Recall that there are three principles that guide us through every question of income tax. See chapter 1. The first of these principles is that “we tax income of a particular taxpayer once and only once.” A good bit of our study to this point has been to identify inconsistencies or anomalies with this principle, i.e., exclusions from gross income and certain deductions. In this chapter, we refine the notion of taxing all income once by adding this caveat: not all income is taxed the same. Taxable income has a “character” that determines the tax burden to which it is subject. Under § 1(h), an individual’s tax liability is actually the sum of the taxes of different rates on income of several different characters.
We have also seen that the Code states rules whose effect is to match income and expenses over time. SeeIdaho Power, Encyclopaedia Britannica, supra. We now find that the Code requires taxpayers – with only quite limited exceptions – to match income, gains, losses, and expenses with respect to character. Taxpayers who perceive these points may try to manipulate the character of income and associated expenses, and the Code addresses these efforts. Generally, a taxpayer prefers gains to be subject to a lower rate of tax, and deductions to be taken against income subject to a higher rate of tax.
The Tax Formula
MINUS deductions named in § 62
EQUALS (adjusted gross income (AGI))
MINUS (standard deduction or
MINUS (personal exemptions)
EQUALS (taxable income)
➔Compute income tax liability from tables in § 1 (indexed for inflation)
MINUS (credits against tax)
We consider here incomes of the following characters: long-term capital gain (and its variations), short-term capital gain, depreciation recapture, § 1231 gain, dividends, and passive income.