1.1 Fundamentals of Taxation and Sources of Tax Authority

The Underlying Rationale of Taxation

Under the Sixteenth Amendment to the U.S. Constitution, Congress has the power to “lay and collect taxes on incomes, from whatever source derived.” The Internal Revenue Code implements this authority through a mandatory, self-assessed system that requires taxpayers to calculate, report, and pay their federal tax obligations independently. The U.S. federal tax system consists of several key components, each targeting different aspects of economic activity. These components include various types of taxes, each serving a distinct purpose within the broader fiscal framework. For example, income taxes are imposed on earnings from employment, investments, and business activities, while payroll and self-employment taxes are specifically designated to fund social insurance programs such as Social Security and Medicare. Additionally, excise taxes target the consumption or use of particular goods and services, ensuring that those benefiting from or impacting these sectors accordingly. Together, these tax categories form an interconnected system that enables the government to allocate resources effectively, address societal needs, and promote economic stability.

The primary rationale for taxation is to raise revenue to finance government operations and public services. However, the purpose of taxation extends beyond simple revenue generation. Modern tax systems are also designed to achieve a variety of economic and social objectives. The design and evaluation of tax systems are often guided by a set of principles that aim to create a fair, efficient, and effective system. These principles provide a framework for understanding the rationale behind various tax policies and for evaluating their success. The following table summarizes the key principles of good tax policy, as identified by the American Institute of Certified Public Accountants (AICPA).

Fundamental Tax Concepts and Framework

The primary components of the tax system can be organized into five key areas: the tax entity, the tax reporting period, accounting methods, the determination of taxable income, and the computation of tax liability.

Tax Entity: Identifying the Taxpayer

Tax entity refers to the specific person or organization legally responsible for paying tax. The identification of the taxpayer is the starting point for all tax-related matters. Tax entities can be broadly classified into two main categories based on how they are taxed: tax-paying entities, which are directly liable for tax on their income, and flow-through entities, which pass their income and tax attributes to their owners.

Tax-paying entities, such as individuals and C corporations, directly calculate and pay tax on their income. Flow-through entities do not pay income tax at the entity level. Instead, their profits, losses, deductions, and credits are allocated among the owners or shareholders.

Trusts and estates are unique legal arrangements that can function as either tax-paying or flow-through entities. If an estate or trust distributes its income to its beneficiaries in a given year, the income is taxed at the beneficiary level (acting as a flow-through). However, if the estate or trust retains the income, it must pay tax on that income itself (acting as a tax-paying entity).

The table below provides a comparison of the primary tax entities:

Limited Liability Companies (LLCs) do not have a single default federal tax classification. By default, a single-member LLC is treated as a disregarded entity, while an LLC with two or more members is taxed as a partnership. However, LLCs may elect an alternative tax treatment by filing a “check-the-box” election under Treas. Reg. §301.7701-3.

Tax Reporting Period: Defining the Timeframe for Taxation

The tax reporting period, or tax year, establishes the specific timeframe over which income is measured and reported. Taxpayers must report their income and calculate their tax liability for each reporting period. The two primary types of tax years are:

• Calendar Year: A 12-month period from January 1 to December 31. This is the most common tax year for individual taxpayers.
• Fiscal Year: A 12-month period ending on the last day of any month other than December. Businesses often adopt a fiscal year that aligns with their natural business cycle.

Accounting Methods: How Income and Expenses are Reported

Accounting methods are the rules and procedures that determine how a taxpayer reports income and expenses. The two principal methods of accounting for tax purposes are:

• Cash-Basis Accounting: Under this method, income is reported in the tax year it is received, and expenses are deducted in the tax year they are paid. This method is simpler and is commonly used by individuals and small businesses.
• Accrual-Basis Accounting: Under this method, income is reported when it is earned, regardless of when it is received, and expenses are deducted when they are incurred, regardless of when they are paid. This method provides a more accurate picture of a business’s financial health and is required for most larger corporations.

Taxable Income: Determining What is Taxed

Taxable income is the base upon which tax is calculated. It represents the amount of income that is subject to tax after all allowable deductions have been subtracted. The general formula for calculating taxable income is:

Gross Income – Allowable Deductions = Taxable Income

• Gross Income: All income from whatever source derived, unless specifically excluded by law. This can include wages, salaries, business profits, interest, dividends, and rents.
• Allowable Deductions: Expenses that the tax law permits to be subtracted from gross income. These can include business expenses, certain personal expenses (such as mortgage interest and charitable contributions), and exemptions.

Tax Computation: Calculating the Final Tax Liability

Tax computation is the process of calculating the amount of tax owed for the tax year. Tax liability is calculated by applying the appropriate tax rate. Tax credits are then subtracted from the calculated tax and directly lower the amount owed.

Hierarchy and Source of the Tax Authority

In the U.S. federal tax system, there are several types of tax authorities that govern how taxes are imposed and administered. These can be broadly categorized as: (1) Legislative authority – the tax laws enacted by Congress (primarily the Internal Revenue Code), (2) Administrative authority – interpretations and guidance issued by the Treasury Department and IRS (regulations, rulings, etc.), and (3) Judicial authority – court decisions that resolve tax disputes. The Internal Revenue Code, Treasury Regulations, court cases, and official IRS rulings are the primary tax authorities that govern tax outcomes.

Primary Authorities

These are official sources of tax law and have the highest level of authority. They include:

Legislative Sources

U.S. constitution the 16th amendment established the right of congress to impose a federal income tax. Congress creates all tax laws through the legislative process.

Internal Revenue Code (IRC)

The primary statutory authority for federal income tax is enacted by Congress. It is codified as Title 26 of the United States Code, which means it is part of the permanent laws of the United States. Within Title 26, the tax provisions are arranged into a logical hierarchy of subdivisions as follows:

Title → Subtitle → Chapter → Subchapter → Part → Subpart → Section

Each level breaks the law into progressively more specific topics. Each section of the Code contains the actual legal provisions – often a mix of definitions, general rules, exceptions, and computational details. Many Code sections have the following pattern: a general rule stated in subsection (a), followed by specific conditions, limitations, or exceptions in later subsections. For example, a section might say “(a) General rule: [main proposition],” and then “(b) Exceptions: This section shall not apply in cases of X, Y, Z,” etc. Sometimes, an exception to a rule isn’t in the same section at all but is given in a different section of the Code entirely.

Subtitle A, Income Taxes, contains the rules for determining the income tax liability for all types of taxpayers. Within Subtitle A, the most significant component is Chapter 1: Normal Taxes and Surtaxes. This single chapter contains the core provisions for calculating the income tax for every taxpayer, from an individual wage-earner to a multinational corporation. To manage this vast scope, Chapter 1 is broken down into a series of Subchapters, designated by letters (A, B, C, etc.). This is where the logic of the Code truly reveals itself. Some subchapters establish rules that apply to all taxpayers, creating a set of universal concepts. Other subchapters provide specific frameworks that apply only to a particular type of taxpayer or entity. This structure ensures that fundamental principles are applied consistently, while also allowing for specialized rules where necessary.

Universal Tax Concepts

Several subchapters within Chapter 1 establish foundational concepts that are applicable across all taxpayer types. These provisions form the common language of tax law, defining core ideas like income, deductions, and accounting rules that are referenced throughout the Code, regardless of whether the taxpayer is an individual, a corporation, or a trust.

• Computation of Taxable Income (Subchapter B): Defines gross income (§61), specifies allowable deductions, and provides the fundamental framework for arriving at taxable income.
• Accounting Periods and Methods (Subchapter E): Dictates the taxpayer’s tax year (calendar or fiscal) and the method of accounting (cash or accrual) used to report income and expenses.
• Taxation of Property Transactions (Subchapters O & P): Provides the rules for determining the gain or loss on the sale or disposition of property (Subchapter O) and the special treatment for capital gains and losses (Subchapter P).

Entity-Specific Frameworks

After establishing the universal concepts, the IRC directs taxpayers to specific subchapters that govern their unique tax treatment.

• Individuals (Subchapters A and B): Subchapters A and B set forth the principal rate schedules and deduction provisions applicable to individual taxpayers.
• C Corporations (Subchapter C): Subchapter C encompasses the intricate regulations governing corporate formations, distributions (including dividends), liquidations, and reorganizations.
• Estates and Trusts (Subchapter J): Subchapter J delineates the rules for the taxation of income generated by estates and trusts, as well as the procedures for distributing such income to beneficiaries.
• Partnerships (Subchapter K): Subchapter K details the pass-through tax treatment for partnerships, whereby income and losses are allocated to individual partners and taxed on their respective returns.
• S Corporations (Subchapter S): Subchapter S outlines the provisions permitting eligible small business corporations to elect a pass-through tax status, which is similar, though not identical, to the treatment afforded to partnerships.

Income Tax Treaties

Tax treaties are international agreements between sovereign nations, such as the U.S. and other countries. Under the U.S. constitution, treaties made by the president with the advice and consent of the Senate have the force of law and generally take precedence over conflicting domestic statutes. U.S. tax treaties provide specific rules on taxation of income such as dividends, interest, royalties, and business profits to avoid double taxation and resolve jurisdictional tax issues.

Administrative Sources

These are interpretations and guidance issued by the executive branch, primarily the Treasury Department and IRS.

Treasury Regulations

Regulations are issued by the Treasury Department and published in the Federal Register and later in the Internal Revenue Bulletin. They can be legislative, interpretative, or procedural, each serving a distinct purpose.

Types of Treasury Regulations

• Legislative Regulations: These are rules issued under express statutory authority that have the force and effect of law, making them legally binding. They aim to implement and interpret the Internal Revenue Code (IRC) in a manner that creates new legal obligations or rights. Legislative regulations are typically explicitly authorized by Congress in the IRC and go through a formal notice-and-comment rulemaking process. E.g., Treasury Regulation § 1.61-2(c).
• Interpretive Regulations: These regulations interpret and explain existing provisions of the Internal Revenue Code but do not create new law or legal obligations. They provide the IRS’s official interpretation of the tax statutes to help taxpayers and IRS personnel understand how the law is applied. Interpretive regulations, while not as binding as legislative regulations,  are given deference by courts as authoritative interpretations.
• Procedural Regulations: These rules govern the internal practices and procedures of the IRS, including filing requirements, administrative processes, and compliance procedures. They do not affect substantive tax rights or obligations but dictate how taxpayers and the IRS handle tax matters administratively.

Treasury tax regulations can also be classified as proposed, temporary or final, based on when they take effect.

Status of Treasury Regulations

• Proposed Regulations: These are draft regulations published by the Treasury for public comment before becoming final. Proposed regulations do not have the force of law and serve to provide taxpayers and interested parties the opportunity to review and suggest changes. They may offer guidance but are not binding until finalized.
• Temporary Regulations: These regulations are issued to provide immediate guidance on new or urgent tax matters before final regulations are completed. Temporary regulations are effective upon publication in the Federal Register and carry the full force of law while in effect. They are temporary by nature, expiring automatically after three years unless finalized. However, the underlying principles or the simultaneously issued proposed regulations can still provide substantial authority until a permanent replacement is finalized.
• Final Regulations: These are permanent regulations officially promulgated after considering public comments on proposed regulations. Final regulations have the force of law and provide conclusive IRS interpretations of the Internal Revenue Code. They are published as Treasury Decisions (T.D.) in the Federal Register and codified in the Code of Federal Regulations.

Internal Revenue Bulletin (IRB)

The internal Revenue Bulletin publishes several specific types of documents related to internal revenue and tax administration. These include:

• • Revenue Rulings: Official interpretations of the tax law by the IRS, applying the law to specific factual situations.
  • Revenue Procedures: Pronouncements by the IRS concerning its internal practices and procedures.
  • Notices: Public announcements that provide interim guidance, typically involving substantive interpretations of the tax law.
  • Announcements: Public pronouncements on matters of general interest, often with immediate or short-term value, such as deadlines or clarifications.
  • Treasury Decisions: Issued for regulations, rules, or other Treasury pronouncements.
  • Executive Orders: Published as issued when pertinent to internal revenue.
  • Private Letter Rulings (PLRs): Written determinations issued by the IRS in response to a taxpayer’s specific request, applying the tax law to their unique situation. PLRs can only be relied upon by the taxpayer who requested them.
  • Technical Advice Memoranda (TAMs): Guidance furnished by the IRS National Office upon the request of an IRS director or area director, concerning the treatment of a specific taxpayer under examination.
  • Actions on Decisions: An action on decision (AOD) is a formal memorandum prepared by the IRS Office of Chief Counsel that announces and explains the future litigation position that IRS will take with regard to the court decision, including whether to acquiesce or nonacquiesce. They are not binding precedent themselves.

Judicial Sources

Decisions issued by federal courts on tax matters.

• U.S. Tax Court: A specialized court that hears only tax cases. Regular decisions and memorandum decisions are issued. Regular decisions involve novel issues, while memorandum decisions address established principles.
• U.S. District Courts: Federal trial courts that hear a variety of cases, including tax cases.
• U.S. Court of Federal Claims: Another federal trial court that can hear tax cases against the U.S. government.
• U.S. Courts of Appeals: Appellate courts that review decisions of the Tax Court and District Courts within their respective circuits.
• U.S. Supreme Court: The highest court in the federal judicial system. Its decisions on tax matters are binding on all lower courts.

Secondary Authorities

These are commentary sources that interpret, explain, or analyze primary authorities. They do not have the force of law but can be helpful in understanding complex tax issues and identifying relevant primary authorities related to a specific research question. Examples include:

IRS Publications

Informational documents published by the IRS to explain tax laws in a more accessible manner for taxpayers. IRS Publications are official booklets and guides written by the IRS to explain tax laws in clear, plain language. IRS Publications are best viewed as educational guides: they reflect the IRS’s interpretation and administration of the law and generally align with the Code, but they do not carry legal weight if there’s a dispute.

When performing tax research, it could be helpful to start with the IRS publication to get oriented before delving into the actual code sections or regulations that were referenced. Each IRS Publication follows a similar logical structure that makes it easy to find information and connect it to the tax code:

• Clear Topic Headings: Publications are broken into sections or chapters by topic. Major headings outline the key subtopics. This structured layout is much like a mini-textbook, which can help quickly locate a particular issue.
• IRC References: Throughout the text, there often are references to the Internal Revenue Code sections (and sometimes Treasury regulations) that underlie the guidance. These references help  identify the tax authorities relevant to the topic being discussed.
• Plain-Language Explanations: IRS Publications translate complex statutory language into everyday terms. They define key terms (like “dependent,” “qualified education expense,” “active participation”, etc.), spell out eligibility requirements, and describe in step-by-step fashion how the law works. Often, important changes in the law are highlighted in special notes or introductory paragraphs (for instance, a “What’s New” section at the start will summarize recent updates to the tax rules covered by the publication).
• Examples and Scenarios: To reinforce the concepts, IRS Publications include numerous worked examples and real-life scenarios in the text. These examples are usually offset or labeled as such (sometimes with the word “Example” in bold). Examples help understand how the rules are applied.
• Worksheets and Tables: Many IRS Publications provide worksheets, charts, or tables to help apply the rules to a specific situation. Worksheets are often step-by-step forms in the publication that taxpayers can fill out with their own figures (e.g., to compute a deduction or credit amount). There may also be summary tables or comparison charts – for instance, an Appendix might compare multiple education benefits side by side. These tools guide readers through complex calculations in a systematic way, mirroring how the tax forms would capture the information.
• Frequently Asked Questions (FAQs) and Notes: Some publications address common misconceptions or special cases in a Q&A format or in highlighted notes. While not every IRS Publication has a formal FAQ section, many include “Notes,” “Cautions,” or “Tip” callouts that answer questions taxpayers often ask. For example, a note might clarify a tricky point (“Note: You cannot claim the Lifetime Learning Credit and the American Opportunity Credit for the same student in the same year”) which essentially addresses a frequently asked question.
• Cross-References to Related Resources: IRS Publications typically point readers to related forms, instructions, or other publications for further guidance. For instance, an IRS Publication might say, “For more information on business use of your home, see Publication 587,” or “See Form 8863 to claim the education credits discussed above.” These references help connect the dots across various IRS resources.

IRS Form Instructions

Form instructions provide explanations, guidance, and directions on how to complete specific forms but do not carry the force of law.

IRS Internal Revenue Manuals (IRM)

The manual serve as internal policy and procedural guidance for IRS operations. It can help tax research by providing detailed guidance on IRS procedures, policies, and administrative practices. It offers insights into how the IRS enforces and interpret tax laws in practical terms, which can be valuable for understanding IRS rulings, audits, and taxpayer rights.

IRS Audit Technique Guides (ATGs)

These guides are designed to provide guidance for IRS employees, and they can also be useful to small business owners and tax professionals who prepare returns.

Tax Journals and Periodicals

Publications that contain articles on current tax developments and issues (E.g., The Tax Adviser, and Tax Notes)

Citing Tax Authorities

Here are some common citation formats for different types of authorities:

• Internal Revenue Code (IRC): Cite by section number. For example, IRC § 162 refers to Section 162 of the Internal Revenue Code. You may also include the title and year if necessary for clarity (e.g., Internal Revenue Code of 1986, § 162).
• Treasury Regulations: Cite by section number, which corresponds to the related IRC section. For example, Treas. Reg. § 1.162-1 refers to Section 1.162-1 of the Treasury Regulations under IRC Section 162.
• Revenue Procedures: Cite by the year and procedure number. For example, Rev. Proc. 2025-28.
• Revenue Rulings: Cite by the year and ruling number. For example, Rev. Rul. 2023-13.
• Private Letter Rulings (PLRs) and Technical Advice Memoranda (TAMs): Cite by the year, week, and document number. For example, Priv. Ltr. Rul. 202410001.
• Tax Court Cases:
  • Regular Decisions: Cite the taxpayer’s name, volume number of the Tax Court Reports (T.C.), page number, and year. For example, Smith v. Commissioner, 150 T.C. 25 (2018).
  • Memorandum Decisions: Cite the taxpayer’s name, volume number of the Tax Court Memorandum Decisions (T.C. Memo.), page number, and year. For example, Jones v. Commissioner, T.C. Memo. 2023-50.
• U.S. District Court Cases: Cite the taxpayer’s name, volume number of the Federal Supplement (F. Supp. or F. Supp. 2d or F. Supp. 3d), page number, court abbreviation (e.g., D. Mass.), and year. For example, United States v. Brown, 450 F. Supp. 3d 100 (D. Mass. 2020).
• U.S. Court of Appeals Cases: Cite the taxpayer’s name, volume number of the Federal Reporter (F., F.2d, or F.3d), page number, circuit number (e.g., 9th Cir.), and year. For example, Miller v. Commissioner, 987 F.3d 654 (9th Cir. 2021).
• U.S. Supreme Court Cases: Cite the taxpayer’s name, volume number of the United States Reports (U.S.), page number, and year. For example, Loper Bright Enterprises v. Raimondo, 144 S. Ct. 2244 (2024).