income tax

n.
A tax levied on net personal or business income.

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annual tax on income levied by the federal government and by certain state and local governments. There are two basic types: the personal income tax, levied on incomes of households and unincorporated businesses, and the corporate (or corporation) income tax, levied on net earnings of corporations.
Under present tax law, there are six tax brackets for individual taxpayers: 10%, 15%, 25%, 28%, 33%, and 35%. The level of Taxable Income for each bracket differs according to filing status (such as married filing jointly, singles, or heads of household) and is revised slightly every year. Long-term capital gains receive preferential tax treatment both for individuals and corporations. Assets held for more than 12 months are taxed at a top rate of 15%, versus a top rate of 35% for short-term gains on assets held for 12 months or less. Because capital gains rates reward taxpayers in a position to take risks, and because loopholes and tax shelters enable the wealthiest corporations and individuals to escape the higher tax brackets, the progressiveness of the tax system has often been more theoretical than real.
There have been many sweeping changes in the tax code, creating an enormous amount of complexity. In 1998, the internal revenue service restructuring and reform act of 1998 instituted numerous changes in the way the Internal Revenue Service conducts business, including shifting the burden of proof from taxpayers to the IRS in court disputes over the amount of taxes owed by a taxpayer. The progression of changes in the tax code is described in great detail in other Dictionary entries, including: economic growth and tax relief reconciliation act of 2001; economic recovery tax act of 1981 (ERTA); energy tax incentives act of 2005; internal revenue service restructuring and reform act of 1998; jobs and growth tax relief reconciliation act of 2003; revenue reconciliation act of 1993; military family tax relief act of 2003; tax equity and fiscal responsibility act of 1982 (TEFRA); tax reform act of 1976; tax reform act of 1984; tax reform act of 1986; taxpayer relief act of 1997; and the working families tax relief act of 2004.

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Questions involving federal income taxes provoked extraordinary controversy throughout the nineteenth century, most strikingly in the 1890s. The controversy ended only with the passage of the Sixteenth Amendment in 1913.

Federal income taxes raised two types of constitutional issues. First, the Supreme Court had to decide, for constitutional purposes, whether an income tax was a “direct tax” or an “indirect tax.” This distinction was critical, since the Constitution commanded that direct taxes had to be apportioned among the several states “in proportion to the Census.” If an income tax were considered a direct tax, it would be unconstitutional since it could not be apportioned. Second, even if an income tax were considered an indirect tax, it still needed to be “uniform” and had to fulfill a variety of other constitutional requirements. The latter requirement was interpreted to apply only to geographic uniformity and was held not to require that a tax be uniform as applied to different individuals with different income levels.

The Supreme Court upheld the Civil War income tax, holding in Springer v. United States (1881) that such a tax was indirect and need not be apportioned. The Springer Court followed a 1796 precedent, Hylton v. United States, which had upheld a carriage tax on the grounds that it was an indirect tax. The fact that a carriage tax could not be apportioned convinced the Court to declare the tax indirect; Justice James Iredell held that “the Constitution contemplated [no tax] as direct, but such as could be apportioned” (p. 181). In Springer, the Court held that the only direct taxes contemplated by the Constitution were “capitation taxes … and taxes on real estate” (p. 586).

In 1895, the income tax issue arose again, this time in a period of extreme political tension. In the midst of the populist movement, conservatives seized upon the tax issue as a question of great moral importance. “The act of Congress which we are impugning before you is communistic in its purposes and tendencies,” argued Joseph Choate before the Supreme Court in *Pollock v. Farmers' Loan & Trust Co. (1895; p. 537). Failure to strike down the tax, Choate told the justices, would endanger “the very keystone of the arch upon which all civilized government rests” (p. 534). The Court's first decision in Pollock, in April 1895, produced a deadlock on the key issues, with the justices divided 4 to 4 on whether the income tax was a direct tax per se and thus unconstitutional. (Justice Howell Jackson, who was ill, did not participate.)

The Court then held another set of hearings, and two weeks later produced a 5‐to‐4 decision striking down the tax on the grounds that income taxes were, per se, direct taxes. Surprisingly, Jackson was in the minority, meaning that one of the four justices who had voted to uphold the tax in the first Pollock decision had switched his vote. The political consequences of the Court's decision were significant. It energized the conservative wing of the Democratic party, providing the key momentum for the conservatives' subsequent takeover of the party at the 1896 convention.

Confusion on whether an income tax was or was not a direct tax continued even after Pollock. In Flint v. Stone (1911) the Court upheld a tax on the income of corporations as an indirect tax on the privilege of doing business in the corporate form. Finally, in 1913, the states ratified the Sixteenth Amendment, explicitly granting to Congress the 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.”

Only technical questions remained—concerning, for example, the definition of income under the Sixteenth Amendment. Federal taxing power, of course, remains subject to other constitutional requirements, including due process, equal protection, and other guarantees.

See also Taxing and Spending Clause.

— William Lasser

Income tax was introduced in 1799 by William Pitt's government to fund the war against the French. The need for a new tax arose from unprecedentedly high expenditure on the British armed forces and on subsidies to the allies. Many supposed that income tax would be a temporary expedient of war and in fact Parliament repealed the tax in 1816 and ordered the commissioners for the affairs of taxes to destroy their records.

Raising revenues continued to present problems to chancellors of the Exchequer. In 1842 Sir Robert Peel proposed that ‘for a time to be limited, the income of the country shall be called upon to contribute to remedying this growing evil [the deficit]’. No chancellor since 1842 has removed income tax.

Although Disraeli proposed, in 1853, the abolition of income tax by 1860, the expense of the Crimean War encouraged Gladstone to keep it. Government expenditures on defence continued to rise and after 1906 the cost of defence and social welfare increased rapidly. David Lloyd George's ‘People's Budget’ of 1909 imposed, for the first time, income tax with rates varying according to the ability to pay. During the First World War alterations in the rates of tax on incomes offset some costs of warfare. The highest personal rate was known popularly as ‘supertax’ and the prosperity of firms involved in wartime activities incurred Excess Profits Duty.

Although changes in the rates of income tax occurred between the two world wars, the Second World War required both more revenue and limits on demand inflation. This latter threat arose from higher wages seeking inadequate quantities of goods and services. The year 1941 saw the introduction of a new type of levy, reimbursable post-war credits, at the rate of 10s.

(50p) in the pound, to enforce savings. Repayment was slow; many taxpayers waited as long as 20 years for their money. Simultaneously the surtax rate increased to 19s. 6d. in the pound. Since 1945 reductions in the standard rate have occurred, although rates have always remained above those of peacetime in earlier periods.

The personal income tax in its present form was first levied by the federal government in 1913. The rate was 1 percent on taxable net income above $3,000 ($4,000 for married couples), less deductions and exemptions. It rose gently to a top rate of 7 percent on incomes above $500,000. The law was class legislation and deliberately so.

The idea was not new. The biblical tithe was an income tax payable in commodities. The British introduced the modern form of the tax during the Napoleonic Wars, and the U.S. Treasury considered an income tax at the time of the War of 1812. The Civil War brought a tax on personal income for the first time, with rates ranging from 3 to 5 percent. This was a historic step in the development of the American federal tax system, but it was phased out by 1872. From then until 1913 the major support of the government came from import duties and excise taxes. Collection of these taxes was entrusted to the Bureau of Internal Revenue, which had been established in 1862. After evidence of irregularities in the bureau surfaced in 1953, the agency underwent a sweeping reorganization and the name was changed to the Internal Revenue Service (irs).

Rising farm and labor discontent had culminated in 1894 in an attempt to write a peacetime tax into law. Although hard times returned in the nineties, the Congress, under pressure from important trade associations, passed the Wilson-Gorman tariff bill in 1894, which included an income tax. Personal exemption was high at four thousand dollars, and the 2 percent rate of the income tax was not graduated. Several months after the tax was enacted, a conservative Supreme Court declared the tax unconstitutional in the Pollock v. Farmers' Loan and Trust Company on the basis that it posed a "communistic threat" to property. Sentiment favorable to the tax gathered such momentum during the Progressive Era, however, that President William Howard Taft in 1909 proposed submitting the question of amending the Constitution to the states. An amendment was drafted giving Congress the authority to impose taxes on the proceeds of any lawful business without apportionment according to population or equal treatment of all taxpayers. By February 1913 the tax amendment--the Sixteenth--had the approval of the required three-fourths of the states. Three years later the word lawful was dropped from a new revenue law. Since 1916 the Treasury has collected on unlawful gains whenever possible.

Support for the amendment came from a coalition of those reluctant to force another Court review, of progressives alarmed by the rapid concentration of industrial wealth, and of some conservatives who felt that the government needed an elastic and reliable system of revenue to cope with national emergencies. From 1913 to the present both major political parties have accepted the desirability of a progressive tax on individuals, although the proper degree of graduation remains a source of intense debate and has led to adjustments and technical corrections in the U.S. Tax Code, which now runs to more than two thousand pages.

During World War I rates rose in an almost vertical ascent to 77 percent. During the prosperous 1920s the tax structure was scaled down, only to be reversed by huge Treasury deficits during the depression years. With the entry of the United States into World War II, taxation once again became directly connected with national survival and the top rate reached 91 percent. In 1943 Congress imposed a withholding system on income tax payers, making collections easier and doubling the government's yield in the first year, an important revenue boost during the war. Although Roosevelt vetoed the withholding bill as neglectful of the welfare of the low- and medium-income groups, the bill became law without his signature. At the same time, however, exemptions were lowered and the base broadened so that what had been a class tax became a mass tax. This can be seen in the numbers of people required to pay in two significant years: in 1939, 4 million people and in 1945, 42.7 million. Today the reach of the tax is shown in figures for 1989 indicating that the irs processed 107.7 million individual returns. This number will rise, the agency estimates, to 118.3 million in 1995. By a wide margin, the income tax is the largest single source of federal receipts.

After World War II income taxes were moderately reduced, only to rise again during the Korean War. Laws enacted during the 1960s and 1970s increased the progressiveness of income tax through reforms designed to achieve equality of sacrifice. This is not a precise concept, however. Abstract justice becomes hard to discern in the thicket of deductions, credits, subsidies, and exemptions, all of which were patched into the Tax Code for the best of reasons--to balance colliding interests fairly. The result: a vast accumulation of precedents, administrative rulings, and case law. Moreover, the code must be framed complexly to counter the machinations not merely of average citizens but of the cleverest adversaries the law schools can produce, many of whom are alumni of the irs itself. As a result, some 40 percent of all who file seek the services of professional tax preparers and simplification remains a distant and probably unattainable goal.

During the 1980s and especially after the passage of the Tax Reform Act of 1986, the progressive feature of the income tax was sharply curtailed. Yet the idea of taxation based upon the theory that the wealthy should contribute not proportionately but according to their ability to pay appeals intuitively to most people. An opposing view, however, is advanced vigorously by conservative economists and high-income taxpayers. It holds that the general welfare is best promoted when the affluent are lightly taxed and so are encouraged to save and invest. For more than seven decades this proposition has been articulated in hearings held before the House Ways and Means Committee where revenue bills originate. The weight of such testimony is evident in the present attrition of the principle of graduation.

Taxation is a political act involving controversial decisions arrived at through the democratic process. Fairness at any given time is what the law says it is. We shall never be certain that we are not paying too much and someone else too little. That is why, as Edmund Burke reminded the British Parliament in his famous speech on taxing the colonists, "to tax and to please, no more than to love and be wise, is not given to men."

Bibliography:

David F. Bradford, Untangling the Income Tax (1986); Gerald Carson, The Golden Egg: The Personal Income Tax: Where It Came from, How It Grew (1977).

Author:

Gerald Carson

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This entry contains information applicable to United States law only.

A charge imposed by government on the annual gains of a person, corporation, or other taxable unit derived through work, business pursuits, investments, property dealings, and other sources determined in accordance with the Internal Revenue Code or state law.

Taxes have been called the building block of civilization. In fact, taxes existed in Sumer, the first organized society of record, where their payment carried great religious meaning. Taxes were also a fundamental part of ancient Greece and the Roman Empire. The religious aspect of taxation in Renaissance Italy is depicted in the Brancacci Chapel, in Florence. The fresco Rendering of the Tribute Money depicts the gods approving the Florentine income tax. In the United States, the federal tax laws are set forth in the Internal Revenue Code and enforced by the Internal Revenue Service (IRS).

History

The origin of taxation in the United States can be traced to the time when the colonists were heavily taxed by Great Britain on everything from tea to legal and business documents that were required by the Stamp Tax. The colonists' disdain for this taxation without representation (so-called because the colonies had no voice in the establishment of the taxes) gave rise to revolts such as the Boston Tea Party. However, even after the Revolutionary War and the adoption of the U.S. Constitution, the main source of revenue for the newly created states was money received from customs and excise taxes on items such as carriages, sugar, whiskey, and snuff. Income tax first appeared in the United States in 1862, during the Civil War. At that time only about one percent of the population was required to pay the tax. A flat-rate income tax was imposed in 1867. The income tax was repealed in its entirety in 1872.

Income tax was a rallying point for the Populist party in 1892, and had enough support two years later that Congress passed the Income Tax Act of 1894. The tax at that time was two percent on individual incomes in excess of $4,000, which meant that it reached only the wealthiest members of the population. The Supreme Court struck down the tax, holding that it violated the constitutional requirement that direct taxes be apportioned among the states by population (Pollock v. Farmers' Loan & Trust, 158 U.S. 601, 15 S. Ct. 912, 39 L. Ed. 1108 [1895]). After many years of debate and compromise, the Sixteenth Amendment to the Constitution was ratified in 1913, providing Congress with the power to lay and collect taxes on income without apportionment among the states. The objectives of the income tax were the equitable distribution of the tax burden and the raising of revenue.

Since 1913 the U.S. income tax system has become very complex. In 1913 the income tax laws were contained in eighteen pages of legislation; the explanation of the Tax Reform Act of 1986 was more than thirteen hundred pages long (Pub. L. 99-514, Oct. 22, 1986, 100 Stat. 2085). Commerce Clearing House, a publisher of tax information, released a version of the Internal Revenue Code in the early 1990s that was four times thicker than its version in 1953.

Changes to the tax laws often reflect the times. The flat tax of 1913 was later replaced with a graduated tax. After the United States entered World War I, the War Revenue Act of 1917 imposed a maximum tax rate for individuals of 67 percent, compared with a rate of 13 percent in 1916. In 1924 Secretary of the Treasury Andrew W. Mellon, speaking to Congress about the high level of taxation, stated,

The present system is a failure. It was an emergency measure, adopted under the pressure of war necessity and not to be counted upon as a permanent part of our revenue structure… . The high rates put pressure on taxpayers to reduce their taxable income, tend to destroy individual initiative and enterprise, and seriously impede the development of productive business… . Ways will always be found to avoid taxes so destructive in their nature, and the only way to save the situation is to put the taxes on a reasonable basis that will permit business to go on and industry to develop.

Consequently, the Revenue Act of 1924 reduced the maximum individual tax rate to 43 percent (Revenue Acts, June 2, 1924, ch. 234, 43 Stat. 253). In 1926 the rate was further reduced to 25 percent.

The Revenue Act of 1932 was the first tax law passed during the Great Depression (Revenue Acts, June 6, 1932, ch. 209, 47 Stat. 169). It increased the individual maximum rate from 25 to 63 percent, and reduced personal exemptions from $1,500 to $1,000 for single persons, and from $3,500 to $2,500 for married couples. The National Industrial Recovery Act of 1933 (NIRA), part of President Franklin D. Roosevelt's New Deal, imposed a five percent excise tax on dividend receipts, imposed a capital stock tax and an excess profits tax, and suspended all deductions for losses (June 16, 1933, ch. 90, 48 Stat. 195). The repeal in 1933 of the Eighteenth Amendment, which had prohibited the manufacture and sale of alcohol, brought in an estimated $90 million in new liquor taxes in 1934. The Social Security Act of 1935 provided for a wage tax, half to be paid by the employee and half by the employer, to establish a federal retirement fund (Old Age Pension Act, Aug. 14, 1935, ch. 531, 49 Stat. 620).

The Wealth Tax Act, also known as the Revenue Act of 1935, increased the maximum tax rate to 79 percent, the Revenue Acts of 1940 and 1941 increased it to 81 percent, the Revenue Act of 1942 raised it to 88 percent, and the Individual Income Tax Act of 1944 raised the individual maximum rate to 94 percent.

The post-World War II Revenue Act of 1945 reduced the individual maximum tax from 94 percent to 91 percent. The Revenue Act of 1950, during the Korean War, reduced it to 84.4 percent, but it was raised the next year to 92 percent (Revenue Act of 1950, Sept. 23, 1950, ch. 994, Stat. 906). It remained at this level until 1964, when it was reduced to 70 percent.

The Revenue Act of 1954 revised the Internal Revenue Code of 1939, making major changes that were beneficial to the taxpayer, including providing for child care deductions (later changed to credits), an increase in the charitable contribution limit, a tax credit against taxable retirement income, employee deductions for business expenses, and liberalized depreciation deductions. From 1954 to 1962, the Internal Revenue Code was amended by 183 separate acts.

In 1974 the Employee Retirement Income Security Act (ERISA) created protections for employees whose employers promised specified pensions or other retirement contributions (Pub. L. No. 93-406, Sept. 2, 1974, 88 Stat. 829). ERISA required that to be tax deductible, the employer's plan contribution must meet certain minimum standards as to employee participation and vesting and employer funding. ERISA also approved the use of individual retirement accounts (IRAs) to encourage tax-deferred retirement savings by individuals.

The Economic Recovery Tax Act of 1981 (ERTA) provided the largest tax cut up to that time, reducing the maximum individual rate from 70 percent to 50 percent (Pub. L. No. 97-34, Aug. 13, 1981, 95 Stat. 172). The most sweeping tax changes since World War II were enacted in the Tax Reform Act of 1986. This bill was signed into law by President Ronald Reagan and was designed to equalize the tax treatment of various assets, eliminate tax shelters, and lower marginal rates. Conservatives wanted the act to provide a single, low tax rate that could be applied to everyone. Although this single, flat rate was not included in the final bill, tax rates were reduced to 15 percent on the first $17,850 of income for singles and $29,750 for married couples, and set at 28 to 33 percent on remaining income. Many deductions were repealed, such as a deduction available to two-income married couples that had been used to avoid the "marriage penalty" (a greater tax liability incurred when two persons filed their income tax return as a married couple rather than as individuals). Although the personal exemption exclusion was increased, an exemption for elderly and blind persons who itemize deductions was repealed. In addition, a special capital gains rate was repealed, as was an investment tax credit that had been introduced in 1962 by President John F. Kennedy.

The Omnibus Budget Reconciliation Act of 1993, the first budget and tax act enacted during the Clinton administration, was vigorously debated, and passed with only the minimum number of necessary votes (Pub. L. No. 103-66, Aug. 10, 1993, 107 Stat. 312). This law provides for income tax rates of 15, 28, 31, 36, and 39.6 percent on varying levels of income and for the taxation of Social Security income if the taxpayer receives other income over a certain level.

Since the early 1980s, a flat-rate tax system rather than the graduated bracketed method has been proposed. (The graduated bracketed method is the one that has been used since graduated taxes were introduced: the percentage of tax differs based on the amount of taxable income.) The flat-rate system would impose one rate, such as 20 percent, on all income and would eliminate special deductions, credits, and exclusions. Despite firm support by some, the flat-rate tax has not been adopted in the United States.

Computation of Income Tax

Regardless of the changes made by legislators since 1913, the basic formula for computing the amount of tax owed has remained basically the same. To determine the amount of income tax owed, certain deductions are taken from an individual's gross income to arrive at an adjusted gross income, from which additional deductions are taken to arrive at the taxable income. Once the amount of taxable income has been determined, tax rate charts determine the exact amount of tax owed. If the amount of tax owed is less than the amount already paid through tax prepayment or the withholding of taxes from paychecks, the taxpayer is entitled to a refund from the IRS. If the amount of tax owed is more than what has already been paid, the taxpayer must pay the difference to the IRS.

Gross Income

The first step in computing the amount of tax liability is the determination of gross income. Gross income is defined as "all income from whatever source derived," whether from personal services, business activities, or capital assets (property owned for personal or business purposes). Compensation for services in the form of money, wages, tips, salaries, bonuses, fees, and commissions constitutes income. Problems in defining income often arise when a taxpayer realizes a benefit or compensation that is not in the form of money.

An example of such compensation is the fringe benefits an employee receives from an employer. The Internal Revenue Code defines these benefits as income and places the burden on the employee to demonstrate why they should be excluded from gross income. Discounts on the employer's products and other items of minimal value to the employer are usually not considered income to the employee. These benefits (which include airline tickets at nominal cost for airline employees and merchandise discounts for department store employees) are usually of great value to the employee but do not cost much for the employer to provide, and build good relationships between the employee and the employer. As long as the value to the employer is small and the benefit generates goodwill, it usually is not deemed to be taxable to the employee.

The value of meals and lodging provided to an employee and paid for by an employer is not considered income to the employee if the meals and lodging are furnished on the business premises of the employer for the employer's convenience (as when an apartment building owner provides a rent-free apartment for a caretaker who is required to live on the premises). However, a cash allowance for meals or lodging that is given to an employee as part of a compensation package is considered compensation, and is counted as gross income. An employer's payment for a health club membership is also included in gross income, as are payments to an employee in the form of stock. An amount contributed by an employer to a pension, qualified stock bonus, profit-sharing, annuity, or bond purchase plan in which the employee participates is not considered income to the employee at the time the contribution is made, but will be taxed when the employee receives payment from the plan. Medical insurance premiums paid by an employer are generally not considered income to the employee. Although military pay is taxable income, veterans' benefits for education, disability and pension payments, and veterans' insurance proceeds and dividends are not included in gross income.

Other sources of income directly increase the wealth of the taxpayer and are taxable. These sources commonly include interest earned on bank accounts; dividends; rents; royalties from copyrights, trademarks, and patents; proceeds from life insurance if paid for a reason other than the death of the insured; annuities; discharge from the obligation to pay a debt owed (the amount discharged is considered income to the debtor); recovery of a previously deductible item, which gives rise to income only to the extent the previous deduction produced a tax benefit (this is commonly referred to as the tax benefit rule and is most often used when a taxpayer has recovered a previously deducted bad debt or previously deducted taxes); gambling winnings; lottery winnings; found property; and income from illegal sources. Income from prizes and awards is taxable unless the prize or award is made primarily in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement; the recipient was chosen, without any action on his or her part, to enter the selection process; and the recipient is not required to render substantial future services as a condition to receiving the prize or award. For example, recipients of Nobel Prizes meet these criteria and are not taxed on the prize money they receive.

In some situations a taxpayer's wealth directly increases through income that is not included in the determination of income tax. For example, gifts and inheritances are excluded from income in order to encourage the transfer of assets within families. However, any income realized from a gift or inheritance is considered income to the beneficiary — most notably rents, interest, and dividends. In addition, most scholarships, fellowships, student loans, and other forms of financial aid for education are not included in gross income, perhaps to equalize the status of students whose education is funded by a gift or inheritance and of students who do not have the benefit of such assistance. Cash rebates to consumers from product manufacturers and most state unemployment compensation benefits are also not included in gross income.

Capital gains and losses pose special considerations in the determination of income tax liability. Capital gains are the profits realized as a result of the sale or exchange of a capital asset. Capital losses are the deficits realized in such transactions. Capital gains and losses are determined by establishing a taxpayer's basis in the property. Basis is generally defined as the taxpayer's cost of acquiring the property. In the case of property received as a gift, the donee basically steps into the shoes of the donor and is deemed to have the same basis in the property as did the donor.

The basis is subtracted from the amount realized by the sale or other disposition of the property, and the difference is either a gain or a loss to the taxpayer.

Capital gains are usually included in gross income, with certain narrow exclusions, and capital losses are generally excluded from gross income. An important exception to this favorable treatment of capital losses occurs when the loss arises from the sale or other disposition of property held by the taxpayer for personal use, such as a personal residence or jewelry. When a capital gain is realized from the disposition of property held for personal use, it is included as income even though a capital loss involving the same property cannot be excluded from income. This apparent discrepancy is further magnified by the fact that capital losses on business or investment property can be excluded from income. Consequently, there have been many lawsuits over the issue of whether a personal residence, used at some point as rental property or for some other income producing use, is deemed personal or business property for income tax purposes.

Taxpayers age fifty-five or older who sell a personal residence in which they have resided for a specific amount of time can exclude their capital gains. This is a one-time exclusion, with specific dollar limits. Consequently, if future, greater gains are anticipated, a taxpayer age fifty-five or older may choose to pay the capital gains tax on a transaction that qualifies for the exclusion but produces smaller capital gains.

Even though a capital gain on a personal residence is realized, it may be temporarily deferred from inclusion in gross income if the taxpayer buys and occupies another home two years before or after the sale, and the new home costs the same as or more than the old home. The gain is merely postponed. This type of transaction is called a rollover. The gain that is not taxed in the year of sale will be deducted from the cost of the new home, thereby establishing a basis in the property that is less than the price paid for the home. When the new home is later sold, the amount of gain recognized at that time will include the gain that was not recognized when the home was purchased by the taxpayer.

Deductions and Adjusted Gross Income Once the amount of gross income is determined, the taxpayer may take deductions from the income in order to determine adjusted gross income. Two categories of deductions are allowed. Above-the-line deductions are taken in full from gross income to arrive at adjusted gross income. Below-the-line, or itemized, deductions are taken from adjusted gross income and are allowed only to the extent that their combined amount exceeds a certain threshold amount. If the total amount of itemized deductions does not meet the threshold amount, those deductions are not allowed. Generally, above-the-line deductions are business expenditures, and below-the-line deductions are personal, or nonbusiness, expenditures.

The favorable tax treatment afforded business and investment property is also evident in the treatment of business and investment expenses. Ordinary and necessary expenses are those incurred in connection with a trade or business. Ordinary and necessary business expenses are those that others engaged in the same type of business incur in similar circumstances. With regard to deductions for expenses incurred for investment property, courts follow the same type of "ordinary-and-necessary" analysis used for business expense deductions, and disallow the deductions if they are personal in nature or are capital expenses. Allowable business expenses include insurance, rent, supplies, travel, transportation, salary payments to employees, certain losses, and most state and local taxes.

Personal, or nonbusiness, expenses are generally not deductible. Exceptions to this rule include casualty and theft losses that are not covered by insurance. Certain expenses are allowed as itemized deductions. These below-the-line deductions include expenses for medical treatment, interest on home mortgages, state income taxes, and charitable contributions. Expenses incurred for tax advice are deductible from federal income tax, as are a wide array of state and local taxes. In addition, an employee who incurs business expenses may deduct those expenses to the extent they are not reimbursed by the employer. Typical unreimbursed expenses that are deductible by employees include union dues and payments for mandatory uniforms. Alimony payments may be taken as a deduction by the payer and are deemed to be income to the recipient; however, child support payments are not deemed income to the parent who has custody of the child and are not deductible by the paying parent.

Contributions made by employees to an individual retirement account (IRA) or by self-employed persons to Keogh plans are deductible from gross income. Allowable annual deductions for contributions to an IRA are lower than allowable contributions to a Keogh account. Contributions beyond the allowable deduction are permitted; however, amounts in excess are included in gross income. Both IRAs and Keogh plans create tax-sheltered retirement funds that are not taxed as gross income during the taxpayer's working years. The contributions and the interest earned on them become taxable when they are distributed to the taxpayer. Distribution may take place when the taxpayer is fifty-nine and one-half years old, or earlier if the taxpayer becomes disabled, at which time the taxpayer will most likely be in a lower tax bracket. Distribution may take place before either of these occurrences, but if so, the funds are taxable immediately and the taxpayer may also incur a substantial penalty for early withdrawal of the money.

Additional Deductions and Taxable Income

Once adjusted gross income is determined, a taxpayer must determine whether to use the standard deduction or to itemize deductions. In most cases the standard deduction is used because it is the most convenient option. However, if the amount of itemized deductions is substantially more than the standard deduction and exceeds the threshold amount, a taxpayer will receive a greater tax benefit by itemizing.

After the standard deduction or itemized deductions are subtracted from adjusted gross income, the income amount is further reduced by personal and dependency exemptions. Each taxpayer is allowed one personal exemption. A taxpayer may also claim a dependency exemption for each person who meets five specific criteria: the dependent must have a familial relationship with the taxpayer; have a gross income that is less than the amount of the deduction, unless she or he is under nineteen years old or a full-time student; receive more than one-half of her or his support from the taxpayer; be a citizen or resident of the United States, Mexico, or Canada; and, if married, be unable to file a joint return with her or his spouse. Each exemption is valued at a certain dollar amount, by which the taxpayer's taxable income is reduced.

Tax Tables and Tax Owed

Once the final deductions and exemptions are taken, the resulting figure is the taxpayer's taxable income. The tax owed on this income is determined by looking at applicable tax tables. This figure may be reduced by tax prepayments or by an applicable tax credit. Credits are available for contributions made to candidates for public office; child and dependent care; earned income; taxes paid in another country; and residential energy. For each dollar of available credit, a taxpayer's liability is reduced by one dollar.

Refund or Tax Owed

Finally, after tax prepayments and credits are subtracted, the amount of tax owed the IRS or the amount of refund owed the taxpayer is determined. The taxpayer's tax return and payment of tax owed must be mailed to the IRS by April 15 unless an extension is sought. Taxpayers who make late payments without seeking an extension will be charged interest on the amount due and may be charged a penalty. A tax refund may be requested for up to several years after the tax return is filed. A refund is owed usually because the taxpayer had more tax than necessary withheld from his or her paychecks.

Tax Audits

The IRS may audit a taxpayer to verify that the taxpayer correctly reported income, exemptions, or deductions on the return. The majority of returns that are audited are chosen by computer, which selects those that have the highest probability of error. Returns may also be randomly selected for audit or may be chosen because of previous investigations of a taxpayer for tax evasion or for involvement in an activity that is under investigation by the IRS. Taxpayers may represent themselves at an audit, or may have an attorney, certified public accountant, or the person who prepared the return accompany them. The taxpayer will be told what items to bring to the audit in order to answer the questions raised. If additional tax is found to be owed and the taxpayer disagrees, she or he may request an immediate meeting with a supervisor. If the supervisor supports the audit findings, the taxpayer may appeal the decision to a higher level within the IRS or may take the case directly to court.

See: Tax Avoidance; Tax Court; Taxpayer Bill of Rights.

A tax that governments impose on financial income generated by all entities within their jurisdiction. By law, businesses and individuals must file an income tax return every year to determine whether they owe any taxes or are eligible for a tax refund. Income tax is a key source of funds that the government uses to fund its activities and serve the public.

Investopedia Says:
Most countries employ a progressive income tax system in which higher income earners pay a higher tax rate compared to their lower earning counterparts. 

The first income tax imposed in America was during the War of 1812. Its original purpose was to fund the repayment of a $100 million debt that was incurred through war-related expenses. After the war, the tax was repealed, but income tax became permanent during the early 20th century.

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n

A tax upon an adjusted gross income (individual or corporate) imposed as a major source of governmental revenue at the state and federal levels.

For a list of words related to income tax, see:

• Types of Taxes - income tax: federal, state, and local government tax on individual and business earnings, providing most of government revenues

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