

Income = Wages + Capital Returns

Wages

Wages are simple (for now). You go to a job, and you get paid some amount of money for performing your duties at work. You get taxed when you get the paycheck. Maybe, you get some refunds at the end of the year if you have deductions or credits.

Interesting thing to note: For the vast majority of American, the income tax is solely a wage tax, since they have no investments and investment returns.

Income = Wages

Another thing to note: a wage tax for most people is simply a tax on consumption because

Wages = Consumption + Savings

And most Americans do not save at all. They are spending all that they earn. Hence,

Income = Wages = Consumption
Pretty surprising, isn’t it? We already have a consumption tax, in America! For most people anyway.

Capital Returns

Capital gains is buying a house, and then, having that house go up in value. But when did you actually get taxed on the gain? Obviously, you don’t get taxed if the market value of a house increases next year. That would be ridiculous. You only get taxed on the house when you sell it. That idea is called realization.

This seems very basic, like how could it be any other way?

But think about another tax: the property tax. Property tax is charged on the assessed value of the property every year. The assessed value is typically defined as 80% or 90% of the fair market value.

Doesn’t this seems very unfair? Imagine you are a poor immigrant in the Mission District of San Francisco who bought a home in the 70s. Housing prices sky-rocket in the late 90s with the tech boom and once again, over the last few years, with tech boom 2.0. How are you supposed to pay the ridiculously high property tax if all you have is your house but you can’t sell it and afford to buy anything else nearby? Fortunately in California, there are limits on how much your property tax can increase year over year.

California passed a law called Proposition 13 in 1978 and thereby created a property tax system different from any other state. The law not only sets every property’s assessed value at 100 percent of FMV, but also sets the property’s annual tax at 1 percent. Furthermore, the law states that a homeowner’s property tax may never increase by more than 2 percent from one year to the next, even if its FMV doubles in value.

I brought up the idea of property tax to illustrate a tax without the realization requirement. It does exist, and it’s not weird as it sounds.

But income tax is supposed to tax income, not property. Having a house that goes up in fair market value isn’t exactly income, is it? I can’t buy food with that appreciation unless I sell the house. And this is exactly how the justices saw it in Macomber.

Macomber and the realization requirement

Eisner v. Macomber is the Supreme Court case that defines the “realization” method of taxation, and according to the author of the book, this is the most important case in all of US tax law.

Mrs. Macomber owned some shares in Standard Oil. Standard Oil did a stock split, causing her to double the number of shares she owned, while the total monetary value stayed the same. The IRS decided to tax Mrs. Macomber for the gains. The majority opinion in Macomber decided two things: the first is fairly obvious and inconsequential, a stock split was certainly not a sale or realization, and secondly, the IRS is only allowed to tax Mrs. Macomber when she realizes her income, which means she would have to sell her stocks.

We are clear that not only does a stock dividend really take nothing from the property of the corporation and add nothing to that of the shareholder, but that the antecedent accumulation of profits evidenced thereby, while indicating that the shareholder is richer because of an increase of his capital, at the same time shows he has not realized or received any income in the transaction.
Income may be defined as the gain derived from capital or from labor or from both derived.

Even though, Mrs. Macomber’s stock had gone up in total value (unrelated to the split) since she purchased them. She had not realized any income during the stock split, and taxation of capital gains (“accumulation of profits”) is only allowed when the gains were realized. She has not received any income in this transaction.

What we have so far: wages are income. Capital gains is income too but only when it is realized.

Are there are other sources of income that we are missing?

Glennshaw Glass

The Glennshaw Glass Company won an antitrust lawsuit, and the judge awarded punitive damages of three times its lost profits. Say one-third of the award, equal to the lost profits, is income derived (per Macomber). But what about the other two-thirds? The company argued unsuccessfully that they should not be taxed on the remainder because it wasn’t income derived from either capital or labor. It was a court award, unrelated to wages or capital.

This situation forced the Supreme Court to define what “income” is, and not just by listing its constituents. The Supreme Court came with this eloquently worded definition:

Here we have undeniable accession to wealth, clearly realized, and over which the taxpayer has dominion.

It doesn’t matter what the source of the “accession to wealth” is, be it a court award or working as a software engineer, or selling drugs.

This is the “balance sheet” approach to income. This also makes everyday sense.

Note that the realization requirement for capital gains is kept by the Glennshaw Glass.

Recognition

Say you buy a nice house in San Francisco for a million dollars. Over the next few years, the value rises up to $1.5 million. But unfortunately one day when you’re out at your job, your house burns down thanks to a cooking fire from your neighbor’s. What a bummer. Thankfully, you have homeowner’s insurance, so you get a check $1.5 million a few weeks later. But now, suddenly your capital gains is realized, you have to pay taxes on the $500k in home value appreciation.

A bit unfair?

Fortunately, the Congress and the IRS have chosen to implement non-recognition statutes for acts of gods, thefts, etc, where unintentionally, an event occurs that leads to the realization of your capital gains.

Therefore, for capital gains, what we have learned so far is that thanks to Glenshaw Glass and Macomber and the IRS non-recognition statues, your gains have to be both realized and recognized.

Borrowing Money

What about a loan? Under the Macomber definition alone, it’s possible to consider loans as income. However, under the balance sheet approach set forth by Glennshaw Glass, loans are clearly not income. A loan adds cash to the assets side of your balance sheet, but also adds to the liabilities side. Hence, there is no increase in net worth when you borrow money.

Say that beautiful house from the previous section didn’t actually burn down. You bought it for a million, and now it’s worth $1.5 million. You’ve paid off your mortgage. And you want use that gain of $500k to fund your adventures but if you sell your house, you have to pay taxes on the gain. Even at a long-term capital gains rate of 20%, if you live in California, you have to pay an additional 10% state tax.

But there is a better alternative! Why not borrow money using the house as collateral? That sounds like a perfect solution and it is. You can use the cash from the loan to pay off the interest every year. And then, one day you’ll die, never having paid taxes on the capital gains built into the appreciated property. Wow. Is this actually legal? It totally is.

What about after you die? Would someone else, whoever inherits the house, have to pay taxes on the $500k gain? No. In fact, thanks to the way IRS treats assets inherited upon death i.e. stepped-up basis, neither your heirs nor the banks have to pay taxes on the capital gains (from a mil to 1.5 mil). Ever.

Tax Planning 101

Combine the realization requirement from Macomber, the balance sheet approach from Glennshaw Glass, and stepped-up basis, you get what the author calls “Tax Planning 101”:

  1. Buy and hold appreciated assets
  2. Take out loans against the asset to fund spending
  3. Pass on assets for your children to sell to fulfill loan obligations when you die

Or as the author puts it,

  1. Buy
  2. Borrow
  3. Die

No income tax is ever paid on such income. Isn’t that just the best kind of income? :)

Disclaimer: This post does not constitute legal advice. I am not an attorney. Not even close. If you need legal advice, please contact an attorney directly.

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