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Historical Perspectives on the Federal Income Tax











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7. ARE WAGES TAXABLE AS INCOME?

Yes, wages are taxable as income. The question is usually based on one of two arguments, historical or definitional.

The historical argument derives from the congressional debates on the Sixteenth Amendment in 1909. Most of the debate centered on the taxing of income from capital assets and the taxing of corporations. The proponents of the position that wages are not taxable income claim that the Sixteenth Amendment was therefore only intended to allow taxation of income from capital.

The fallacy of this argument is that taxation of wages had never been found unconstitutional and therefore an amendment to the Constitution was not necessary to permit this type of taxation. The Sixteenth Amendment was enacted in response to the Supreme Court decision in Pollock v. Farmers' Loan and Trust Company,33 in which the Income Tax Act of 1894 34 was struck down. The 1894 Act imposed a Federal income tax on:

"the gains, profits, and income received in the preceding calendar year by every citizen of the United States…whether said gains, profits, or income be derived from any kind of property, rents, interest, dividends, or salaries, or from any profession, trade, employment, or vocation carried on in the United States or elsewhere ...."

The Court, in Pollock, found that the Constitution had sought to avoid the levy of a burdening tax on accumulations of property, real or personal, except as subject to the "regulation of apportionment."35 The Court concluded that a tax imposed on the rents or income of real estate was not significantly distinct from a tax on the property itself and was, therefore, a direct tax within the meaning of the United States Constitution.36

The Pollock Court did not, however, hold that all income taxes were direct taxes. Rather, it held that although income taxes are generally indirect taxes

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in the nature of excises (subject only to the rule of uniformity), income taxes on the gains derived from investments in real or personal property had so substantial an impact on the underlying assets that they should be viewed as direct taxes falling on the property. In this respect, the 1894 tax would have been valid to the extent that it was imposed on 'gains, profits, or income ...derived from... salaries, or from any profession, trade, employment, or vocation.. "37  Nonetheless, on rehearing Pollock, the Court struck down the entire 1894 Act because it believed that to void only the tax on income derived from investments in real and personal property and leave the tax burden solely upon wages and other forms of compensation income would be contrary to the congressional intent.38 Therefore, since only the taxation of income derived from capital had been found to be unconstitutional unless apportioned, the debate on the Sixteenth Amendment centered on the taxation of this type of income.

The definitional argument concerning the taxation of wages is based on the contention that labor worth a certain amount is exchanged for money worth the same amount and therefore there is no income to be taxed. This argument fails from lack of understanding of the concept of taxable income. There are three basic requirements which must be satisfied before income is considered taxable income. The requirements are gain, realization, and recognition.

The Sixteenth Amendment clarified the power of Congress to lay and collect taxes on income, from whatever source derived.39  Income has been defined as gain derived from capital, from labor, or from both combined.40 The operative word in this definition is gain. Gain, in the tax context, is the surplus when the basis of an item (in many cases, and in the following, basis is synonymous with cost) is subtracted from the item's fair market value. For example: John Doe purchases a piece of real estate with a fair market value of $5,000 for a cost of $5,000. One year later the property has appreciated in value to a fair market value of $6,000. Mr. Doe has a gain of $1,000 (current fair market value, $6,000 minus $5,000 basis).

The gain in the example above is not a taxable gain though, because it has not been realized. The Supreme Court has ruled that income is not taxable income until it has been realized, i.e. received or the right to receive has been

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Established.41  Therefore if Mr. Doe sold his property for $6,000 he would realize his gain of $1,000.42

The next question which must be answered is whether Congress has determined that this type of gain should be taxed. In other words, should this gain be recognized. Congress has determined, by enacting Internal Revenue Code (IRC) section 61(a), that every type of gain should be taxed unless it has been specifically excluded in some other part of the tax code. Section 61(a) provides:

Except as otherwise provided in this subtitle, gross income means all income from whatever source derived ....

The “except as otherwise provided” clause anticipates specific non-recognition provisions. A good example of a non-recognition provision is IRC § 103 which excludes the interest from certain state and local bonds from gross income. Interest on these bonds is gain and when paid, or constructively received, it is realized, but Congress has specifically decided not to recognize it.

There are non-recognition provisions which could affect the transaction in the above example. For instance, if the property was Mr. Doe's principal residence and he sold it and within two years bought another principal residence of comparable value, his gain would not be currently recognized under IRC §1034.

Wages to be taxable must pass the same type of examination. For example, if John Doe works 5 hours for $5.00 per hour, is the $25.00 he receives taxable income to him? As we have seen in the above analysis, we must determine if there has been a gain which is realized and recognized.

To see if there was a gain we do not look only to the fair market value of the labor, but rather we determine the difference between the fair market value and his basis (cost) in the labor. Generally one has a zero basis in one's own labor. Therefore, Doe's gain is $25.00 minus 0, or $25.00. This gain is realized when Doe is paid or has right to receive payment.

The gain is recognized specifically in IRC § 61(a)(1) (compensation for services) and there is no non-recognition section which is generally applicable to wages. Therefore, John Doe has $25.00 of taxable income.


32 Young v. IRS, 596 F.2d 141 at 149 (N.D. Ind. 1984).

33 157 U.S. 429 (1895), rehearing 158 U.S. 601(1895).

34 28 Stat. 509 (1894). .

35 157 U.S. at 581.

36 Id. at 583.

37 28 Stat. 509.

38 158 US. at 637.

39 Brushaber v. Union Pacific Railroad Co., 240 U.S.1(1916).

40 Eisner v. Macomber, 252 US. 189 (1920).

41  Id.

42 It should be noted that Mr. Doe does not have to receive money for the property for there to be a realization of his gain. As long as the total value of money, property, and money's worth he receives is greater than his basis, he has realized a gain.


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