Income Tax Myths
"Income is Taxable Only if Connected to a Federal Privilege."
(The "Cracking the Code" theory)
Some protestors argue that income is taxable only if it is connected to a federal "privilege." Under this theory, income derived from being a federal employee, a federal contractor, or something like that would be taxable, but other income would not. The normal income of most Americans, particularly the wages of a private employee working for a private company in one of the 50 states, would not be taxable.
A prime purveyor of this theory is Peter Hendrickson, who used it in his tax protestor book, "Cracking the Code." Hendrickson asserts that for tax purposes, the term "income" has a "narrow legal meaning exclusively involving, and applying to, certain privileged activities, such as holding or administering a government office, or working in one."
It's easy to disprove the "privilege" theory. You need only look at one of the most basic sections of the tax code, Section 61.
Section 61 defines "gross income" to include "all income from whatever source derived." There is no requirement that income be tied to any kind of "privilege," federal or otherwise, to count for tax purposes. For tax purposes, gross income includes all income from whatever source derived, not just income tied to a federal privilege.
That's it, really. It's very simple.
So how could Hendrickson and other tax protestors come up with the kooky "privilege" theory? As is often true, the theory is based on an irrelevant section of the tax code -- which is misinterpreted.
Hendrickson bases (see p. 59) his erroneous view on section 3401 of the tax code. Section 3401 defines "wages" as "all remuneration (other than fees paid to a public official) for services performed by an employee for his employer." Then it defines "employee" as follows:
As you can see, the definition provides that the term "employee" includes federal officials. Therefore, Hendrickson argues, the term does not include ordinary employees of ordinary private companies. So, Hendrickson argues, ordinary employees' wages are not taxable.
This argument is nonsense. There are two reasons.
First, the word "includes" does not mean "includes only." Section 3401(c) provides that the term "employee" includes federal officials, but it doesn't say that it includes only federal officials. Hendrickson's absurd theories are built on his mistaken belief (p. 37) that the term "includes" means "includes only," which it doesn't.
How do we know that "includes" doesn't mean "includes only"? First, this is clear from the ordinary, dictionary definition of the term "include," which means "to contain as a part." But just in case that isn't clear enough, the tax code nails it down by providing:
Thus, the tax code expressly states that a definition that provides that a term "includes" something is not limiting. Once this is understood, Hendrickson's whole argument collapses.
Moreover, in any event, section 3401 has nothing to do with the question of what constitutes income for tax purposes. It isn't in the part of the tax code that imposes the income tax. It's in a different part of the tax code -- the part that sets up the system of employer withholding of taxes from people's wages. So even if Hendrickson were right about the meaning of the term "employee" (which he isn't), that wouldn't prove that people don't owe income tax on their wages. It would only prove that some people aren't subject to income tax withholding on their wages. They'd just have to pay their income tax some other way (like by sending in a check when they file their tax return).
But don't take my word for it -- let's see what the courts have had to say about Hendrickson's argument. In fact, let's consider the opinions of courts in Hendrickson's own cases. Hendrickson has been in court on multiple occasions. Guess what? He lost, big time.
Hendrickson got hauled into court after he filed tax returns falsely showing that he earned zero "wages", even though his employer paid him what any normal person would call "wages" and withheld federal income tax from them. Hendrickson sought a refund of the tax withheld.
As is often the case, the IRS started by trusting the returns. It refunded or credited to Hendrickson the amounts he claimed. (The IRS has millions of returns to process and can't catch everything right away.) Later, the IRS caught up with Hendrickson, and he was the subject of multiple court cases.
In a civil case against Hendrickson, United States v. Hendrickson, No. 06-11753 (E.D. Mich. 2007), the court determined that Hendrickson and his wife were indebted to the United States for the erroneous refunds or credits they had received. The court said (bolding added):
On appeal, the court's judgment was affirmed and the Hendricksons were fined a further $4,000 for the "patent baselessness" of their arguments.
Hendrickson's troubles weren't over. The government prosecuted Hendrickson criminally. In that case, Hendrickson continued to rely on his absurd theories. He filed a copiously briefed motion for acquittal, in which he pressed his bizarre understanding of the word "includes" and argued that the case against him had to be dismissed under the law. Denying the motion, the court observed that:
Hendrickson was convicted and sentenced to nearly three years in federal prison and ordered to pay over $40,000 in fines and restitution. So the courts have squarely determined Hendrickson's theories to be wrong -- indeed, not just wrong, but "frivolous," "false," and "preposterous." (Update: On February 8, 2012, Hendrickson's conviction was affirmed but the court of appeals determined that there had been an error in his sentence. On May 15, 2012, his prison sentence was reduced from 33 months to 27 months.)
If anybody could make the Cracking the Code theories work in court, it would be the guy who wrote the book -- Hendrickson himself. But in fact, he lost his own cases. His theories are wrong and they do not work.
Hendrickson's followers haven't had any luck in court either. An employee of Dell Products who earned about $150,000 a year filed amended tax returns based on Cracking the Code, claimed that he earned zero wages, and sought a refund of all amounts withheld from his pay. When his case got to court, not only did he lose, but he was fined an additional $20,000 for pursuing frivolous arguments. Montero v. Commmisioner, 354 Fed. Appx. 173 (5th Cir. 2009).
Another Hendrickson follower, a Northwest Airlines pilot, claimed that the money he received from Northwest was not taxable income because Northwest is a "private sector company, which is not owned or operated on behalf of the United States" (i.e., no federal "privilege" was involved in his work). The court said that that was "immaterial" to whether the money was taxable income. The court noted that the pilot's theory appeared to be based on Cracking the Code and characterized it as "a frivolous tax-protestor argument." The pilot lost. Nelson v. U.S., 2009 WL 5851082 (N.D. Fla. 2009).
In short, like other tax protestor arguments, Hendrickson's argument has been to court many times and has a batting average of zero. It certainly didn't work out for Hendrickson in his own cases.
So how could anyone ever fall for Hendrickson's nonsense? One thing helps him fool people: some people have actually obtained tax refunds using his method. Images of their refund checks, and in some cases the underlying tax filings that led to them, are posted as "victories" on Hendrickson's website.
If Hendrickson's arguments and methods are nonsense, why does the IRS sometimes issue refunds to people who use them?
This happens because the IRS has over 100 million returns to process every year and can't catch everything right away. The IRS wants to get refunds out quickly. So in many cases the IRS starts out by trusting the filed return. If you file a return showing that you are owed a refund, the IRS may send it to you, even if the return is filled with fake numbers that you made up.
But later, the IRS can check more carefully. What Hendrickson doesn't tell you on his "victories" page is that the IRS later catches up with a lot of the people who got initial refunds using his method. And when it does catch up with them, it collects the refund back, plus interest, plus penalties. In many cases the penalties include a $5,000 penalty for filing a frivolous return.
Hendrickson's own story is a good illustration. As mentioned above, he initially got refunds or credits using his method, but later the IRS came after him and got a judgment that he owed the money back, plus interest and penalties. And he went to prison to boot. Not exactly a roaring success.
In addition, starting in the mid-2000s, the IRS reprogrammed its computers to catch people using Hendrickson's method even before the initial refund check goes out. So while some Hendrickson-style filings still slip through, it's harder than it used to be to get even an initial refund using his method. Hendrickson's web forum is filled with stories of people who tried to use his method and who are getting hit up with $5,000 penalties for frivolous filings.
So if you file a return that falsely says that your W-2 is a mistake and that in fact you received no wages, it may initially produce a refund. But it's more likely to produce a $5,000 penalty. And even if you get an initial refund, the IRS can catch up with you later and get the money back, plus interest and penalties.