Here's what tax professor Jonathan R. Siegel of George Washington University Law School says about the argument:
The 861 argument, as articulated by Larken Rose, contains much, much buildup, but in the end it's all based on a misunderstanding of this regulation. The regulation just provides a list of the situations in which it matters whether income is from foreign sources or not. The regulation does not show that domestic income is not taxable. The above references, and particularly code section 61's definition of gross income as "all income from whatever source derived" (as opposed to section 871's limitation to "the amount received from sources within the United States"), shows that the domestic income of a U.S. citizen is subject to the income tax.
By the way, the notion that the whole thing turns on a regulation is somewhat ironic: most tax protestors are particularly insistent that they want the government to rely on laws (which have to be passed by Congress), not just regulations (which come from a government agency such as the IRS).
Siegel adds that as long as we're consulting the IRS regs, we might as well look at 26 C.F.R. § 1.1-1:
. . . (b) Citizens or residents of the United States liable to tax. In general, all citizens of the United States, wherever resident, and all resident alien individuals are liable to the income taxes imposed by the Code whether the income is received from sources within or without the United States.
As we've come to expect, there's nothing to the 861 argument. For more, click here.