Another Sour Note from the IRS

The IRS is scheduled to release a "notice" in late June of 2001, addressing the 861/"source" issue. Here it is, addressed point-by-point. The blue text is from the IRS, with our comments being in black text.

The Internal Revenue Service and the Treasury Department are aware that certain persons are promoting the view that U.S. citizens and residents are not subject to tax on their wages and other income earned or derived within the United States based on the claim that the Internal Revenue Code imposes taxes only on income derived from certain foreign-based activities. [Close, but not quite. See below.] The Service and Treasury are issuing this notice to inform taxpayers that this reporting position has no basis in law. [The regulations are the IRS’ official interpretation of the law. ("Revenue Rulings" are another form of official interpretation, though they are "outranked" by the regulations.) On the other hand, this "notice" carries zero legal weight, and whoever wrote it is mistaken if he believes that his "notice" represents an official legal opinion of the Treasury Department and the IRS. It represents his own erroneous beliefs.]

The proponents of this position misread the Code and the Treasury Regulations. [The proponents of this position believe that the regulations mean what they say. See below.] Although the proponents acknowledge that section 1 imposes income tax on "taxable income," that taxable income" consists of "gross income" minus deductions (section 63) and that "gross income" is income "from whatever source derived" (section 61), they assert that sections 861 through 865 of the Code and the regulations thereunder (in particular, Treasury regulation section 1.861-8) limit taxable "sources" of income to certain foreign-based activities. [Close, but not quite. The taxable sources are all about those involved in international or foreign commerce, which includes some income derived from within the U.S. (which isn’t a "foreign-based" activity).]

That assertion is refuted by the express and unambiguous terms of the Code. [As long as you only read one section. See below.] Section 61 includes in gross income "all income from whatever source derived." As the Supreme Court stated in Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955), "Congress applied no limitations as to the source of taxable receipts . . . ." [It makes a nice quote... as long as you don’t mind being completely dishonest. Though the court used the word "source," the case shows they were talking about "items" of income, not "sources" as that word is used in 26 USC § 861 and related regulations. Here is the context of the quote: "Respondents contend that punitive damages, characterized as ‘windfalls’ flowing from the culpable conduct of third parties, are not within the scope of the section. But Congress applied no limitations as to the source of taxable receipts, nor restrictive labels as to their nature." The case had nothing to do with the 861/"source" issue, or with the type of commerce (international versus purely domestic). It was only about whether that type of gain would constitute "income," (i.e. whether it fit in the list of "items" in Section 61) and we agree with the Court that it would. Out of context, it makes a nice quote for the IRS to use, but it wasn’t at all about what the IRS is pretending it was about.]

Nothing in sections 861 to 865 of the Code limits the gross income subject to United States taxation to foreign-source income. [True. The domestic income of foreigners, and certain domestic corporations (which also receive income from within possessions), is also taxable. Prior to 1986, citizens could also have taxable domestic income if they also received income from federal possessions (see the older Section 931).] The rules of sections 861 through 865 have significance in determining whether income is considered from sources within the United States or without the United States, which is relevant, for example, in determining whether a U.S. citizen or resident may claim a credit for foreign taxes paid. [That is one thing those sections do. At least they admit that the sections are relevant to U.S. citizens. Actually, in a sense it is entirely correct to say that Section 861 does not exclude the domestic income of U.S. citizens from taxation. Those statutes do not, for example, specifically say that the domestic income of citizens is exempt. In fact, those statutes give the general rules about "within"/"without," and the general rules about determining taxable income from within and without, but the statutes do not list the taxable activities or types of commerce (though the predecessor statute from 1921 did). The full scope and purpose of Section 861 can only be understood in light of the related regulations, which list the "specific sources" to which the general terms of those statutes apply.] See Great-West Life Assurance Co. v. United States, 678 F.2d 180, 183 (Ct. Cl. 1982) (stating that "[t]he determination of where income is derived or 'sourced' is generally of no moment to either United States citizens or United States corporations, for such persons are subject to tax under I.R.C. § 1 and I.R.C. §. 11, respectively, on their worldwide income" and that "[l]ikewise, the income of a resident alien individual is taxed under I.R.C. § 1 without regard to source"). [The court was correct on one point: the geographical origin (a.k.a. "source") of the income is not the limiting factor; it is whether the income derives from one of the specific "sources" or activities which are taxable. The actual argument of the plaintiff is unknown, but the court was at least in part incorrect in its assertions, as shown below.] The source rules do not operate to exclude from U.S. taxation income earned by United States persons from sources within the United States. [Again, this is correct in one sense. The general "source" rules about within/without are not what exempts the income of most Americans. But, as shown below, Section 861 related regulations, show that the domestic income of most U.S. citizens is not shown to constitute "taxable income from sources within the United States."] Williams v. Commissioner, 114 T.C. 136 (2000) (rejecting the claim that income was not subject to tax because it was not from any of the sources listed in Treas. Reg. sec. 1.861-8(a)); Aiello v. Commissioner, T.C. Memo. 1995-40 (1995) (rejecting the claim that section 861 lists the only sources of income relevant for purposes of section 61).

[The Tax Court’s assertions are addressed here. What is interesting is that neither Tax Court rulings or District Court rulings are generally binding on the IRS, while the Treasury regulations are.

"The Federal Income Tax Regulations (Regs.) are the official Treasury Department interpretation of the Internal Revenue Code."
[Internal Revenue Manual, § [4.2]7.2.3.1]

"The Service is bound by the regulations."
[Internal Revenue Manual, § [4.2]7.2.3.4]

"Decisions made by lower courts, such as Tax Court, District Courts, or Claims Court, are binding on the Service only for the particular taxpayer and the years litigated." [Internal Revenue Manual, § [4.2]7.2.9.8]

So why does the IRS "notice" only cite non-binding court rulings (in addition to misrepresenting one Supreme Court ruling) instead of citing their own regulations? Well, it could be because their assertions directly contradict their own regulations. Where in the following is there the slightest hint that U.S. citizens should ignore Section 861 and related regulations when determining their taxable income? (Emphasis in citations below has been added.)

The courts have categorically rejected contentions that U.S. citizens are not lawfully subject to Federal income tax on their income from all sources and have upheld criminal convictions of individuals who based their refusal to pay Federal income tax on such contentions. See, e.g., United States v. Condo, 741 F.2d 238 (9th Cir. 1984).

[While that case is not available at FindLaw.com, we highly suspect that the case was not about anyone who relied on the 861/"source" issue. (Very few people, if any, actually knew of or understood the issue back in 1984.) If anyone can prove us wrong on this, which will promptly and prominently post it on this site. And again, a District Court ruling would not override the regulations, even if the case had been about that.]

[**6/13/01 Note:  The "Condo" case, as I suspected, was NOT about the 861/"source" issue AT ALL.  "Condo" was arguing about the taxability of federal reserve notes, claiming that they are a debt, and therefore cannot be taxed.  He was not arguing anything remotely related to the 861/"source" issue.  The court itself even said "Condo is adamant in asserting the unconstitutionality of the taxing system."  Once again, the IRS is using an official-looking citation, that ends up being worthless and irrelevant. - Larken Rose**]

[The remainder of the IRS’ "notice" consists of threats.]

The Internal Revenue Service and the Treasury Department advise taxpayers that if they file returns reflecting this theory that only certain foreign-source income is taxable, they may be subject to penalties including, but not limited to, the accuracy-related penalty under section 6662 and the frivolous return penalty under section 6702. Under some circumstances, taxpayers adopting this position on tax returns may be subject to additional sanctions, including failure to file or pay penalties under section 6651 and civil fraud penalties under section 6663, and may be prosecuted for criminal violations of the tax law. [Since Larken Rose has invited the DOJ to prosecute him if they think he is incorrect in his conclusions, why is the IRS still only making threats?] In addition, practitioners advocating this position may be subject, under some circumstances, to the return preparer penalty under section 6694 or aiding and abetting penalties under section 6701, and may be prosecuted for criminal violations of the tax law.

The Internal Revenue Service and the Treasury Department recognize that some taxpayers may have chosen not to file or have filed incorrect tax returns, taking the position that they were not required to report wages or other income earned in the United States for taxation. We [Is that the royal "we"?] advise these taxpayers to take prompt action to file correct returns and to comply with the tax laws. [Translation: "We really want people to go back to ignoring what the law says, and just assume they owe something."] Taxpayers can obtain tax forms, including those necessary to amend previously-filed returns, via the IRS web site (http://www.irs.gov), obtain them through the IRS' TaxFax Services (from a fax machine call: 703-368-9694 (not a toll-free number)), or order the forms by phone: 1-800-TAX-FORM (1-800-829-3676).

[This "notice" may have been, at least in part, an attempt to respond to Operation Honest Inquiry (information about which can be found here). However, it doesn’t answer any of the three questions of that campaign. It’s easy for some IRS employees to assert that everyone’s income is taxable, but when it comes to specifics, they are totally unable to answer. This is because for each of the three questions, they must either directly contradict their own regulations, or admit the truth. Here is a quick summary of the questions, and why they can’t answer them:

1) The first question is: Are 26 USC § 861(b), and the related regulations beginning at 26 CFR § 1.861-8, the sections to use to determine one’s taxable income from sources within the United States? The IRS, including in the above-mentioned "notice," has been completely unable (or unwilling) to answer the simple question of "Should I use these sections to determine my taxable income?" What could be more bizarre than the IRS being unable to tell people what sections to use to determine their taxable income? The reason they cannot answer is this: they must choose between directly contradicting numerous sections of their own regulations (see the above citations), or admitting that people should be using a section which does not show the income of most Americans to be taxable (as shown in the next paragraph).

2) The second question is: When a U.S. citizen lives and works exclusively within the 50 states, and derives all of his income from within the 50 states, do 26 USC § 861(b), and the related regulations beginning at 26 CFR § 1.861-8, show such income to be taxable? Again, the IRS has been unable to answer this question (including in the above-mentioned "notice"). Is it not suspicious that they (again) cannot answer such an obviously relevant question? The reason they cannot answer is this: they must choose between directly contradicting more than 80 years worth of statutes and regulations related to Section 861 and its predecessors (Section 217 of the Revenue Act of 1921 being the most obvious), or admitting that the section for determining "taxable income from sources within the United States" (according to Sections 1.861-1(a), 1.861-1(b), 1.861-8, 1.862-1, and 1.863-1 of the regulations, among others) does not show the income of most Americans to be taxable.

3) The third question is: Should one refer to 26 CFR § 1.861-8T(d)(2) to determine in which situations the "items" of income listed in 26 USC § 61 are excluded for federal income tax purposes? The IRS has been unable (or unwilling) to answer this question as well. The problem is that, while they love to point people to Section 61 (and point them away from everything else), their own regulations specifically say that the "items" listed in Section 61 (e.g. compensation for services) make up "classes of gross income" (26 CFR § 1.861-8(a)(3)), and then specifically instruct the reader to see "paragraph (d)(2) of this section which provides that a class of gross income may include excluded income" (26 CFR § 1.861-8(b)(1)). The reason they cannot answer the question is that when the regulations then list in which circumstances the "items" are not exempt for federal income tax purposes (i.e. when they are taxable), the income of most Americans is not on the list (see 26 CFR § 1.861-8T(d)(2)(iii)).

Perhaps now you understand why hundreds of Congressmen, Senators, and IRS officials, have been unable or unwilling to answer even a single one of these questions, more than a month and a half after Operation Honest Inquiry started. And while the IRS’ "notice" is a fine piece of scare-tactic propaganda, it still does not address the substance of the issue, or answer the crucial questions. Their over-generalized baseless assertions, and avoidance of specific questions, would be akin to this:

Prosecutor: "Where were you on October 7th, at 5:20 p.m.?"
Defendant: "I didn’t kill Fred, and your accusation is frivolous."
Prosecutor: "Were you at Fred’s house that day?"
Defendant: "I didn’t kill Fred, and your accusation is frivolous."
Prosecutor: "Did you know Fred?"
Defendant: "I didn’t kill Fred, and your accusation is frivolous."
Prosecutor: "Is this your knife?"
Defendant: "I didn’t kill Fred, and your accusation is frivolous."
Prosecutor: "Can you explain why your fingerprints are on the knife?"
Defendant: "I didn’t kill Fred, and your accusation is frivolous."
(etc.)

If the income of most Americans really is taxable, then the IRS should have no problem at all ANSWERING THE SPECIFIC QUESTIONS. So what’s the problem?