Moore v. United States: the U.S. Supreme Court’s Impending Revisiting of the Definition of “Income”

Abstract

The passing of the Tax Cuts and Jobs Act (“TCJA”) in December 2017 made significant changes that affect both domestic and international businesses income taxes. One of the most notable changes involves the Internal Revenue Code (“IRC”) section 965 transition tax on foreign earnings of foreign subsidiaries of U.S. companies, which deems those earnings to be repatriated. Effectively, this transition tax disregards the realization element thought by some to be a U.S. Constitutional requirement. As such, questions have arisen in the courts regarding the constitutionality of these laws. The most noteworthy case of Moore v. United States has found its way to the steps of the U.S. Supreme Court. Petitioners are asking the U.S. Supreme Court to overturn the Ninth Circuit holding that income realization is not a requirement when upholding the transition tax. The outcome of this case could redefine the term “income” and thus disrupt the entire U.S. income tax code.

The ruling from Moore will greatly affect not only current tax regimes such as Subpart F, GILTI, passthrough tax treatment, but also may have large implications on proposed tax laws such as the mark-to-market tax. Eliminating the realization requirement in the definition of income would effectively eliminate all possibility of the mark-to-market tax, otherwise known as the wealth tax, and quite possibly change all of tax law as we know it.

I. Overview

The 16^thAmendment of the U.S. Constitution allows Congress to tax “incomes from whatever source derived.” It does not authorize the government to directly tax the pockets of the people or to directly tax their wealth. [3] The Constitutional Convention in enacting the 16^thAmendment, decided that direct taxes would be authorized only if each state paid a per capita amount. [4] Therefore, direct taxes should be allowed only if the taxes were apportioned to the population. [5]

There have been proposals as of late to institute “direct taxes” that would enter the pockets of solely the wealthiest Americans and would not rely on apportionment. [6] Scholars and critics lately have argued that such a proposal would violate several parts of the U.S. Constitution. Namely, that a non-apportioned direct tax violates the Sixteenth Amendment because it fails as an income tax. In other words, the Sixteenth Amendment only permits the taxation of income, and generally, unrealized gains with no recognition event are not income. Such a tax could also violate Article I, Section 9, Clause 4, which states that “No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census[,]” because it is an unapportioned direct tax. [7]

In the 1920s, the U.S. Supreme Court held in Eisner v. Macomberthat income may be defined as “the gain derived from capital, from labor, or from both combined, provided it be understood to include profit gained through a sale conversion of capital assets.” [8] This case read along with Glenshaw Glass Co., have generally been understood and interpreted since then to define gross income. Following these cases, Congress intended under IRC section 61, to tax all gains or undeniable accessions to wealth, clearly realized, over which taxpayers have complete dominion and control. [9] This has been the understanding many lawmakers and taxpayers have operated under until 2017, when the Tax Cuts and Jobs Act enacted IRC section 965, i.e., “the transition tax.” [10]

II. The Transition Tax

A. Overview of the Transition Tax

The transition tax is a one-time tax that aims to prevent American shareholders invested in “specified” foreign companies who have not received a distribution from gaining a windfall due to never paying taxes on such undistributed offshore earnings. [11] Generally, IRC section 965 defines the specified foreign corporations as either: (i) a controlled foreign corporation [12] ; or (ii) a foreign corporation (other than a passive investment company) that has a United States shareholder that is a domestic corporation. [13] This definition also includes other foreign corporations that are at least 10% U.S. shareholder-owned but not controlled (otherwise known as a Specified Foreign Corporation). [14]

Effectively, U.S. taxpayers must pay once on the untaxed foreign earnings in foreign companies as ifthose earnings had been repatriated, i.e., “sent back” to the U.S. They are mandated to include income of its pro rata share of accumulated post-1986 deferred foreign income that was not previously subject to the foreign taxes. [15] The end policy goal of this section was to encourage American companies and shareholders to bring back profits that were made internationally and to invest them in the U.S. economy.

Therefore, if a shareholder in a foreign country had received unrecognized gains in the foreign corporation from 1986-2017 (the statutory period for the one-time tax), IRC section 965 demands requires the transition tax be paid. [16] While paying back taxes for all of those accumulated years of qualified earnings seems scary, the TCJA amendments allow for the repatriated earnings to be heavily discounted. [17] In addition, taxpayers may pay the balance of the transition tax over an eight year period without any interest. [18]

B. Comparison to the Mark-to-Market Tax

The Mark-to-Market tax is a proposed tax similar to the IRC section 65 transitional tax. States such as New York and California have proposed a tax on unrealized appreciation of billionaire residents’ assets. [19] Specifically, proposed legislation in New York will attempt to levy a state tax on unrealized capital gains that have made an increase in market value only since the billionaire has been a resident of New York. The unrealized gain of assets would then be taxed at said taxpayer’s income tax bracket as normal. [20] The tax rate of unrealized appreciated assets would be 8.8%, and taxpayers would also have the option to pay this tax over a period of ten years with a 7.5% annual interest charge. [21] This tax works by determining the increase in fair market value of the billionaire’s assets over the last taxable year. Under the proposed law, “fair market value,” would be defined as “the price at which such asset would change hands between a willing buyer and a willing seller.” [22] The tax would only apply to those applicable “net gains” that contributed to the individual’s overall income and would not be subjected to previously earned income.

Many lawmakers and critics raise concerns regarding the evaluation method. How does one evaluate the price of something if there is no recognition event where it is traded between two willing sellers? Perhaps the item is so rare or so expensive that there are no comparable sales in the marketplace to base the sale on. In this case, the mark-to-market tax would pose logistical problems in its execution. Lastly, by taxing billionaires on their unrealized gains, many billionaires may have to continually sell off assets to pay off such taxes if they are not liquid enough.

Here is an overly simplified example of the mark-to-market tax. A billionaire resident of New York buys $100,000 of stock at an IPO. In the subsequent year, the stock appreciates to $150,000 because the company is very successful. The billionaire would now be subject to an 8.8% tax on the $50,000 that the stock appreciated even though the billionaire never sold the stock.

In contrast, the realization doctrine of Eisner and Glenshawstate that appreciation in assets will not be included in the tax base until there is a sale or other disposition of the assets. [23] Additionally, many taxpayers hold assets until death so that the property may receive a stepped-up basis at fair market value. [24] Thus, holding property until death avoids the payment of taxes from accumulated gains at a subsequent sale by the recipient. [25] This escapement has been a fundamental aspect of the American tax system, which would be disrupted by the implementation of a mark-to-market policy. The main goal of the mark-to-market approach would be the targeting of unrealized appreciation via an additional state tax. Additional factors to consider for such a policy are to increase revenue and fairness in the system, and to more accurately reflect the income that individuals receive. Since many billionaires hold substantial assets, this would be a more accurate way to efficiently target wealth. Such a proposal has been estimated to potentially have raised an additional $23.2 billion in revenue for New York since 2020. [26]

IRC section 965, on the other hand, also seeks to address fairness and close potential tax avoidance loopholes. As we have seen, the transition tax implemented in 2017 is similar to the mark-to-market tax in that it specifically targets high net worth individuals or corporations and taxes unrealized gains of assets without a disposition or recognition event.

C. Transition Tax as an Excise Tax

An excise tax is a tax that is legislated on specific goods or services when they are purchased. [27] Common examples of goods subject to this tax are tobacco, alcohol, and fuel. Excise taxes are primarily taxes on business. These intranational taxes are imposed by the government rather than an international tax that is imposed across country borders. [28]

In 2018, the IRS provided excise tax relief for funds that were taxed as regulated investment companies (“RIC’s”) that had to increase their gross income because of the IRC § 965 transition tax. [29] Revenue Procedure 2018-47 allowed RIC’s that had to include income from accumulated earnings and profits in foreign corporations due to IRC § 965, to treat the inclusion of the income as if it were made in 2018, instead of 2017. [30]

RIC’s are required to make distributions under two separate sections: (1) IRC section 852 requires that RIC’s must distribute “90% of their investment company taxable income” to qualify as an RIC; [31] (2) IRC section 4982 allows RIC’s to avoid excise taxes by distributing 98% of their ordinary income and 98.2% of their capital gain net income. [32] The excise tax is 4% of the required distributions that was not actually distributed. [33] The relief provided by the IRS allows RICs who follow the necessary distribution amounts to be exempt from the 4% tax. In order to give taxpayers enough time to calculate this required distribution to be exempt from the excise tax, it has been set so “the required distribution for the calendar year is based on the capital gain income during the one-year period ending with October 31 of each tax year.” [34]

III. Moore v. United States

A. Overview of the Case

On June 26, 2023, the Supreme Court granted certiorari to hear Charles and Kathleen Moore’s claim against the United States regarding the constitutionality of the transitional tax regarding IRC section 965. [35] The case is titled Moore v. United States, [36] and it has the potential to challenge the constitutionality of the transition tax. It also has the potential to fundamentally change the way our government views the realization doctrine. The plaintiffs emphatically state in their brief submitted to the Court that income must first be realized to be taxable. [37]

Charles and Kathleen Moore both own shares in a company called KisanKraft. [38] In 2006, the couple invested $40,000 for a 13% stake in the company. [39] KisanKraft is an international company in India. [40] The company provides basic tools to farmers in India’s most impoverished regions, and the company has reinvested all of its earnings to pursue that aim. [41] Because of the reinvestment, the Moore’s have not received any distribution, dividend, or monetary payment from KisanKraft. [42] The couple has not disposed of the stock nor sold it in a recognition event, yet they are still taxed under IRC section 965. [43] The mandatory repatriation tax subjected the couple to a tax on a mere investment. The tax was based on a pro rata share of the company’s accumulated earnings, and because such earnings had not been distributed to the Moores, the Moores were effectively taxed on an investment to which there was no income. [44]

After being slapped with an approximately $15,000 transition tax, the Moores took action in District Court, which rejected the challenge to the tax. [45] This decision was upheld on appeal in the Ninth Circuit as well. [46] In making its decision, the Circuit stated that “courts have held consistently that taxes similar to the MRT [mandatory repatriation tax, i.e., transition tax] are constitutional.” [47] Whether income is realized or not is not determinative of constitutionality. [48] So far, the Moores have lost at every stage of the litigation, but there is a good possibility that the Supreme Court will take an interesting position on the transition tax or else they would have just affirmed the determination of the Ninth Circuit. [49] Four justices of the Circuit dissented in the rejection of an en banc motion for rehearing, arguing that the case has huge implications for wealth and property taxes in general. [50] These justices would have granted a rehearing to create a limit on the unapportioned direct tax for unrealized income. [51]

B. The United States’. Position

The government argues that defining income is a difficult task. [52] However, precedent indicates that courts have consistently held that taxes similar to the MRT are constitutional. [53] For example, the Second Circuit has held that foreign income inclusion under a statute that was created before Subpart F was constitutional. [54] Decades later, the United States Tax Court rejected the challenges to pre-MRT provisions of Subpart F, and these decisions were upheld by the Second and Tenth Circuits. [55]

The government further argued that whether the taxpayer has income is not determinative of whether or not a tax is ultimately unconstitutional. [56] In Heiner v. Mellon, the Supreme Court stated that the ability or inability of distributions of a proportionate share of the net income of a partnership was immaterial to whether it could be taxed. [57] The Supreme Court has further stated in Helvering v. Horst, that realization of income is not a constitutional requirement, but merely an administrative one of convenience. [58] Essentially, the government’s argument is that taxable gains should be broadly construed in order to promote fairness, raise revenue, and better reflect the income of certain individuals.

C. The Moore’s Position

The Moores interpret the precedent in a different way. They agree with the Cato Institute’s amicus argument that the Ninth Circuit holding MRT constitutional is a flat-out rejection of well-established principles and U.S. Supreme Court precedent. [59] The Ninth Circuit has “twisted” the definition of income beyond recognition. [60] Ultimately, this approach by the Ninth Circuit would permit Congress to “tax items that are not income without regard to the Constitution’s apportionment requirement [under Article I].” [61]

International tax law before the enactment of the Tax Cuts and Jobs Act of 2017 recognized that the income of foreign corporations was generally not subject to a tax until a distribution or realization event occurred. [62] This idea accords with the principle that a taxpayer should not be subject to an income tax until the taxpayer receives income. It was not until 1962 that Congress enacted Subpart F. [63] This legislation sought to tax U.S. shareholders in foreign corporations who had at least 10% share ownership in the foreign corporation. [64] Subpart F then “taxes U.S. shareholders on CFC’s [Controlled Foreign Corporations]” regardless of whether the CFC distributed the income. [65] Congress, therefore, determined when the shareholder constructively realized the income. [66]

In essence, the Moores argue that the MRT creates a fiction. The Moores were taxed as if KisanKraft had issued a distribution of 13% of KisanKraft’s total earnings since 2006. The way the TCJA operates is that it assumes the corporation paid Charles and Kathleen a dividend in 2017 that was based on earnings that went back many years. [67] Thus, the MRT is unconstitutional because it taxes U.S. shareholders regardless of whether they received a repatriation or could ever possibly receive one over multiple prior years. [68]

The main substantive argument proposed by the Moores is that the Sixteenth Amendment only grants Congress the power to tax income. [69] Congress may only “collect taxes on incomes, from whatever source derived[.]” [70] Apportionment requires that there be no direct taxes on individuals without apportioning such taxes among the states based on their population. [71] The Sixteenth Amendment should be taken as it is written, and it should not permit the government to extend beyond the meaning “clearly indicated by the language used.” [72] This language is harmonious with IRC section 61 and has been etched into the Code. [73] In fact, Eisner v. Macomberfamously held that an event like a stock split transaction did not give rise to income. [74]

Specifically, the corporation in Eisnerissued a stock dividend. This dividend issued each shareholder new shares that were created by the dividend. [75] Because each shareholder was issued a pro rata amount of new shares, each shareholder’s ownership percentage in the corporation did not change. [76] Therefore, each individual share was worth only 66.7% of what it was worth prior to the dividend, but the stock dividend “simply increase[d] the number of the shares, with consequent dilution of the value of each share.” [77] In simple terms, this action effectively took nothing property-wise from the corporation and added nothing to the shareholder. [78] Since no percentage interest had changed, the Court determined that the receipt of the dividend was not income and was not subject to an income tax. [79] It is important to note that the Sixteenth Amendment’s apportionment exception onlyapplies to income. [80]

The holding from the Supreme Court in Eisner clearly correlates with the Moores’ argument that “enrichment through increase in value of capital investment is not income,” and “neither under the Sixteenth Amendment nor otherwise has Congress power to tax without apportionment a true stock dividend made lawfully and in good faith, or the accumulated profits behind it, as income of the stockholder.” [81] This holding from the U.S. Supreme Court directly conflicts with the Ninth Circuit’s holding to deny the Moores’ rehearing petition regarding this subject. Therefore, the Moores argue that this subject needs to be clarified for all similar cases moving forward.

IV. Analysis of the Possible Implications to Tax Law

A. “Realization of Income”

The realization requirement, emerged in the early twentieth century, and was soon after endorsed by the Supreme Court in the United States. [82] The Court originally found that the imposition of federal income taxes was constitutionally limited to only realized gains, however it soon retreated from this viewpoint declaring that realization is not constitutionally mandated. [83] The realization requirement now means that tax liability is “assessed only when assets are exchanged on the market, and not, as an ‘ideal’ income tax would dictate, when the market values of assets change.” [84] Historically, the U.S. Supreme Court has not held its ground regarding the constitutionality of whether realization is necessary to tax income. Now, accepting this case, the Supreme Court is forced to make a decision that could have astronomical effects on tax law.

The 16^thAmendment’s exception from apportionment is limited to taxes on “realized” income and that a shareholder’s interest or stock in corporate profits is not “realized” until distributed. [85] Congress then backtracked and declared that the realization requirement is not mandatory. If the U.S. Supreme Court rules in favor of the government, critics argue that without the realization requirement, it will be constitutionally permissible for the government to impose federal taxes on all property and wealth. [86] However, if the U.S. Supreme Court rules broadly in favor of the taxpayers, the government will be forced to prove realization of all income before taxing without apportionment. If the Court rules broadly in favor of the taxpayers, it will likely spawn similar constitutional challenges to tax beyond the transition tax, including the Subpart F rules.

B. Subpart F Effects

Prior to the enactment of Subpart F, many United States taxpayers used foreign corporations to conduct business due to their tax-favoring qualities. [87] This includes income tax deferral: “generally, U.S. tax on the income of a foreign corporation is deferred until the income is distributed as a dividend or otherwise repatriated by the foreign corporation to its U.S. shareholders.” [88] Because of this tax avoidance quality, U.S. taxpayers were able to achieve income through these foreign corporations without paying any sort of domestic U.S. income tax. Therefore, the IRS developed Subpart F provisions to “eliminate deferral of U.S. tax on certain categories of foreign income by taxing certain U.S. persons currently on their pro rata share of such income earned by their foreign corporations.” [89] Subpart F rules operate by treating U.S. shareholders of foreign corporations as if the income made by a controlled foreign corporation (“CFC”) were actually made and distributed in the United States, even if the CFC does not distribute the income to its shareholders in that year. [90] Because subpart F is able to tax income that has not yet been distributed, it violates the realization of income requirement. Although the U.S. Supreme Court has never ruled on the constitutionality of Subpart F, lower courts have long upheld its rulings and if the U.S. Supreme Court now decides to rule in favor of Moore, Subpart F could be wiped out completely.

However, there may still be a way for the U.S. Supreme Court to rule in favor of Moore while not rendering Subpart F to be unconstitutional in its entirety. The Court could distinguish the transition tax specifically to the Moores’ fact pattern from the rest of subpart F “(including the global intangible low-taxed income rules) not involving a tax abuse that justifies the attribution of realized income from the corporation to the U.S. shareholders (i.e., constructive dividend treatment).” [91] If the Court returns a holding narrow enough to specifically fit the Moores’ fact pattern, Subpart F may still remain constitutional as to avoid hundreds of others suing for refunds. However, if the Court returns a broad holding to invalidate all or some of Subpart F will result in significant revenue loss for the U.S. government. Taxpayers may also suffer adverse collateral consequences such as “the treatment of prior distributions of foreign earnings that had been thought to be previously taxed earnings and profits and now could be viewed as distributions of untaxed earnings and profits, which may require the application of Section 245A rules in order for the distributions to be tax-free.” [92]

C. GILTI Effects

Another tax correlated with CFCs is the global intangible low-taxed income (“GILTI”) tax. The GILTI tax was created by the 2017 Tax Cuts & Jobs Act in “an effort to discourage U.S. corporations from shifting specific profits to low-tax jurisdictions abroad.” [93] Before the Tax Cuts & Jobs Act, U.S. businesses and individuals were subject to U.S. income taxes on worldwide income. [94] Now, multinational corporations earning income overseas are generally exempt from U.S. corporation taxation, even if repatriated so as to avoid moving these profits abroad. [95] Generally, GILTI is foreign income earned by CFCs from intangible assets, including copyrights, trademarks, and patents. [96] CFC shareholders who own 10% or more of a CFC are liable for the tax on GILTI, ranging between 10.5% and 13.125%. [97] These “intangible assets” are seen as the profits made by certain CFC shareholders. [98] Whereas the transition tax is a one-time tax on untaxed foreign profits of certain specified worldwide corporations, GILTI taxes must be reported every year. GILTI tax applies to non-previously taxed earnings as well as undistributed earnings each year. Hence the complication once again if the U.S. Supreme Court rules against the transition tax and the realization requirement.

D. Passthrough Treatment Effects

A ruling declaring an income must be realized before it is taxed may also affect the tax regime of “pass-through” entities. Pass-through taxation involves businesses that do not pay taxes on the entity level, but instead the income passes to the business owners who then pay personal income tax for their shares in the business. [99] This may include proprietorships, partnerships, and S-corporations. [100] Even if the entity does not immediately distribute the income to the interest holder, they are seen as having full control since it passes-through the corporation, never touching it. However, the passthrough treatment may not be affected as drastically as critics may think. In United States v. Carlton regarding changed rules to an estate tax deduction, the Court held that “the retroactive changes did not violate due process.” [101] The retroactive change from the estate tax deduction reached back only one year, whereas the transition tax reaches back decades; therefore, the Court could rule the transition tax is allowed solely because retroactive change is constitutionally allowed since it does not violate due process. [102] It could also be argued that a taxpayer chose to conduct business as a partnership or through the passthrough treatment, thereby deeming the right to waive a realization requirement. [103] Whatever the arguments may be, if the Court rules in favor of Moore, there will be questions raised and arguments put forward regarding all of these other tax regimes.

V. Conclusion

The U.S. Supreme Court may be able to do what Congress has not be able to do: reform the tax code. No matter what the U.S. Supreme Court rules, the results will be monumental. If the U.S. Supreme Court rules in favor of the taxpayers, more than just the transition tax will be affected. In fact, a ruling in favor of the petitioners that holds the transition tax is unconstitutional, and that it violates the 16^thAmendment, could reform a large portion of the tax code including mark-to-market rules, pass-through tax regimes, GILTI taxes, and Subpart F effects. However, if the U.S. Supreme Court rules in a narrow holding to conclude that the 16^thAmendment imposes a realization requirement, they could limit that approach solely to IRC section 965 to prevent further confusion with the entire tax code. However, no matter what happens, by accepting this case the U.S. Supreme Court has opened the door to questioning the constitutionality of other tax regimes, not only those that are in existence, but may also shut the door on many proposals for future federal wealth taxes. Even with a narrow holding, the fallout certainly could leave taxpayers and the U.S. government scrambling.

In light of recent events, and in the upcoming months until the U.S. Supreme Court reaches a decision mid-2024, attorneys are encouraging taxpayers who may have been affected by these questionable taxes to file protective refund claims in the event that these regimes are overturned. When the holding is published by the U.S. Supreme Court, hopefully the definition of “income” will be more clearly defined and eliminate future confusion amongst taxpayers attempting to pay the correct amount of their taxes.