It is said that the Tax Code [1] (“Code”), which contains approximately 3.7 million words, [2] would take an average person thirteen 24-hour days to read.Even if someone were to read the Code straight through is this fashion, such an undertaking would not prove very useful for the reader. Like any other body of statutory law, the Code is not written as a story that unfolds in a liner fashion from start to finish.

The rules set out in the Code can best thought of in terms of a decision tree, with points or rules, connected by lines, or relationships, that often, but not necessarily, lead to one or more additional points. The points or rules may or may not be clearly identified in the Code.A single point or rule may be contained in a single sentence in one Code section, consist of an entire Code section, or consist of language that spans several different Code sections.Other points or rules may not even be included in the Code at all; they may be implied or simply absent.The connecting lines or relationships between the rules may not be evident from the language in the Code itself.This can make it very difficult to read and apply the rules set out in the Code.

It need not be difficult to read and apply the Code.Most of the rules set out in the Code fall within one of a mere six categories, namely, they are either inclusion, exclusion, tax deduction and credit, timing, limitation, or definition rules.These categories provide the statutory framework for evaluating and applying the rules set out in the Code.This paper describes each type of rule and cites examples with the aim of helping readers gain a better understanding of the Code.

Inclusion Rules

Our federal income tax system is based on the notion that the receipt of income is to be subject to tax.This is carried out in the Tax Code by income “inclusion” rules.Inclusion rules identify the income that must be included a taxpayer’s gross income.

Inclusion rules are often easily identified.The terms “income” and “inclusion” are typically used in the Code section itself.Inclusion may be described by reference to income, particular property that is known to produce income, or the individual items of income.Income, dividends, interest, rents, royalties, payments, proceeds, services, prizes and awards, loans, benefits, pensions, and annuities are all terms used to describe income that must be included. [3] Included income may also be described using the terms “amount realized” or “gain” (and conversely, the absence of income may be referred to using the term “loss”).

Inclusion rules usually reference a triggering event.The triggering event may be expressly stated.Triggering events include a sale, [4] exchange, [5] sale or exchange, [6] sale or other disposition, [7] disposed of, [8] disposition, [9] conversion, [10] transfer, [11] distribution of property, [12] a termination, [13] or even the cutting of timber. [14] There are others.Some of these triggering events overlap and remain consistent across Code sections or are presumed to be incorporated into other Code sections. [15] Others are unique to specific Code sections. [16]

A few inclusion rules identify a particular taxpayer.The taxpayer is often referred to as a “shareholder,” “partner,” “employee,” “[bond] holder,” or “beneficiary” in these rules.These rules help ensure that income is included by at least one taxpayer.For example, I.R.C. §§ 652 and 662 provide that the beneficiary of certain trusts must include the trust’s income in his own gross income.Section 701 provides that a partner in a partnership must include the partnership’s income in his own gross income.Section 951 provides that a United States shareholder of controlled foreign corporation must include the corporation’s Subpart F income in his own gross income.Section 1271 provides that a bond holder must include the amount received from retiring a bond in his gross income.Section 1366 provides that a shareholder of Subchapter S Corporations must include the corporation’s income it his own gross income.

Section 61 is the primary inclusion rule.In addition to providing several examples of items of income that must be included, it provides the general rule is that every accession to wealth must be included in gross income. [17] There are other inclusion rules in the Code.These rules clarify that specific items of income must be included in gross income as they may not appear to fall within the general inclusion rule provided in I.R.C. § 61.Sections 71 through 90 describe several of these additional items of includible income. These items of income include alimony payments, [18] prizes and awards, [19] reimbursed moving expenses, [20] unemployment compensation, [21] and others.

Exclusion Rules

Exclusion rules are the opposite of inclusion rules.Items that are excluded from gross income do not result in a tax liability.This is true even though the excluded income may have been received by the taxpayer.

It is not difficult to identify most exclusion rules.The term “excluded” and “nonrecognition” are typically used in the Code section itself.Exclusion rules often identify income, particular property that is known to throw off income, or the individual items of income.Gain, [22] gross income, [23] amounts received, [24] value, [25] payments, [26] interest, [27] and even the value of unpaid rent [28] are all terms used to describe excluded income.

Like inclusion rules, exclusion rules include a triggering event.The triggering events found in exclusion rules are more limited than those found in inclusion rules.They are usually sale and purchase, [29] exchange, [30] transfer, [31] receipt [32] or recovery [33] of money or property.These terms may not be implied in the Code, rather than expressly stated. [34]

Exclusion rules are frequently associated with sensitive or poignant situations in which it would be distasteful to impose an income tax.For example, life insurance benefits received on account of death of a third party [35] and compensation for physical injuries or sickness are excluded from gross income. [36] Income from the discharge of indebtedness for a taxpayer who is insolvent is excluded from gross income. [37]

Sections 101 through 140 provide several exclusion rules.These exclusion rules relate to life insurance death benefits, gift and inheritance proceeds, and various other items of income that can be excluded from income.There are many others scattered throughout the Code.For example, I.R.C. § 337 allows corporate taxpayers to exclude from income amounts received on complete liquidation of a subsidiary.Sections 351 and 721 allow investors to exclude from income amounts received in exchange for capital contributions to corporations and partnerships.Section 354 allows taxpayers to exclude from income amounts received in tax-free reorganizations.

Tax Deduction and Credit Rules

A tax deduction or credit does not exist without an express rule in the Code.A tax deduction merely reduces gross income or taxable income; whereas, a tax credit reduces the taxpayer’s actual tax liability.

Tax deduction and credit rules will always include the word “deduction” or “credit.”Like income inclusion and exclusion rules, tax deductions and credits usually reference a specific triggering event.The triggering event is usually a capital outlay, such as an expense, [38] amount paid, [39] or contribution. [40] There are other triggering events; such as property becoming worthless, [41] property being used up, [42] or distribution of property. [43] Even the receipt of income [44] or having unused business credits [45] can trigger a tax deduction rule.

Tax deduction and credit rules often refer to activities related to the expenses.This includes activities related to trade or business, [46] investment, [47] or other expenses. [48] The activity may also relate to some item of property or the development of property that is deemed to have high social value, such as the use of energy-saving property, [49] making low-income housing available, [50] manufacturing of a product, [51] or research and design of a product. [52]

Sections 21 through 53 provide for a number of tax credits.These tax credits include various business and personal, refundable and non-refundable tax credits. This includes the adoption expense, child, hope and lifetime learning, earned income, and disability access expense tax credits.Sections 151 through 249 provide for a number of tax deductions.These tax deductions include various deductions available to individual and corporate taxpayers.This includes the personal and dependent exemption, bad debt, depreciation, black lung trust contribution, and start-up expense tax deductions.

Timing Rules

The Code contains a number of timing rules.Timing rules speed up or delay income, exclusion, deduction, and credit rules.Timing rules are “realization” rules.The term realization refers to when the income, exclusion, deduction, or credit must be counted for tax purposes.Thus, timing rules provide for when income or tax attributes, such as tax deductions and credits, are counted for tax purposes.

Some timing rules are easy to identify as they specifically reference specific tax periods or the carryforward or carryback of tax attributes.Timing rules may even be tied to the date the taxpayer reaches a certain age. [53] Code sections dealing with methods of accounting rules and loss carryforward and carryback rules [54] and methods of accounting [55] are timing rules.For example, I.R.C. § 451(a) provides the general rule that income is to be included in the year it is received.Section 453(a) allows taxpayers to recognize income from an installment sale, which consists of payments received after the close of the taxpayer’s taxable year, using the installment sale method.Both of these Code sections include timing rules.

Timing rules often refer (or relate) to a taxpayer’s tax basis in property.Tax basis is the method to account for capital outlays when a deduction is not immediately available. [56] These are often delayed deduction rules.These rules often use terms such as “amortization,” “capital expenses,” or “capitalization.”For example, I.R.C. §§ 611(a) and 613(a) allow a taxpayer to deduct amounts for depletion of certain natural resources.Section 197(a) allows a taxpayer to amortize and deduct costs to acquire certain intangible assets.Section 248(a) allows a taxpayer to defer deduction of organization expenses over several years.

Some timing rules are less obvious. It can be difficult to distinguish non-recognition exclusion rules and timing rules.Section 1031 provides an excellent example.Subsection 1031(a) provides for the “nonrecognition of gain” for exchanges of certain like-kind property.This may seem like an exclusion rule as it uses the term “nonrecognition.”However, a closer inspection of the Code section reveals that it merely delays the recognition of income until some future point in time.Its non-recognition is not permanent and, therefore, it is not a true exclusion rule. [57] As a result, I.R.C. § 1031(a) is primarily a realization or timing rule.

Many timing rules are grouped together in separate Code sections.Sections 441 through 483 provide a number of timing rules.These rules relate to methods of accounting.Sections 381 through 384 provide additional timing rules.These rules relate to the carryover of tax attributes by corporations.There are many other timing rules sprinkled throughout the Code.These timing rules may be included as part of another Code section, such as I.R.C. § 166 (bad debts are deductible in the tax year when they become wholly worthless), or as a standalone Code section, such as I.R.C. § 1212 (limitation on capital loss carrybacks and carryovers).

Limitation Rules

The Code contains a number of limitation rules. As the name implies, limitation rules provide limits.Anything provided in the Code can be limited.Amounts of income that is to be included or excluded, tax deductions, or credits, or the time involved can be subject to a limitation rules.Limitation rules are particularly important in the context of tax deductions and credits as deductions and credits are deemed to be a matter of legislative grace and they are to be strictly construed. [58]

Some limitation rules are easily identified as they are expressly noted as such.They usually include terms like “disallowance,” “reduction,” “phase out,” or “limitation.”Limitation rules are usually targeted to specific transactions, items of income, amounts, or tax deductions or credits.In this case the statute will spell out what type of transactions, items of income, amounts, or tax deductions or credits for which the limitation applies.For example, the deductibility of student loan interest is limited for taxpayers whose income is greater than a specified amount. [59] Section 1211 limits capital losses to the extent of capital gains.Section 38(c) limits certain business tax credits available in any one tax period.

Like tax deduction and credit rules, limitation rules may refer to the taxpayer’s activities.The limitation usually relates to whether the taxpayer was involved in a trade or business, [60] rental, [61] investment, [62] non-for profit, [63] or other activity.These limitations usually measure the level of the taxpayer’s activity.For example, I.R.C. § 183 limits the availability of any tax deduction associated with an activity if the activity does not rise to a business or investment activity.Section 465 limits the availability of any tax deduction associated with an activity to the extent the taxpayer is subject to a risk of financial loss.The activity in limitation rules may be described in terms of characterization.Income may be characterized as capital or ordinary depending on the activity or use of the asset that produced the income. [64] Income is subject to different tax rates and the availability of certain tax deductions may be limited based on these classifications.

Some limitation rules impose reasonable requirements.These requirements are another form of limitation rule that is found in the Code. These rules use terms such as “reasonable allowance” or “reasonable under the circumstances.” [65] For example, I.R.C. § 162 limits the deduction for salary paid to an employee for service to an amount that is reasonable.Section 174 limits the deduction for qualified research and experimental expenses to those expenses that are reasonable under the circumstances.

Limitation rules also include term and definition rules.Term and definition rules are de facto limitation rules in that they specify what does not qualify.They often include the word “means” or “definition.” [66] These rules may be limited to specific transactions, or entire income, exclusion, deduction, credit, or timing rules.In this case the Code section will typically identify the specific transactions, or entire income, exclusion, deduction, credit, or timing rules to which they relate.

Limitation rules are often included in individual Code sections to which they relate.This is especially true for term and definition and reasonableness limitation rules.Limitation rules may also be found in separate standalone Code sections. For example, I.R.C. §§ 465 and 469 limit tax deductions to amounts the taxpayer has at risk and passive activity losses to passive activity gains.Other limitation rules are found in separate Code sections that function as repositories for a number of different limitation rules.For example, a number of term and definition rules, which are limiting rules, can be found in I.R.C. § 7701.Sections 261 through 280H are rules that provide a number of different limits for various tax deductions.These limitation rules relate to personal and capital expenses, and losses between related taxpayers, among others.

Conclusion

The rules set out in the Code are part of a very specific statutory framework.The framework is made up of inclusion, exclusion, tax deduction and credit, timing, limitation, and definition rules.Each category of rule has its own unique characteristics.Key words, triggering events, and activities are but a few of these characteristics.By identifying the category and the characteristics that are expressly stated, implied, or omitted, the reader can appreciate how the rules in the Code interact and, ultimately, gain a better understanding of the Code.

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