Answers to Six Questions Regarding Determining Taxable Income

Disclaimer: The author of this document is neither a lawyer, certified public accountant, nor enrolled agent. The answers below are offered only for the purposes of analysis and discussion, and are not to be construed as legal advice. If you have questions about the law, seek competent counsel.
1) Should I use the rules found in 26 USC 861(b) and 26 CFR 1.861-8 (in addition to any other pertinent sections) to determine my taxable domestic income?
If you are a nonresident alien individual or foreign corporation, then you should use the rules found in 26 USC 861(b) and 26 CFR 1.861-8 to determine your taxable income from sources within the United States.

If you are not a nonresident alien individual or foreign corporation, then you may use 26 USC 861(b) and related regulations to determine your taxable income from sources within the United States, however the taxes imposed are not necessarily limited to such income. There may therefore be little reason for you to do so, and in particular doing so will not affect your determination of what income is subject to tax.

2) If some people should not use those sections to determine their taxable domestic income, please show where the law says who should or should not use those sections for that.
26 USC 1 imposes a tax on “taxable income.” It does not impose a tax on “taxable domestic income,” so it is important to understand where this qualification comes from, and why some people would need to determine it.

The determination of gross income is a prerequisite to the determination of taxable income. 26 USC 63(a) states:

(a) In general

Except as provided in subsection (b) [individuals who do not itemize their deductions], for purposes of this subtitle, the term “taxable income” means gross income minus the deductions allowed by this chapter (other than the standard deduction).

There are some sections of the law which restrict or exclude gross income in certain cases. For example, 26 USC 872(a) states:

(a) General rule

In the case of a nonresident alien individual, except where the context clearly indicates otherwise, gross income includes only —

(1) gross income which is derived from sources within the United States and which is not effectively connected with the conduct of a trade or business within the United States, and
(2) gross income which is effectively connected with the conduct of a trade or business within the United States.

Similarly, 26 USC 882(b) states:

(b) Gross income

In the case of a foreign corporation, except where the context clearly indicates otherwise, gross income includes only —

(1) gross income which is derived from sources within the United States and which is not effectively connected with the conduct of a trade or business within the United States, and
(2) gross income which is effectively connected with the conduct of a trade or business within the United States.

In such cases gross income from sources within the United States can be determined under 26 USC 861(a) (and 26 USC 863 in certain cases), and taxable income—from sources within the United States—subsequently determined under 26 USC 861(b) (and 26 USC 863) and related regulations.

These cases are exceptions to the general definition of gross income. 26 USC 61(a) states:

(a) General definition

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

It is clear then that some people—for example, nonresident alien individuals—should use 26 USC 861(b) and 26 CFR 1.861-8 to determine their taxable income from sources within the United States, while other people will have no such need.

Reason for first two questions: The regulations at 26 CFR 1.861-8 begin by stating that Sections 861(b) and 863(a) state in general terms “how to determine taxable income of a taxpayer from sources within the United States” after gross income from the U.S. has been determined.
This is easily understood to mean the sections offer instructions for determining taxable income from sources within the United States, when such determination is necessary.
Section 1.861-1(a)(1) confirms that “taxable income from sources within the United States” is to be determined in accordance with the rules of 26 USC 861(b) and 26 CFR 1.861-8 (see also 26 CFR 1.862-1(b), 1.863-1(c)).
Again, when such determination is necessary, the cited rules provide instructions for making the determination.

26 CFR 1.861-1(a) is also often cited for the following confusing sentence:

(a) Categories of income. Part I (section 861 and following), subchapter N, chapter 1 of the Code, and the regulations thereunder determine the sources of income for purposes of the income tax.

The confusion arises out of the use of the word “determine” here which is sometimes alleged to mean “to limit (or identify) the sources of income under purview of the income tax.” However, a careful study of the statutes, regulations, and authority of the Secretary to prescribe those regulations will clearly show this to be incorrect. Instead, the word “determine” can be easily understood to mean “to place definitely and authoritatively sources of income into categories of that derived either within or without the United States.”

Indeed this meaning is clear from the very next sentence of the regulation:

These sections explicitly allocate certain important sources of income to the United States or to areas outside the United States, as the case may be; and, with respect to the remaining income (particularly that derived partly from sources within and partly from sources without the United States), authorize the Secretary or his delegate to determine the income derived from sources within the United States, either by rules of separate allocation or by processes or formulas of general apportionment.
Cross-references under 26 USCS 61, as well as entries in the USC Index under the heading “Income Tax,” also refer to Section 861 regarding income (“gross” and “taxable”) from “sources within U.S.
Pursuant to 26 USC 7806, cross references and other descriptive matter have no legal effect. However, for persons who have a legal requirement to determine their gross and taxable income from sources within the United States, such references may certainly be helpful.

It is important to realize that just because a taxpayer believes his income to be derived from sources within the United States does not mean such income will necessarily agree with the statutory or regulatory meaning of “income from sources within the United States.” Thus, a taxpayer should not assume his income is from one source or another, but look to the law to see which it is from—and accord the treatment of it the significance attached to that status.

3) If a U.S. citizen receives all his income from working within the 50 states, do 26 USC 861(b) and 26 CFR 1.861-8 show his income to be taxable?
26 USC 861 states, in relevant parts:
(a) Gross income from sources within United States

The following items of gross income shall be treated as income from sources within the United States:

(3) Personal services

Compensation for labor or personal services performed in the United States; except [exceptions].

To the extent that a U.S. citizen’s “income from working within the 50 states” consists of “compensation for labor or personal services performed in the United States” and does not fall into the listed exceptions, such income is clearly considered income from sources within the United States.

(b) Taxable income from sources within United States

From the items of gross income specified in subsection (a) as being income from sources within the United States there shall be deducted the expenses, losses, and other deductions properly apportioned or allocated thereto and a ratable part of any expenses, losses, or other deductions which cannot definitely be allocated to some item or class of gross income. The remainder, if any, shall be included in full as taxable income from sources within the United States.

After properly applying the appropriate deductions to gross income from sources within the United States (using guidance from 26 CFR 1.861-8), the remainder is taxable income from sources within the United States.

Keep in mind that an individual who is not a nonresident alien does not receive the benefit of 26 USC 872(a), and thus his taxable income is not limited to “taxable income from sources within the United States.” His gross (and thus, taxable) income also includes income from sources without the United States—in other words, all income from whatever source derived.

Nonetheless, what this exercise will not show is that 26 USC 861(b) or 26 CFR 1.861-8 operate to define or restrict what income may be subject to tax.

Reason for question: Section 217 of the Revenue Act of 1921, predecessor of 26 USC 861 and following, stated that income from the U.S. was taxable for foreigners, and for U.S. corporations and citizens deriving most of their income from federal possessions, but did not say the same about the domestic income of other Americans.
This misunderstands the significance of the section by ignoring its context.

217 of the Revenue Act of 1921 read as follows, in part:

NET INCOME OF NONRESIDENT ALIEN INDIVIDUALS.

SEC. 217. (a) That in the case of a nonresident alien individual or of a citizen entitled to the benefits of section 262 [income from sources within the possessions of the United States], the following items of gross income shall be treated as income from sources within the United States: [...]

(b) From the items of gross income specified in subdivision (a) there shall be deducted the expenses, losses, and other deductions properly apportioned or allocated thereto and a ratable part of any expenses, losses, or other deductions which can not definitely be allocated to some item or class of gross income. The remainder, if any, shall be included in full as net [taxable] income from sources within the United States.

This is easily understood to mean that in certain cases, particular items of gross income were to be treated as income from sources within the United States. But items not so treated, whether because not listed or because the section was inapplicable, were still items of gross income.

It was necessary for some other section of law to restrict the meaning of gross income only to that from sources within the United States in order to give this section a meaningful effect. For example, 213 read as follows (with added emphasis):

GROSS INCOME DEFINED.

SEC. 213. That for the purposes of this title (except as otherwise provided in section 233 [gross income of corporations defined]) the term “gross income”—

(a) Includes gains, profits, and income derived [...] from any source whatever. [...]

(b) Does not include the following items, which shall be exempt from taxation under this title: [...]

(c) In the case of a nonresident alien individual, gross income means only the gross income from sources within the United States, determined under the provisions of section 217.

In the case of an individual who was not a nonresident alien, 217 was not applicable to the determination of gross income, and 213(a) and 213(b) alone determined what was taxable after the application of deductions. 213(c) is the obvious predecessor of 26 USC 872(a) today.

Other sections similarly restricted the meaning of gross income for foreign corporations and for citizens and domestic corporations receiving most of their income from sources within possessions of the United States. 233(b) stated:

(b) In the case of a foreign corporation, gross income means only gross income from sources within the United States, determined (except in the case of [certain insurance companies]) in the manner provided in section 217.

Note that 217 was consequently applicable to foreign corporations even though it did not specifically mention them.

262 stated, in part:

INCOME FROM SOURCES WITHIN THE POSSESSIONS OF THE UNITED STATES.

SEC. 262. (a) That in the case of citizens of the United States or domestic corporations, satisfying the following conditions, gross income means only gross income from sources within the United States— [...]

It is easy to see that the context of 217 did not require it to mention the “domestic income of other Americans.” It turns out that it was unnecessary for 217 to mention any contexts in which it applied at all, and today’s version at 26 USC 861 does not—but its effect is unchanged.

The regulations under the 1939 Code (e.g. 29.119-1, 29.119-2, 29.119-9, 29.119-10 (1945)) showed the same thing. The current regulations at 1.861-8 still show income to be taxable only when derived from certain “specific sources and activities,” which still relate only to certain types of international trade (see 26 CFR 1.861-8(a)(1), 1.861-8(a)(4), 1.861-8(f)(1)).
This is incorrect and misunderstands the purpose of the regulations.

26 CFR 1.861-8(a)(1) states, in part:

The rules contained in this section apply in determining taxable income of the taxpayer from specific sources and activities under other sections of the Code, referred to in this section as operative sections.

This is easily understood to mean the rules are applicable when the taxpayer is affected by the specific sources and activities mentioned.

26 CFR 1.861-8(a)(4) states, in part:

For purposes of this section, the term “statutory grouping of gross income” or “statutory grouping” means the gross income from a specific source or activity which must first be determined in order to arrive at “taxable income” from which specific source or activity under an operative section.

This is easily understood to be referring to the gross income from a specific source or activity (under an operative section)—in the case of such income—from which the inherently related taxable income will be derived.

26 CFR 1.861-8(f)(1) states, in part:

The operative sections of the Code which require the determination of taxable income of the taxpayer from specific sources or activities and which give rise to statutory groupings to which this section is applicable include the sections described below.

This is easily understood to mean the sections described are the ones which give rise to the statutory groupings that are addressed by the regulation.

The current regulations at 26 CFR 1.861-8 provide many instructions that are clearly applicable only in specific circumstances. However, when those circumstances do not exist, the effect of the regulations is not to acknowledge that certain income is not subject to tax, but rather no effect at all.

Pursuant to 26 USC 861(b), taxable income from sources within the United States must be determined by applying appropriate deductions to the items of gross income specified by 26 USC 861(a) as being income from sources within the United States. The Secretary’s authority to prescribe regulations to aid in this purpose is derived from 26 USC 863, which states, in part (with added emphasis):

(a) Allocation under regulations

Items of gross income, expenses, losses, and deductions, other than those specified in sections 861(a) and 862(a), shall be allocated or apportioned to sources within or without the United States, under regulations prescribed by the Secretary.

The Secretary cannot through regulations alter that which has already been determined by statute to be gross income from sources within the United States. Nor can he specify what sources of income are subject to tax (except to the extent he allocates or apportions items of gross income not specified in 26 USC 861(a) or 862(a) to sources within the United States, in cases where this is significant to the taxpayer), or otherwise assert any income to be exempt from tax.

26 USC 863(a) continues:

Where items of gross income are separately allocated to sources within the United States, there shall be deducted (for the purpose of computing the taxable income therefrom) the expenses, losses, and other deductions properly apportioned or allocated thereto and a ratable part of other expenses, losses, or other deductions which cannot definitely be allocated to some item or class of gross income. The remainder, if any, shall be included in full as taxable income from sources within the United States.

This is the correctly understood purpose of 26 CFR 1.861-8—to assist in the application of deductions to gross income in order to arrive at “taxable income from sources within the United States.” Indeed this purpose is clear from the beginning of the regulation itself, which states, in part (with added emphasis):

(a) In general—(1) Scope. Sections 861(b) and 863(a) state in general terms how to determine taxable income of a taxpayer from sources within the United States after gross income from sources within the United States has been determined. [...] This section provides specific guidance for applying the cited Code sections by prescribing rules for the allocation and apportionment of expenses, losses, and other deductions (referred to collectively in this section as “deductions”) of the taxpayer.

It is clear that the regulations at 26 CFR 1.861-8 cannot and do not “show income to be taxable” (or not); that is neither their purpose nor their effect.

4) Should one use 26 CFR 1.861-8T(d)(2) to determine whether his “items” of income (e.g. compensation, interest, rents, dividends, etc.) are excluded for federal income tax purposes?
No.

26 CFR 1.861-8T(d)(2) states, in part:

(2) Allocation and apportionment to exempt, excluded or eliminated income—(i) In general. In the case of taxable years beginning after December 31, 1986, except to the extent otherwise permitted by 1.861-13T [transition rules for interest expenses], the following rules shall apply to take account of income that is exempt or excluded, or assets generating such income, with respect to allocation and apportionment of deductions.

This section does not determine whether any items of income are excluded for federal income tax purposes; rather, it determines how to apply deductions to income so excluded.

Reason for question: The regulations (26 CFR 1.861-8(a)(3)) state that a “class of gross income” consists of the “items” of income listed in 26 USC 61 (e.g. compensation, interest, rents, dividends, etc.). The regulations (26 CFR 1.861-8(b)(1)) then direct the reader to “paragraph (d)(2)” of the section, which provides that such “classes of gross income” may include some income which is excluded for federal income tax purposes.
This is true, but misunderstands the derivation and significance of “excluded” income.

26 CFR 1.861-8(b) states, in part:

(b) Allocation—(1) In general. For purposes of this section, the gross income to which a specific deduction is definitely related is referred to as a “class of gross income” and may consist of one or more items of gross income. The rules emphasize the factual relationship between the deduction and a class of gross income. See paragraph (d)(1) of this section which provides that in a taxable year there may be no item of gross income in a class or less gross income than deductions allocated to the class, and paragraph (d)(2) of this section which provides that a class of gross income may include excluded income.

This is easily understood to mean that a specific deduction may be definitely related to gross income that has been excluded—e.g. by operation of 26 USC 872(a) or 882(b) in the case of a nonresident alien or foreign corporation.

26 CFR 1.861-8T(d)(2) gives special rules for excluded income for the purpose of applying deductions. Paragraph (d)(2)(i) states, in relevant part (with added emphasis):

(A) Allocation of deductions. In allocating deductions that are definitely related to one or more classes of gross income, exempt income (as defined in paragraph (d)(2)(ii) of this section) shall be taken into account.

(B) Apportionment of deductions. In apportioning deductions that are definitely related either to a class of gross income consisting of multiple groupings of income [...] or to all gross income, exempt income and exempt assets (as defined in paragraph (d)(2)(ii) of this section) shall not be taken into account.

The effect of allocating or apportioning any deduction thus depends on whether the gross income to which it is definitely related includes “exempt income,” which is defined in paragraph (d)(2)(ii) as follows:

(ii) Exempt income and exempt asset defined—(A) In general. For purposes of this section, the term exempt income means any income that is, in whole or in part, exempt, excluded, or eliminated for federal income tax purposes.

It is instructive to note that “exempt income” is defined only for purposes of the section in which it is defined, and the section uses the term only in connection with the allocation and apportionment of deductions. The term describes the income to which deductions may or may not be allocated or apportioned pursuant to paragraph (d)(2)(i), and which is already exempt, excluded, or eliminated for federal income tax purposes.

For nonresident aliens and foreign corporations, “exempt income” obviously includes the portion of their gross income excluded by 26 USC 872(a) or 882(b). “Exempt income” would also include, for example, the foreign earned income excluded at the election of a qualified individual under 26 USC 911(a), which states:

(a) Exclusion from gross income

At the election of a qualified individual (made separately with respect to paragraphs (1) and (2)), there shall be excluded from the gross income of such individual, and exempt from taxation under this subtitle, for any taxable year —

(1) the foreign earned income of such individual, and
(2) the housing cost amount of such individual.
5) What is the purpose of the list of non-exempt types of income found in 26 CFR 1.861-8T(d)(2)(iii), and why is the income of the average American not on that list?
26 CFR 1.861-8T(d)(2)(iii) reads as follows:
(iii) Income that is not considered tax exempt. The following items are not considered to be exempt, eliminated, or excluded income and, thus, may have expenses, losses, or other deductions allocated and apportioned to them:

(A) In the case of a foreign taxpayer (including a foreign sales corporation (FSC)) computing its effectively connected income, gross income (whether domestic or foreign source) which is not effectively connected to the conduct of a United States trade or business;

(B) In computing the combined taxable income of a DISC [domestic international sales corporation] or FSC and its related supplier, the gross income of a DISC or a FSC;

(C) For all purposes under subchapter N of the Code, [...] the gross income of a possessions corporation for which a credit is allowed under section 936(a) [Puerto Rico and possession tax credit]; and

(D) Foreign earned income as defined in section 911 and the regulations thereunder [...].

As the language itself says, the listed items “may have expenses, losses, or other deductions allocated and apportioned to them”—because they are not considered to be exempt, excluded, or eliminated income for this purpose.

The rules given by 26 CFR 1.861-8T(d)(2)(i) help determine the applicability of deductions to items of income not listed, depending whether the income is “exempt income,” and whether the deduction is to be allocated or apportioned:

Income
“Exempt” Not Exempt
Deduction Allocated applicable always
applicable
Apportioned not applicable

To the extent the “income of the average American” is not “exempt, excluded, or eliminated for federal income tax purposes,” such income is by definition not considered exempt for the purpose of allocating or apportioning deductions.

Reason for question: After defining “exempt income” to mean income which is excluded for federal income tax purposes (26 CFR 1.861-8T(d)(2)(ii)), the regulations list types of income which are not exempt (i.e. which are subject to tax), including the domestic income of foreigners, certain foreign income of Americans, income of certain possessions corporations, and income of international and foreign sales corporations; but the list does not include the domestic income of the average American (26 CFR 1.861-8T(d)(2)(iii)).
This is an incorrect characterization of the items of income listed in 26 CFR 1.861-8T(d)(2)(iii), and suggests an erroneous conclusion with respect to the taxability of any income not listed.

The listed items are neither necessarily subject to tax, nor are they the only items which may be taxed. The listed items are simply to be taken into account when allocating and apportioning deductions.

That the list includes items of income not necessarily subject to tax can be seen by observing that item (D) describes income that may be excluded from gross income (and hence, not subject to tax) under 26 USC 911(a). It can also be seen by observing that item (A) includes income that is excluded by 26 USC 872(a) and 882(b), namely gross income from sources without the United States which is not effectively connected with the conduct of a trade or business within the United States.

That the list is not exhaustive can be seen by observing that the list does not include the gross income of a nonresident alien individual which is effectively connected with the conduct of a trade or business within the United States, and yet such income is explicitly included in gross income at 26 USC 872(a)(2).

It is therefore impossible to draw any conclusion concerning the taxability of any item of income from this list. Indeed that is not its purpose, and any such purpose would in any case be in excess of the authority granted to the Secretary under 26 USC 863 to prescribe regulations.

The list is best understood as simply providing specific guidance for applying deductions to income in certain special cases.

6) What types of income (if any) are not exempted from taxation by any statute, but are nonetheless “excluded by law” (i.e. not subject to the income tax) because they are, under the Constitution, not taxable by the federal government?
The answer to this question may be open to debate.

One possible explanation for the references to income “excluded by law” insofar as constitutionally untaxable income is concerned has to do with the constitutional prohibition on the diminishment of the pay of federal judges during their tenure in office. Although this issue was resolved by a Supreme Court decision in the 1930s (ruling that the tax did not amount to such a diminishment), the references may have been preserved even after the decision as a fallback in case another such controversy was ever entertained by the court.

Another possible explanation is that these references refer to the principle that a sovereign entity may not exercise its taxing power over the instrumentalities of another sovereign, as for example state and federal governments may not ordinarily tax each other in our system of dual sovereignty. Although state and federal employees presently pay taxes with respect to both jurisdictions by way of mutual agreement between the sovereignties, such an arrangement may nonetheless be unconstitutional.

As stated by Judge Cooley in his work on the Principles of Constitutional Law: “[...] The taxing power of the federal government does not therefore extend to the means or agencies through or by the employment of which the states perform their essential functions; since, if these were within its reach, they might be embarrassed, and perhaps wholly paralyzed, by the burdens it should impose. ‘That the power to tax involves the power to destroy; that the power to destroy may defeat and render useless the power to create; that there is a plain repugnance in conferring on one government a power to control the constitutional measures of another, which other, in respect to those very measures, is declared to be supreme over that which exerts the control,—are propositions not to be denied.’ It is true that taxation does not necessarily and unavoidably destroy, and that to carry it to the excess of destruction would be an abuse not to be anticipated; but the very power would take from the states a portion of their intended liberty of independent action within the sphere of their powers, and would constitute to the state a perpetual danger of embarrassment and possible annihilation. The constitution contemplates no such shackles upon state powers, and by implication forbids them.” Pollock v. Farmers’ Loan & Trust Co., 157 U.S. 429, 601 (1895)

Notwithstanding any such speculation, a careful study of the laws enacted by Congress since 1862 will nonetheless show that the earnings of most Americans are not taxed—but not for the reasons suggested by the above questions. A serious student in these matters would do well to read Cracking the Code: The Fascinating Truth About Taxation in America.

Reason for question: Older income tax regulations defining “gross income” and “net income” said that neither income exempted by statute “or fundamental law” were subject to the tax ( 39.21-1 (1956)), and said that in addition to the types of income exempted by statute, other types of income were excluded because they were, “under the Constitution, not taxable by the Federal Government” ( 39.22(b)-1 (1956)). (This is also reflected in the current 26 CFR 1.312-6.)
Indeed. But whether regulations acknowledge it or not, this is axiomatic.
It is elementary law that every statute is to be read in the light of the constitution. However broad and general its language, it cannot be interpreted as extending beyond those matters which it was within the constitutional power of the legislature to reach. McCullough v. Com. of Virginia, 172 U.S. 102, 112 (1898)

Rob Leslie

With thanks and acknowledgment to:
Pete Hendrickson

Last modified: Tue Sep 28 05:54:51 PDT 2004