Update 739 — SCOTUS Seems Moore Unsure: Re Congress’ Authority to Tax Certain Income

Shockwaves hit the tax policy world in late June when the U.S. Supreme Court agreed to hear Moore v. U.S., a case with broad implications regarding Congress’ authority to tax unrealized income. The Court rarely grants cert. on cases brought under the 16th Amendment, which grants Congress the right to levy a federal income tax. 

But after yesterday’s oral argument, it was not any clearer why the Court took the case. Many, if not most, Justices seemed inclined to rule narrowly, upholding precedent, rather than address a wealth tax or adopt the Moores’ reasoning and call into question the validity of large swathes of the current Code.

Below, we present background on the case, explain the stakes in policy terms, analyze the oral argument heard yesterday and outline possible outcomes and consequences.  

Best, 

Dana

The Supreme Court heard oral arguments yesterday in Moore v. U.S., a rare case for the Court concerning the constitutionality of a tax provision enacted by Congress. But depending on the scope of the ruling, it could have major implications for the U.S. tax code. The Court could consider whether the 16th Amendment authorizes Congress to tax unrealized income – for example, appreciation on investments like stocks and bonds that have yet to be sold. A clarification on this issue could call into question the constitutionality of many tax provisions, endangering a large portion of the U.S. revenue base. 

The case was brought by Charles and Kathleen Moore, a couple from Redmond, Washington with an investment of over ten percent in KisanKraft, an Indian company that reinvested its profits without distributing them to its shareholders. The Moores have challenged the Mandatory Repatriation Tax (MRT), a one-time transition tax enacted as part of the 2017 Tax Cuts and Jobs Act (TCJA). To prevent foreign accumulated earnings from going untaxed in perpetuity, the MRT taxes U.S. shareholders of foreign-controlled corporations—like KisanKraft—on the shareholders’ portion of the profits, regardless of whether the profits were distributed to the shareholders, or instead reinvested in the corporation.

The Moores argue that the MRT is unconstitutional under the Sixteenth Amendment for two reasons. First, they argue that under the Sixteenth Amendment, taxable income includes only economic gains that have been realized by the taxpayer specifically. Second, they argue that the MRT is a tax on unrealized income–even though the income has been realized by the corporation—because the income may not have been distributed to the shareholders. In the Moores’ view, such a tax is an unconstitutional tax on personal property. This position runs counter to Congress’s long history of enacting taxes that attribute a business entity’s profits to its individual owners and investors. 

While the Moores’ position has received support from some far-right organizations, such as the Cato Institute, a bipartisan coalition that spans the ideological spectrum has urged the Court to reject the Moores’ reasoning. Stakeholders on both sides of the aisle—including conservative institutions like the American Enterprise Institute—have warned that a ruling in favor of the Moores could lead to trillions in lost revenue. Some progressive organizations have also warned that such a ruling would create an obstacle to future tax policy.

TCJA and the Constitutional Challenge

Before Congress passed the TCJA in 2017, voluntary repatriation laws allowed U.S. corporations and individuals to indefinitely defer paying taxes on earnings from investments made overseas. To transition to a new territorial system for taxing foreign income, the Act included the MRT, a one-time tax to be paid on international earnings from holdings exceeding a ten percent share in foreign corporations since 1986. The Joint Committee on Taxation estimated that the MRT will generate $340 billion in additional tax revenue between its implementation in 2017 and 2027 through the taxation of more than $2.6 trillion in offshore earnings. 

The Moores challenged the taxation of unrealized income in federal court in 2019, after paying $15,000 in taxes on their 13 percent share of KisanKraft under the MRT and being denied a refund from the IRS. They argue that they never received income attributed to them by the IRS and therefore should not have to pay tax under the MRT. They assert that the shares of the company’s earnings were never realized in the form of distributions or dividends and therefore do not qualify as taxable income under the 16th Amendment. A district court and the Ninth Circuit Court of Appeals rejected this argument, ruling in favor of an unrestrictive interpretation of ‘income’ that includes unrealized income, asserting that “whether the taxpayer has realized income does not determine whether a tax is constitutional.”

Oral Arguments Signal a Narrow Ruling

Yesterday, the case was heard by the Supreme Court in a lengthy oral argument. Doubts about the Moores’ challenges and hesitancy to issue an expansive opinion were expressed by both liberal and conservative Justices, suggesting that the Court may back away from both the sweeping appeals made by the Moores and those from the Justice Department for a ruling that would have major implications for the U.S. tax code depending on which party prevails. 

Andrew Grossman, arguing on behalf of the Moores, contended that: 

• income “refers to gains coming into the taxpayer, like wages, rents, and dividends,” and 
• taxes on unrealized income, which do not meet the court’s previous definitions of ‘income’, are unconstitutional under the 16^th Amendment. 

To support these claims, Grossman relied on the precedent set in Eisner v. Macomber (1920), which held that taxing stock dividends was unconstitutional. He argued the case establishes “that a shareholder must realize – or directly receive – income from a corporation before that income can be taxed.” 

Solicitor General Elizabeth Prelogar, on behalf of the U.S. Government, argued that: 

• the 16th Amendment does not include specific language that establishes a realization requirement, 
• Congress has “the power to make reasonable determinations about what counts as income and who can be taxed on it,” and
• a realization requirement under the 16th Amendment would call into question the constitutionality of other parts of the tax code and lead to trillions of dollars in lost revenue.

Rather than rely on the precedent in Macomber, which has been narrowed in application over the ensuing decades without being explicitly overturned, Prelogar suggested that the Court instead adhere to the doctrine of Heiner v. Mellon (1938). In Heiner, the Supreme Court upheld the constitutionality of a taxing partner’s capital gains, regardless of whether the gains were distributed to the partners. According to this precedent, there is no legal basis for the Moores’ argument that shareholders cannot be taxed on a corporation’s income if it has not been distributed to the shareholders. 

The Moores’ position was met with widespread skepticism by liberal Justices. Justice Sonia Sotomayor asserted that the idea of realization was “well-established” at the time the 16th Amendment was drafted and would have been understood by its drafters. The term “realization” was notably not included in the Amendment, giving rise to the ambiguity addressed in this case. 

Justices Ketanji Brown Jackson and Elena Kagan added concerns about Grossman’s definition of income, and the history of Congress enacting provisions that attribute corporate income to shareholders and then tax them on it. Such provisions include, for example, Subpart F of the Internal Revenue Code in 1862, which required American shareholders in foreign corporations to pay taxes on their pro rata shares of companies’ undistributed passive income. 

Conservative Justices, including conservatives Brett Kavanaugh and Amy Coney Barrett, challenged both parties regarding the implications of both the narrow and broad definitions of income they offered. They noted the significant consequences of ruling on a realization requirement in the 16th Amendment, saying that the Supreme Court does not have a history of ruling on congressional authority over taxation and that doing so would have unprecedented consequences for other areas of the Code that have never been adjudicated. An opinion that affirmatively adopts a realization requirement in the 16th Amendment would, as Solicitor General Elizabeth Prelogar argued, “wreak havoc on the proper operation of the tax code.” Such a ruling could invalidate:

• mark-to-market accounting-based taxation, 
• large parts of Subchapters K (partnerships), 
• Subchapter S (S corporations),
• Subpart F mentioned above, 
• the GILTI international tax regime, and
• taxation of certain futures contracts and life insurance proceeds. 

The consequence would result in trillions in revenue losses, or, per House Speaker Paul Ryan, “about a third of the Code.” 

Prelogar responded to various questions about potential implications of the Court’s ruling. Specifically, Justice Samuel Alito expressed concerns that such a broad definition of income could result in taxes on the appreciation of a stock’s value or the increase in value of mutual funds. This unease was shared by Justices Clarence Thomas and Neil Gorsuch, who noted that the ruling could have implications for the future taxation of retirement and real estate holdings.

But Justice Kavanaugh noted that these scenarios regarding enactment by Congress of taxes on holdings beyond cases of constructive realization to include property, for example, are ”hypothetical” and “farfetched,” as members of Congress are unlikely to take action that would put their reelection in jeopardy. Until Congress takes unconstitutional action, preemptive decisions about hypothetical taxes and their presumed constitutionality will be met with appropriate judicial restraint. 

Good News, Bad News for the Tax Code

The Justices considered two narrow rulings in favor of the U.S. Government’s case:

• The 16th Amendment requires economic gains to be realized before they can be taxed as income, but the MRT meets this requirement. 
• The MRT meets the realization requirement, but the Court does not make a direct determination about whether such a requirement exists under the 16th Amendment.

The Court could issue a narrow opinion, which would restrict the scope of their ruling to the facts at hand. They could avoid determining whether the 16th Amendment requires realization by finding that — regardless of whether it’s required — there was realization in this case. Specifically, KisanKraft realized income, even if that income was not distributed to shareholders. As Justice Kavanaugh noted, “Even assuming or leaving open whether realization is a constitutional requirement, there was realized income here to the entity, and then it’s attributed to the shareholders in a manner consistent with how Congress has done that and this Court has allowed.” This action would allow them to side-step a decision that would call into question the constitutionality of a large portion of the tax code. The questioning in yesterday’s oral argument, however, signaled doubt surrounding the constitutionality of wealth taxes. The Government’s case suggested that Congress would not likely depart from its history of not instituting taxes on wealth, while noting that a ruling in Moore v U.S. would not necessarily serve as a precedent for the constitutionality of such a tax. But, in referring to the tax concept as a hypothetical, Justice Alito suggested that an example of a wealth tax more consistent with proposals from Senator Elizabeth Warren (D-MA) may be unconstitutional. Prelogar responded by noting a tax on wealth would indeed be a direct tax, requiring equal apportionment. The fight to protect taxes on unrealized income and debate about some form of wealth tax are far from over.