Congress creates the Commissioner of Internal Revenue and enacts the first national income tax to pay war expenses. (The Confederacy also adopts an income tax.) At first, a flat 3 percent tax was set on all incomes greater than $800. This is later modified to 5 percent for incomes between $600 and $5,000, and 10 percent for incomes greater than $5,000. After the war, in 1872, Congress repeals the income tax.
In an effort to reduce tariff rates, which provide the federal government with most of its revenue, Congress institutes another income tax of 2 percent on incomes greater than $4,000. Opponents decry the tax because it “takes from the wealth of the thrifty and the enterprising and gives it to the shifty and the sluggard.”
The Supreme Court rules in Pollock v. Farmer’s Loan & Trust Co. that the new federal income tax is unconstitutional because it violates Article I, sections 2 and 9 of the Constitution. These sections, known as the “rule of apportionment,” specify that all federal taxes must be imposed based on the population of each state, rather than directly on the people.
Soon after the Sixteenth Amendment is ratified, Congress levies a 1 percent tax on personal incomes greater than $3,000 and a 6 percent tax on incomes above $500,000. These taxes affect only a very small portion of the population. At the same time, the Treasury Department devises the first Form 1040.
In Stratton’s Independence v. Howbert, the Supreme Court defines income under the tax law as the “gain derived from capital, from labor, or from both combined” including both the dividends paid to corporate stockholders and the profit that is gained from selling assets.
To raise additional taxes necessary to finance the First World War, Congress increases the top rate of the income tax to 77 percent, an all-time high. Modern federal tax rates vary between 10 and 38 percent.
Congress creates the U.S. Tax Court to give taxpayers a place to dispute decisions of the Internal Revenue Service involving payment of federal income, gift, or estate taxes. The Tax Court’s decisions can be appealed to the federal courts of appeals and are subject to review by the U.S. Supreme Court. Today, there are nineteen tax court judges who are appointed by the President for terms of fifteen years.
In United States v. Sullivan, the Supreme Court holds that financial gains made from illegal activities, such as drug sales or gambling, are taxable income under the Revenue Act of 1921. The Court finds that there is no reason to exclude revenues made from illegal businesses. The statute specifically requires payment from businesses of any kind and taxes are due as if the business were lawful.
To pay the rising costs of the World War II, Congress imposes income taxes on people with average incomes. So many people default, because they have not saved sufficiently to pay their taxes, that the government creates a new system for collecting income taxes by mandatory “withholding from wages and salaries.” Employers are required to deduct the tax from employees’ salaries before paying them.
The Bureau of Internal Revenue, first established in 1862, is reorganized and renamed the Internal Revenue Service (IRS). It remains the largest of the bureaus within the Department of the Treasury and is responsible for collecting federal taxes. The IRS deals directly with more Americans than any other institution, public or private.
The U.S. Tax Court imposes financial penalties on taxpayers who pursue “frivolous cases” to delay the payment of their taxes. The IRS also rejects many claims raised by people who refuse to pay their taxes, such as filing returns with zeros on every line, or demanding a refund equal to the amount withheld from their earnings.