Why is this Topic Important to Wealth Managers? Provides an introduction into the Internal Revenue Code so that tomorrow’s blogticle about specific sections of the Code may be better understood, in particular the taxation of life insurance companies.
How are the laws related to tax organized or in other words, what’s the general process in finding an answer to a tax question?
All federal laws of the United States arise out of the Constitution. The Constitution has granted Congress certain enumerated powers, such as the power to regulate commerce among the several states. Congress also has the power to create laws that are necessary and proper in governing based on its listed powers. All powers not granted to the Federal government are reserved by the States through the 10th Amendment – meaning only the States may enact laws in those areas (al least this is how it is supposed to work).
Once Congress passes a necessary and proper law to carry out its enumerated powers, that law becomes a United States Statute, or a Statute already existing is either amended or deleted. The Statutes of the United States are called the United States “Code”.
The United States Code is divided into 50 different titles. Title 26 is perhaps the most infamous, being the “Internal Revenue Code”. The Internal Revenue Code, or Title 26 of the United States Code is further delineated, into Subtitles, Chapters, Subchapters, Parts, and finally Sections and Subsections.
Congress has delegated the power of enforcement of these laws, which lies with the executive branch, of Title 26 to the Secretary of Treasury to create Regulations or Administrative Interpretations of the Statutes. The regulations are not in and of themselves laws but rather, direction from the Secretary of interpretation of the laws. The regulations have legal authority, which means they may be presented in court. In almost all tax cases, there is some Statute, that is called into question, therefore the Court’s exclusive job is to rule on interpretation of the Statute as it applies to the situation before the court, not to overrule any statute, unless it found the law unconstitutional. Therefore, additional law is generated by courts’ interpreting Statutes. This is known as “case law”.
Let’s look at a simple example to illustrate the concept. To determine how much tax an individual will pay on a certain transaction say, the receipt of life insurance payments as a beneficiary of a policy. Where do we start? It is generally unquestioned that since the issue is about taxes we can look in Title 26 of the United States Code to find out what amounts paid to the taxpayer are taxable as income.
Moreover, Subtitle A of Title 26 is entitled “Income Taxes”, so that is a natural place to continue looking to see what taxes will be owed, if any on this payment. Within Chapter 1 “Normal Taxes”, Subchapter A is called “Determination of Tax Liability”. Determination of tax liability sounds on point in consideration of what we’re trying to accomplish. In that Subchapter, Part 1 concerns “Tax on Individuals”. Here is where we will start. Section 1 is titled, “Tax Imposed”, and states “There is hereby imposed on the taxable income of” and lists the different filing statuses and applicable rates.
A question should then naturally arise, if there is a tax imposed, what is it imposed on? The answer is nearby. The wording of the statute says there will be imposition of tax on the “taxable income” of different filing statuses. Well we might want to know then what taxable income means for federal legal purposes. Looking in the index, or though a common search, one will find that Part I of Subchapter B “Computation of Taxable Income”, is entitled “Definition of Gross Income, Adjusted Gross Income, Taxable Income, Ect.”. So there it is, and if we look at the sections under Part 1 of Subchapter B, we will see Section 63’s title of “Taxable Income Defined.”
Section 63 (a) states, in part, “the term ‘taxable income’ means gross income minus the deductions allowed.” Well it would certainly be helpful to know then what “gross income” means. Not too far away, in the same Part, one can find in Section 61, which is entitled, “Gross income defined”. Section 61(a) states in part, “Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:
(3) Gains derived from dealings in property.” Life insurance contracts are property, generally.
Notwithstanding the meaning of “all income from whatever source derived” we know if some item is “otherwise” excepted in Subtitle A, “Income Taxes”, that such item would not be included in gross income. Further, if the item is not included in gross income, it will not be included in taxable income, and even further, if the item is not included in taxable income, the imposition of a tax on such item does not apply.
We now must look in Subtitle A to see what, if any items are excepted. Part III of Subchapter B, is conveniently enough titled “Items Specifically Excluded From Gross Income.” The first Section of this Part is entitled “Certain Death Benefits”. Payments from a life insurance contract to a beneficiary is on point with this Section, so it should be read. Section 101 states, in pertinent part, “gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured.” So if life insurance payments are not included in gross income, the life insurance payments are not taxable income, and therefore are not subject to an imposition of income tax, or in other words – no tax is due.
In this simple example, there was no need to examine the Regulations or any court cases, as our issue was straightforward. However, most issues will involve additional questions which then the practitioner will look to further sources, i.e., regulations and case law, to determine the answer to the question presented.
For further explanatory discussion of the structure and sources of federal tax law, please see the AdvisorFX Main Library Section 50.6 Sources And Structure Of Federal Tax Law: A—Sources And Structure Of Federal Tax Law
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