Personal income tax Summary

  • Last updated on November 10, 2022

Taxes are an important source of revenue for local, state, and federal governments. Historically, the federal government has used tax policies to promote investment in the American economy. Giving deductions for certain business expenses and tax breaks for small businesses are among the ways that the federal government has used personal income tax laws to promote business.

When the U.S. Constitution was adopted in 1789, the federal government was empowered to collect excise taxes and duties. To pay the debts of the Revolutionary War, the U.S. Congress levied taxes on alcohol, sugar, tobacco, carriages, and property sold at auctions. Collecting taxes, however, was a sensitive issue, as resentment against British taxation had been a primary cause of the Revolutionary War. Whiskey tax of 1791When the government charged taxes on whiskey, a group of farmers rebelled in 1794. President George Washington had to send in troops to suppress the Whiskey RebellionWhiskey Rebellion. Therefore, until the U.S. Civil War, the early government raised most of its revenue by selling land and charging duties rather than by levying taxes.Income tax;personalTaxation;personal income tax

Early Tax Efforts

In 1862, as a way to finance the Civil War, U.S.;income taxCivil War, the government started collecting personal income taxes. The tax was 3 percent on incomes above $800 per year and was repealed in 1872. This measure created the office of the commissioner of Internal Revenue, the predecessor of the Internal Revenue ServiceInternal Revenue Service (IRS).

Congress tried to reenact the income tax in 1894, but the Supreme Court found the collection of income taxes to be unconstitutional. In 1913, the ratification of the Sixteenth AmendmentSixteenth Amendment and enactment of the Revenue Act allowed the federal government to legally collect income taxes. That same year, Congress adopted an income tax with rates starting at 1 percent on income of $3,000 and rising to 7 percent on incomes of more than $500,000. At the time, less than 1 percent of the American population paid income tax. The first codes allowed for taxation of only lawful income. As a result, people chose to run illegal businesses to avoid taxation until Congress deleted the word “lawful” from the definition of income in 1916.

When the United States entered World War I, the tax rate was raised from 1 to 2 percent, and the top rate was raised to 15 percent. The economy boomed during the 1920’s, and Congress decreased taxes, but after the stock market crash, Congress raised taxes because it needed revenue. After World War I, tax rates have both declined and risen depending on the economy and the country’s involvement in wars.

Between the end of World War I and 1939, various revenue acts were passed. The Great Depression resulted in the passage of the Social Security Act of 1935Social Security Act in 1935, which created a tax shared by the employer and employee. In 1939, the varied personal income tax laws were codified into the Internal Revenue CodeInternal Revenue Code.

Taxes on citizens and businesses have increased over time. In 1942, an act was passed that increased income taxes but allowed deductions for medical and investment expenses. In 1943, another act required employers to withhold taxes from employees’ wages and remit them quarterly.

By 1945, 43 million Americans were paying income taxes. The tax code went through two modifications in 1954 and 1986. The Tax Reform Act of 1986Tax Reform Act of 1986, with three hundred tax provisions, was the most significant piece of tax legislation passed in thirty years, taking three years to implement.

How the Tax Works

The calculation of income tax starts with an individual’s gross income, from ordinary income and capital gains. Ordinary income includes earnings, business profits, dividends, and interest income; capital gains are typically from the sale of investment property. Above-the-line deductions, including moving expenses and alimony payments, are taken from the gross income to create the adjusted gross income. Then taxpayers either take the standard deduction or subtract itemized deductions. This leaves taxable income, which is multiplied by the tax rate to produce the tax due the government. Some taxpayers qualify for tax credits, which are taken from the amount due.

Individuals can have several types of businesses on which they can be taxed, including rental properties, sole proprietorships, and farms. Also, taxpayers who are employees of businesses can take deductions for business-related expenses incurred on the job. Several significant tax provisions affect these taxpayers. These provisions are usually written to stimulate the economy or with the goal of administrative ease.

Taxpayers who own these types of businesses must report total revenues and related expenses. In addition, they are allowed to recover the cost of investments in capital assets. Cost recovery provisions refer to the deductibility of capital expenditures, which are assets with a life longer than one year. This includes vehicles, computers, equipment, furniture, land and leasehold improvements, livestock, and real estate. These different classes of assets have different recovery periods. For example, computers are depreciated over 5 years, furniture over 7 years, and real estate over 29.5 years if residential and 39 years if nonresidential. These cost recovery provisions are subject to change. The Economic Recovery Act of 1981Economic Recovery Act of 1981 included provisions to accelerate cost recovery. Businesses were allowed to depreciate equipment at an accelerated rate and were given an investment tax credit to encourage investment in the economy. In 1986, these laws were repealed because they were considered overly generous.

A group of people fill out tax forms at an Internal Revenue office around 1920.

(Library of Congress)

Another cost recovery provision is the deduction allowed by Internal Revenue Code section 179. This provision allows for the immediate write-off of some capital purchases in the year of purchase. The deduction is limited by the amount of business income and amount of assets purchased. This deduction has been increased over the years, again to encourage investment in the economy. In 2002, the section 179 expense was limited to $24,000 but was increased to $250,000 in 2008. The same philosophy pertains to depreciation. In 2004, businesses were allowed bonus depreciation in addition to the regular cost recovery amounts; this benefit ended in 2005 but has been reenacted for 2008.

Expense Deductions

The prevailing rule for whether a business expense is deductible is determined by the “ordinary” and “necessary” rules. “Ordinary” means the expense would be considered common for the business, and “necessary” means the expense is helpful and appropriate. In addition, to be deductible, the expense must be “reasonable.” This is where subjectivity enters into the picture, because what might be reasonable for one business might not be for another.

Congress has placed some restrictions on the deductibility of certain expenses. Expenses such as speeding tickets, tax penalties, and bribes are not deductible, nor are political contributions and most lobbying expenses. Furthermore, common expenses prone to abuse have become limited in their deductibility. For example, meals are only 50 percent deductible rather than 100 percent as in earlier years, and the depreciation of personal automobiles used for business is also limited. These expenses can be deducted only if backed up by written records. The time, place, and business purpose of the meal must be recorded, and a mileage log must be kept for automobiles.

Businesses generally receive more favorable tax treatment than individuals for the same deductions. For example, theft and casualty losses for individuals are limited to amounts in excess of 10 percent of adjusted gross income and $100 per event, but there is no such limitation for business theft losses. In addition, losses on investments are classified as capital losses (limited to $3,000 per year), but business losses are often treated as ordinary losses, meaning there is no limitation to their deductibility.

Expenses for the investigation of new businesses are also deductible if the individual goes into the business or already has a business in the same field. If it is a new business, the expenses are deductible only over time, but if it is a continuation of an already existing business, investigation expenses are deductible in the year incurred. The only time investigation expenses are not deductible is if the business is a new venture and the taxpayer does not start the business.

Self-Employment Issues

One area that received media attention in 1993, when the Commissioner of the Internal Revenue Service vs. Soliman (1993)Commissioner of the Internal Revenue Service vs. Soliman case was heard by the Supreme Court, is the home office deduction. Whether the taxpayer is an employee of a company or self-employed, the taxpayer may, under certain circumstances, deduct expenses related to the business use of a home office. Typically the office must be used exclusively for business and to meet clients or customers. If the taxpayer is an employee, the office must also be for the convenience of the employer. The Court found that even though Nader Soliman, an anesthesiologist, spent ten to fifteen hours working in his home office, he did not meet patients there; thus his home office deductions were disallowed. As a result of this ruling, many taxpayers, such as plumbers, builders, and restaurant owners, also lost their home office deductions. In 1997, Congress modified the home office tax laws so that if the office is used for administrative or management activities and if there is no other fixed location at which those duties can be conducted, taxpayers may take the home office deduction.

One other major tax provision related to individuals is the self-employment tax. Employees pay 7.65 percent of the social security tax, and employers pays 7.65 percent. Self-employed individuals must pay the entire 15.3 percent themselves. This places an increased tax burden on the self-employed person.

Income taxes affect all income earners, whether employed by a company or self-employed. Although they reduce the amount of money taxpayers have to invest or to spend, they provide important revenue for governments. In 2007, personal income taxes made up 45 percent of federal revenue.

Further Reading
  • Conable, Barber B., Jr., and A. L. Singleton. Congress and the Income Tax. Norman: University of Oklahoma Press, 1989. A history of the role of Congress in the development of tax policy and laws.
  • Department of Treasury: Internal Revenue Service. Publication Seventeen: Your Federal Income Tax. Washington, D.C.: Government Printing Office, 2007. Thorough, annual publication from the IRS on all the basic tax laws dealing with individual tax filing.
  • Willan, R. Income Taxes: Concise History and Primer. Baton Rouge, La.: Clairor’s, 1994. The history of tax development and a primer on special topics, such as capital gain rates, depreciation, investment tax credit, alternative minimum tax, and itemized deductions. Concludes with a discussion on tax simplification and fairness.
  • Willis, Eugene, William H. Hoffman, David M. Maloney, and William Raabe. West’s Federal Taxation 2008: Comprehensive Volume. Boston: Southwestern Publishing, 2008. College-level textbook that covers all the basics of tax law.
  • Witte, J. The Politics and Development of the Federal Income Tax. Madison: University of Wisconsin Press, 1985. A thorough history of tax policy changes from the War of 1812 until the administration of Jimmy Carter. The author also discusses tax politics and how taxes are spent.

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