How Federal Income Tax Works

This post expands on a comment I made to another post.

The federal income tax is confusing to many people.  Like everything else, it’s easier to grasp if you know the basic principles.  The general idea is to tax income, but only once.  First, you have to define “income,” then specify exemptions, and finally set tax rates according to your revenue expectations (“you” and “your” here referring to Congress).

The stupidest thing I did in law school was sneak into tax class late without having read the assignment.  The professor nailed me good.  He said, “Mr. Rabbit, what is ‘income’?”  I blurted out the first words popping up between my ears, viz., “Everything that comes in?”  The classroom instantly erupted in paroxyms of mirth.  I was clueless, until after class, another student explained that just before I arrived the professor explained the tax code’s definition of “income” and then said, “Just wait, I’ll ask this question on a quiz, and some idiot will say ‘everything that comes in.'”  I learned three important lessons that day:  (1)  Get to class on time, (2) read the f—— assignment, and (3) the tax code has its own definition of “income” which is different from the vernacular meaning of “income.”

There’s no shortcut to figuring out whether the money that came in last year is tax income.  Either read the 1040 instructions or hire a tax preparer to do it for you.  The closest I can come to a general definition of tax income is that the IRS usually considers profit and compensation to be income for tax purposes.  I’ll give you an example of what isn’t “income” for tax purposes:   If you get run over by a bus, sue Metro, and get a $50,000 personal injury settlement, that’s not income.  It’s property.  You simply exchanged one type of property (body parts) for another type of property (cash).

Lots of income is exempt from taxation, but unless you’re a big corporation or rich enough to buy a congressman, most exemptions don’t apply to you.  Remember that earlier business of violently revolting over “taxation without representation?”  To avoid that, the new regime bestows on the masses a lunch money exemption.  They don’t want you to have any representation in Congress, so as a compromise, they give you some minor relief from taxation, consisting of a “personal exemption” of $3,650 and a “standard deduction” of $6,100, for a total exemption of $9,750 per person, except kids get only $3,650, because they don’t vote and therefore don’t have to be appeased as much.  (These amounts, which change yearly, are for 2014.)  From this you’re expected to pay rent, buy food and clothing, pay for transportation to a job, education and medical care, and all of your personal expenses.  It seems to work for keeping the Bolsheviks at bay, which is its purpose.

After defining “income” and setting some of it aside, the government taxes what remains.  Well, not quite, because we haven’t covered all the exceptions yet.  Let’s start with corporations.  As you know, tort law thinks of corporations as separate from the shareholders who theoretically own them but in practice have no say in their policies, just as ordinary voters have no say in our government’s policies.  Establishing that separation is the whole point of incorporating, so if a corporation sells you a car with a defective ignition switch that sets the car on fire, the corporation is liable for your injuries but the shareholders aren’t because they’re different people.  It works the same way for taxes.  After the definition of “income” and all the exemptions and deductions are worked through, if a corporation has taxable income, a federal corporate income tax takes part of it for the government, unless the corporation is able to avoid those taxes through various complicated strategems not available to wage earners or other individual citizens.  Then, if the corporation pays some of what’s left to its shareholders as dividends, the federal individual income tax takes part of it for the government, except when very rich shareholders who also own shares of Congress are able to get exemptions not available to the rest of us.  Some people argue this is double taxation of corporate profits, but no, it’s not, because the corporation and the shareholder are different people so each is being taxed only once.  Some shareholders, especially those with a lot of money, whine about it anyway; so Congress appeases them by giving shareholders much lower tax rates than wage earners get.  This has the possibly unintended consequence of disincentivizing work, but Congress can ignore that because workers have no say in anything anyway.

For definitional purposes, the tax code makes a distinction between “income” and “capital gains.”  I’m not a tax expert, so I don’t know whether the tax code considers capital gains a type of income, or a different beast altogether.  Capital gains are what happens when you exchange one type of property (e.g., real estate or stock) for another type of property (e.g., cash) and get an increase of property in the exchange.  For example, let’s say you bought stock for $10,000 and sell it for $15,000.  I think of the $5,000 profit as income, and so does the tax code.  But like dividends, capital gains get a lower tax rate, because the people who benefit from capital gains are represented in Congress and you’re not.  Still, the basic principle of taxing income once, and only once, applies here.  Even though this type of income enjoys a lower tax rate, it’s not exempt, except for the huge part of it that is.

Most very large estates consist mostly of capital gains that haven’t been taxed yet.  The death of the taxpayer puts these untaxed gains out of reach of the income tax permanently.  The estate tax isn’t simply an income tax by another name.  It’s a tax on property, not on income.  Sometimes it hits wealth on which income taxes were paid, which effectively gets taxed twice.  But the system of taxing estate property in lieu of taxing income is far more likely to produce huge windfalls of tax savings for heirs and beneficiaries.  To the extent the estate tax imposes exactions on previously untaxed gains, the principle of taxing income once, and only once, remains intact; but in practice this is shredded by the huge exemptions from estate taxes that result in billions of dollars of capital gains never being taxed by either the income tax or estate tax.

The estate tax doesn’t kick in when the estate goes to a spouse, but this only defers the estate tax and doesn’t avoid it.  If the estate goes to a charity, taxes are permanently avoided.  Otherwise, for the 2014 tax year, the first $5.34 million of estate property is exempt, and to the extent this property consists of untaxed gains, that income is tax-free forever.  (The heirs won’t owe taxes on those gains when they sell the property, because they get a basis step-up that erases those gains, but they will owe taxes on gains that accrue after they get the property, unless some exemption of shelter of their own protects the new gains from taxation.)

Some people argue the estate tax should be abolished.  Fair enough, but if that happens, the basis step-up should also be abolished, and heirs should pay taxes on previously untaxed gains.  There’s no logical reason why heirs should get an exemption from capital gains taxes that nobody else gets.  An idea I like even better is heirs paying income taxes on inheritances — let’s just abolish the estate tax and treat inheritances like any other income.  At least, you can use that argument to shut up people who think inherited wealth should be exempt from both income taxes and estate taxes, and shouldn’t be taxed at all.  The lost tax revenue would have to be made up by raising taxes on wage earners, or cutting government services that benefit the non-wealthy.  

So there you have it.  The IRS taxes income only once, except for income that’s taxed twice or isn’t taxed at all.  Simple, huh?  I told you it was.  If you still don’t understand, then I suggest you give up and pay a CPA to fill out your tax forms for you.  Mine charges me $600 to do my tax return.  What?  You’re surprised I don’t prepare my tax return myself?  Well, that’s so he’ll be the one who goes to jail if it isn’t done right.  I’m going to plead ignorance of the lawRoger Rabbit icon.           








0 Comments Add Yours ↓

  1. theaveeditor #

    So, Mr. Bunny

    Why not have a wealth tax?

    After all we already tax real estate and luxury good, but why not tax anything stuff that does not … the noble words of the right … “create jobs.?”

    Say .. yachts and too big homes and pied a terre and wine collection and personal space ports (Bezos) and gold and Teslas and Lambos and money in bank accounts (esp. foreign banks and ,,, oh yeh foundations!

    Now I know our answer will be because the animals that owns THAT stuff are better than plan folks! Sure nuff, but wasn’t it Lenin who said from each as they got it to each as needs it?

  2. Roger Rabbit #

    Don’t look at me! I’m not the schmuck who decided to tax income instead of wealth. I wasn’t even around then.

  3. theaveeditor #

    Sure you were. Pookah are immortal and like dogs, always guilty of whatever humans need someone to blame.

  4. Roger Rabbit #

    Ha. I see how that works. No surprise there.

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