The Internal Revenue Service (IRS), part of the U.S. Department of the Treasury, is mandated by federal law to enforce the tax laws of the United States. In addition to collecting income tax from individuals and corporations—the largest source (55 percent) of the government's income—the IRS also collects such major revenues as Social Security taxes, excises (taxes on commodities), gift taxes, and estate taxes. Internal revenues derived from the sale of alcohol, tobacco, and firearms are no longer collected by the IRS.


For the most part, the revenue history of this country has consisted of tariffs levied on imported goods and, in colonial times, various property taxes. The extreme reaction to "taxation without representation" might have been due to the abhorrence of taxation in general. Raising revenue to fund George Washington's army turned out to be a thankless task; when Americans finally installed a government that represented them in 1781, they made sure that the Articles of Confederation deprived the central government all right to levy taxes.

The stinginess of the state treasuries and obvious need for revenue led the founding fathers to insert into the new federal Constitution a clause (Article I, Section 8) granting the federal government the right to raise taxes. As the first Secretary of the Treasury, Alexander Hamilton (1755-1804) exerted every effort to strengthen the taxing power of the government, and thanks to his initiative, Congress passed the first revenue bill in U.S. history, the Revenue Act of 1791. This created the office of the Commissioner of Revenue, predecessor to today's IRS. The commissioner was empowered to collect the excise tax not only on distilled liquor, but also excises on all manner of other goods, as well as a progressive tax on property.

Judging from the fierce opposition to these taxes, especially the one on liquor, taxation with representation proved to be every bit as unpopular as without. Thomas Jefferson, who became president in 1801 and led the opposition, helped to repeal the act and disband the commissioner's office. The federal government subsequently relied on the lucrative revenues derived from tariffs, and the Treasury recorded surpluses annually until the eve of the Civil War.

The War of 1812 necessitated levying a new internal tax that resembled a sales tax on purchased goods. The office of Commissioner of Revenue was restored. When the war ended in late 1814, Treasury Secretary Albert Gallatin hoped the taxes would continue, but Congress abolished them, as well as the commissioner's office, in 1817. There was enough money in the treasury to fund the Mexican War 29 years later without an internal tax.

The real birth of the IRS, or the U.S. Bureau of Internal Revenue as it was originally called, had to wait until the Civil War. With $2 million per day going to fund the public debt, the need for more revenue was desperate. In July 1862, President Lincoln signed the largest revenue bill in U.S. history. Once again, it revived the office of Commissioner of Internal Revenue. The commissioner was empowered to establish a system to collect a progressive income tax based on income withholding (a tax return form was duly created), as well as to collect numerous other internal taxes. For the first time, failure to comply with the tax laws could result in punishment: prosecution and confiscation of assets most extreme cases. Tax returns had to be signed under oath.

Operating in a tiny room in the U.S. Treasury Building in Washington, the new commissioner, George S. Boutwell, read every letter from anxious new taxpayers and kept his office open day and night to accommodate the crush of inquiries. The income tax forms seem simple by today's standards but were complicated to most new taxpayers then: even Abraham Lincoln failed to understand his form and unnecessarily overpaid (a sizable refund arrived posthumously). By the end of fiscal year 1863, the new revenue bureau took in, through its assessors and collectors, nearly $40 million.

By war's end, the Bureau of Internal Revenue had grown from I employee to more than 4,000. Despite the revenue garnered, the public deficit stood at an unprecedented $3 billion in 1865. Surprisingly, the income tax was discontinued after the Civil War, including the lucrative inheritance tax. The bureau, however, was not dismantled along with the taxes. Until 1913, most of the nation's revenue derived from taxes on fermented and distilled liquor and tobacco. The bureau was put in charge of collecting the liquor and tobacco taxes, and a rather odd tax on oleomargarine that Congress levied in 1886 to protect the butter interest. In 1890, to control the sale of opium, a tax on it was also collected by the bureau.

How is it that the Bureau of Internal Revenue became identified almost exclusively with the income tax? In 1894, a bill restoring the progressive income tax passed Congress, in response to the agitation and lobbying efforts of Populists, Greenbackers, and other reformers who believed the rich should pay their dues to society. The next year the U.S. Supreme Court, in Pollack v. Farmers Loan and Trust Co., struck down the income tax as unconstitutional, to the dismay of reformers. The newly created Income Tax Division of the Bureau of Internal Revenue was duly disbanded.

Lobbying on behalf of a progressive income tax intensified after 1895. The vast majority of Americans would be exempt from paying income tax, with only the well-to-do expected to pay. President Taft (1909-13) supported the idea of an amendment to the Constitution that would specifically allow the government to implement such a tax. The amendment he supported was quickly adopted by the states, and in February 1913, under President Woodrow Wilson, who had defeated Taft in the interim, the 16th Amendment inaugurated the income tax. In October followed a revenue bill establishing a progressive income tax for those earning over $3,000, only I percent of the population. Corporations also were subject to a tax on net income. Almost immediately, the Income Tax Division, heir to the one dismantled in 1895, was revived.

World War I, which cost the nation nearly $35 billion, was financed in part (33 percent) by internal revenues. Even before the United States became involved in the war, the Revenue Act of 1916 enlarged the number of taxpayers and created other internal taxes. The bureau was charged for the first time with publishing income tax statistics.

Following the 1916 tax law, other laws were swiftly passed to raise revenue for the war. The War Revenue Act of 1917 created new excess profits and estate taxes and other revenue measures. The bureau was a beneficiary of some of this windfall, as its budget increased from $8 million in 1917 to nearly $15 million in 1918. In that same period, revenue collectors in the field increased from 4,500 to 7,400.

During World War I, the bureau for the first time made a determined effort to educate the public about the patriotism of paying taxes. Clergyman were encouraged to preach the morality of income tax filing from the pulpit. The bureau also established its first intelligence division, with specially trained officers to detect tax fraud (a system of withholding tax money from paychecks had been repealed by Congress in 1916, undoubtedly making evasion easier).

Postwar agencies maintained the need office for revenue, so that by 1920, the bureau collected a record $5.5 billion in revenue, compared to $350 million in 1913. From a total of 4,000 employees in 1913, its bureaucracy sprawled to 15,000 seven years later.

In 1919 the 19th Amendment, outlawing alcoholic beverages, became part of the Constitution. Prohibition occasioned the establishment of a prohibition unit in the Bureau of Internal Revenue. Oddly, the Prohibition Law of October 1919 gave the Commissioner of Internal Revenue the authority to enforce the criminal aspects of the ban on liquor. Although distilleries were illegal, they were subject, if detected, to prosecution for tax evasion. The Bureau of Internal Revenue in 1925 alone made over 77,000 arrests, besides seizing and impounding property. After 1930, the U.S. Department of Justice took over these duties. When the 19th Amendment was repealed in late 1933, the bureau switched to collecting a liquor revenues again.

In that year the Great Depression reached its height. The trauma of that experience ushered in the New Deal, which was committed to the philosophy that the government should spend money, even at the risk of an unbalanced budget, to get people back on the job. Another concern in those desperate times was the elderly indigent, whose plight resulted in the Social Security Act of 1935. Two years later, the Social Security Tax Division was up and running in the Bureau of Internal Revenue.

By 1941, the number of employees at the bureau, thanks to the New Deal, rose to an all-time high of 27,000. Because of five major tax cuts in the 1920s, revenues stood at only $1.6 billion in 1933. In 1941, because of government spending, tax revenues of necessity increased to a record $7.4 billion. Four years later, the cost of the war had driven revenues up to $45 billion.

Despite $7.4 billion collected by the IRS in 1941, still only a segment of the U.S. population filed income tax returns—at most 8 million, including corporations. The huge demands of wartime spending changed that. More and more individuals earning modest salaries, previously excluded from taxation, were required to pay. While in 1939 those earning less than $5,000 made up only 10 percent of the taxpayers, by 1948 these accounted for at least 50 percent. After 1941, therefore, the number of taxpayers increased greatly—from 8 million in 1941 to 60 million in 1945—and unlike the decade following World War I, there would not be a reduction in taxation after 1945.

The final building block to the creation of a modern revenues state was the reintroduction (after it was repealed in 1916) of tax withholding in July 1943. This money was sent directly from the place of employment to the bureau. A year later, the "standard deduction" came into force for the first time also. Such a massive number of tax returns were coming into the bureau that it was collapsing under the strain, despite the debut of an abbreviated tax form in 1941, and tax refunds were taking over a year to be processed. This gave rise to bitter public criticism.

The result of the 1951 House subcommittee investigation of the bureau was the 1952 Reorganization Plan No. 1, inaugurating the most extensive restructuring of this agency in its history. All politically appointed posts within the bureau, except for the commissioner and deputy commissioner, were replaced by civil service positions. The agency was significantly decentralized, with headquarters in Washington determining policy, while field offices were given wide latitude in decision making. In addition, electronic machines—predecessors of the computer—were introduced to speed up processing of forms, which in turn were further simplified. Lastly, the name of the agency was changed officially to the Internal Revenue Service.

The organization of the IRS remained basically unaltered from 1952 until the late 1990s, when new reforms were enacted. Reporting to the headquarters in Washington were seven regional IRS offices headed by a regional commissioner, and 64 district offices headed by a district director. It was at the district level that the tax laws are interpreted and applied, and often no two districts applied the laws alike. Ever since the U.S. Bureau of Alcohol, Tobacco, and Firearms became a separate division within the Treasury Department in 1972, the IRS has no longer been responsible for collecting revenue on these items.


Tax collection can be uncomplicated: most pay their taxes through payroll deductions. Tax returns are sent processing centers, where a computer scans each one for errors. For error-free returns, this is the end of the line, with the exception of processing a refund for those eligible. Unlike in Sweden, where the majority of tax returns are audited, in the United States only a small proportion—around 10 percent—are audited. This is mainly because of the expense involved. If tax fraud is discovered through an audit, any one of a range of 150 penalties can be assessed against the taxpayer. The severest is the seizure of one's property. In 1990, nearly 3 million seizures took place. Taxpayers have the right to appeal such seizures.

Detecting such fraud is an important and expensive pursuit on the part of the IRS, requiring specialized computer equipment and skilled research staff to pour over complex financial transactions. The IRS has the legal authority to request information from any bank and to inquire into any type of vehicle registration or business activity. This uncovers a huge amount of information on businesses or individuals, particularly as financial transactions and records are increasingly automated.

The IRS can also legally transmit taxpayer information to a variety of other government agencies. In this way, a person who has defaulted on a student loan or who has failed to pay child support can be ferreted out and forced to pay.


Businesses generally have two kinds of tax obligations to the IRS: payroll and income. Federal payroll taxes are mostly withheld from employee wages and submitted to the IRS on a regular schedule that depends on the size of the business. (State and local taxes may also be withheld, but these are not processed by the IRS.) Larger businesses, e.g., with more than $50,000 in payroll tax liabilities per year, are required to deposit withholding taxes more frequently, and in some cases, electronically. In addition to deductions from wages, employers must match employee Social Security contributions.

While almost any company has payroll liabilities, not all companies pay corporate income tax. Net income (profit) at subchapter S corporations, or small business corporations, is not taxed separately from the owners' personal income tax. The same is true of sole proprietorships and most partnerships (limited liability partnerships may be taxed as corporations under some circumstances). In addition, if a regular C corporation has no net profit for the year, there generally is no corporate tax at the federal level. When a corporation is liable for federal income tax, the basic tax rate is between 15 and 35 percent, depending on the amount of income. If a C corporation distributes profits in the form of dividends to shareholders, the shareholders are usually also taxed, creating double taxation.

As with individual income tax, business taxes paid to the IRS are "voluntary" in the sense that the company is responsible for determining the correct amount to pay and for meeting the appropriate deadlines. Companies that underpay or fail to file in a timely manner are usually subject to stiff penalties and interest charges.


As of 1997, the IRS received income tax returns from nearly 1.8 million partnerships, 5.2 million corporations, and approximately 17 million sole proprietorships. Employer wage withholdings and contributions accounted for around two-thirds of the IRS's $1.5 trillion in net collections. Corporate income tax that year made up just 12.3 percent, or $182 billion, of total collections.

In 1997 a labor force of 101,703 carried out the collection and processing of federal taxes at the IRS. Nearly 93 percent of these employees worked in field offices, and the remainder staffed the IRS national headquarters in Washington, D.C. This employment level, which was at its lowest point since 1986, reflected the Clinton administration's efforts to downsize the federal government. IRS staffing reached its apex in 1992, when the bureau employed 116,673 workers, including more than 9,000 at its headquarters.

The IRS cost $7.2 billion to run in 1997. Cost-containment measures during the mid-1990s improved the bureau's overall efficiency, as measured by the ratio of operating costs to dollars collected. The IRS's cost efficiency had waned in the late 1980s and early 1990s as its expenditure growth outpaced revenue growth. By 1997 the cost of collecting each $100 in taxes was back down to $0.44, from a peak of $0.60 in 1993. Over the previous 30 years, the IRS's most cost-efficient year was 1981, when operating costs ran at just $0.41 per $100 of revenue.

Always the object of public scrutiny and mistrust, the IRS during the 1990s underwent a number of reform initiatives—some voluntary and some legislated by Congress—to improve its performance and accountability to taxpayers. Perhaps the most sweeping of these was the bureau's decision in 1999 to abandon its long-standing geographical organization, which granted significant latitude to regional offices. In a move mandated by the Restructuring and Reform Act of 1998, the bureau announced that it would create instead four operating units to specialize in various revenue categories. The four were (1) the Wage and Investment Income Operating Division, based in Atlanta; (2) the Small Business and Self Employed Operating Division, based in Washington, D.C.; (3) the Tax Exempt Operating Division, also based in Washington; and (4) the Large and Mid-Size Business Operating Division, based in New Jersey. These divisions replaced the geographic structure of four regions containing 33 district offices. Other reforms included placing a greater burden of proof on the IRS when it brings cases in U.S. Tax Court and creating an oversight board for the bureau.


Bumham, David. A Law unto Itself: The IRS and the Abuse of Power. New York: Vintage Books, 1989.

Fay, Jack R. "What Form of Ownership Is Best?" CPA Journal, August 1998.

Internal Revenue Service. 1997 Internal Revenue Service Data Book. Washington, 1999. Available from .

Philips, Bernie. "Are the IRS Districts Being Eliminated?" National Public Accountant, March-April 1999.

Saunders, Laura. "Congress Giveth—With Strings." Forbes, 23 March 1998.

Worsham, James. "IRS Overhaul Is Good News for Small-Business Owners." Nation's Business, September 1998.

User Contributions:

Comment about this article, ask questions, or add new information about this topic: