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Concepts Underlying the U.S. Tax Code.

Updated on October 18, 2010

The U.S. federal income tax is one of the most complex pieces of legislation ever written. People build high-paying careers based on trying to unravel and interpret the tax code. I’ve spoken to IRS agents that directly admit that even they don’t always know exactly what the code intends. This helps explain why, in addition to the Internal Revenue Code of 1986, there are Treasury Regulations, revenue rulings, private letter rulings, tax memorandum, as well as Tax Court rulings that all try to shed light on this convoluted piece of writing. It seems strange that something so basic to good government should be so very complex and today there are hundreds of thousands of people who all claim to have a better solution. Why so complicated though? The code is built around some broad general concepts that set the tone for the tax rules.  If you do your own taxes, or are just interested in tax research, you these concepts are the place to start building your knowledge.

No relation

Ability-To-Pay Concept

The first important concept to understand is the ability-to-pay. It sounds simple: the tax code is structured so that taxes levied on a taxpayer should be based on the amount a taxpayer can actually pay. The effect of this concept is that you don’t pay taxes based on just income, but rather on net income, total income less deductions. Losses suffered from casualty or business reduces your income and thus your ability to pay. Similarly, the more children you have, the less you can afford to pay.

A second effect of this is the progressive tax system. Now, I know there are a number of complaints with the progressive tax system. Many argue that citizens that make more money shouldn’t have to shoulder a greater portion of the burden. (I would point out that these comments are usually NOT attributed to the top 1% richest people who pay 85% of the nation’s taxes. It’s usually the upper-middle class.)  The progressive tax rate reflects the fact that those who make more money can afford to pay more tax.

Administrative Convenience Concept

Do you keep track of every penny you make when you do your budget? Of course not, there are some things you spend money on that don’t really impact your financial situation, for instance change for gumballs. Keeping track of your gumball spending probably isn’t worth the money you might save. The federal government feels the same way. For instance, any benefit you receive from your employer is considered to be income, right? What about the free coffee you get in the break room? Technically, this is a benefit and should be considered part of your annual income. But how do either you or the company keep track of how many cups of coffee you drink annually? More importantly, is the revenue generated by tracking your coffee benefit going to out-weigh the cost of keeping track of it. When you drink as much coffee as I do, the answer is maybe, but for most of us, probably not. So there are some items that, for the sake of administrative convenience, the IRS doesn’t require you to keep track of.

It’s this same concept that the standard deduction for individuals was developed. For many of us who don’t spend a lot on medical expenses or who don’t own a home or don’t drive, it isn’t worth the time and expense to try and keep track of what little we spend for tax purposes. And so, in order to allow taxpayers to include these small amounts against their income, the standard deduction was implemented.

Arm’s-Length Transaction Concept

The federal government has no objection to its citizens trying to minimize the amount of tax due at the end of the year. What they object to is either breaking the law to avoid taxes or manipulating transactions in ways that fail to reflect the economic reality of the transaction. The arms-length transaction concept is based on the idea that transactions are completed in a way such that bargaining is done in good faith and for their individual benefit, not for the benefit of the whole group. Failure to abide by this concept can result in failing to gain any tax effect or not gaining the intended effect. An example might help clarify this.

Let’s say that John is a sole proprietor of the Feats of Strength Shoe Company. He has a piece of equipment that he bought for $10,000 and is currently worth $12,000. He sells the equipment to the company for $500 and puts the $11,500 loss on his Form 1040, schedule C.  Six months later he gets a letter from the IRS saying that the loss is disallowed and they are going to be stopping by to visit soon. In essence, what he did was to sell the piece of equipment to himself, since he is the sole owner of the business. What if he had sold it to his grandmother? Still a related party transaction, disallowed.

What are the guidelines you need to know? Who’s considered to be a related party?

  1. Family members:  Self, spouse, siblings, descendants (children and grandchildren), and ancestors (parents and grandparents).
  2.  Sales between an individual and a corporation or partnership if the individual owns more than 50% of the business. Why 50%? Generally a partner who owns 50% of a business is considered to be in control of the business.
  3. Transactions between a corporation and a partnership, if an individual owns more than 50% of both businesses.

What if our friend John only owns 20% of the business while his wife and best friend both control 40%? Under constructive ownership rules, John and his wife are essentially one entity who therefore control 60% of the company.

Pay-As-You-Go Concept

There is a fundamental truth that the government doesn’t want you to know! Much like law enforcement the income tax system works by voluntary compliance. And the majority of Americans comply with it. They understand the value they receive from their taxes, like highways and national defense. In order to aid this compliance, taxes are collected periodically throughout the year through withholding and quarterly estimated tax payments. For people receiving salaries from an employer, regular deductions for withholding help implement this concept. For the self-employed, contract employees or Social Security beneficiaries, this may not be as easy. Instead, the IRS requires estimated quarterly payments for those whose tax liability is at least $1,000.

So these are the four general concepts that guide our tax laws. In theory, law makers use these as they build amendments to the IRC. As you can no doubt guess, too often these concepts are thrown out in favor of short sighted changes that are intended to benefit special interest groups. At least now you know what the underlying concepts are and if you find yourself discussing tax issues with your state’s Representative, or doing some research on a tax issue, you’ll know what to look for as you build your case.


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    • Dark knight rides profile imageAUTHOR

      Dark knight rides 

      7 years ago from Denver

      What I'm talking about here are the concepts that underlie the IRC. These are not specifically codified, but rather are part of the historical discussion on what factors must be considered as the code was developed.

      "Singly out taxpayers by the ability to pay should be an unequal protection issue." -- In theory, this means that there is no favoritism and everyone pays relative to what they earn.

      The income tax is constitutional. No valid argument has ever been made to contest it.

      "The IRS can issue warrants and take property without ever going to a federal judge." -- They do have to get a court order, and they do before seizing assets. They have no more jurisdiction to take personal property without court order than any other government entity.

      "Requiring you to sign your tax return under penalty of perjury should be a violation of the fifth amendment." -- It can't be perjury if you don't lie. If you make a good faith effort to fill out your taxes and pay them, then perjury should never come up.

      "Also the requirement that you disclose all your income including those acquired from illegal acts should also be a violation of the 5th amendment." -- The IRC could care less how you earn your money as long as it's properly accounted for. Don't engage in illegal activity and it shouldn't be an issue.

      "None of these arguments has had the blessings of the courts." -- Actually, many of these specific issues have been brought to the court and have been settled for the government.

      "With the million of so words in the Internal Revenue Code the tax system is not only highly invasive of your privacy, it is also very complex." -- Yes, it is invasive. Yes, it is complex. But as I tell the people I work with, the rules are there because some one messed it up for the rest of us by manipulating the spirit of the law.

      "The IRS enforces it code with criminal sanctions." -- Yes, if you are deemed to have committed fraud on your return, you can face criminal prosecution.

      "Obama and his congress want to ADD the sales tax to the income tax." -- Show me where he's said that. The proposal to change from an income to a sales tax has been presented. Realize that this means you pay regardless of what your income is, which means that on everyday goods, the poor get taxed more heavily than the middle and upper class. Or rather the effect of the tax is greater on the people making less money.

      Thank you for your input, OpinionDuck. I do enjoy the discussions.

    • OpinionDuck profile image


      7 years ago


      Where do you base your statement that Income Tax is based on a pay as you go basis. Is it in the code or the 16 amendment?

      as for the progressive tax aspect

      the Income Tax skirts a few constitutional issues and has had the support of the Supreme Court.

      Singly out taxpayers by the ability to pay should be an unequal protection issue.

      Also the IRS can create due process where none is ever given.

      The IRS can issue warrants and take property without ever going to a federal judge.

      Requiring you to sign your tax return under penalty of perjury should be a violation of the fifth amendment.

      Without that signature, your tax return is deemed incomplete.

      Also the requirement that you disclose all your income including those acquired from illegal acts should also be a violation of the 5th amendment.

      None of these arguments has had the blessings of the courts.

      With the million of so words in the Internal Revenue Code the tax system is not only highly invasive of your privacy, it is also very complex.

      The IRS enforces it code with criminal sanctions.

      This whole system could be replaced and I say replaced with a national sales tax. The state sales tax mechanism can be used for the federal sales tax. It would be clean, simple and taxes would be paid on the spot.

      Obama and his congress want to ADD the sales tax to the income tax.

      This country rebelled against England for taxation without representation and double taxation.

      Today we would be happy to go back to just double taxation, as well as taxation without representation.

      BTW, social security for a self employed single person business is a SS tax ripoff. In your example of the single owner selling the equipment the government looks at it one way, and when it comes to SS tax they look at it another way. Both ways favor the government.



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