Supreme Court Will Hear Case Targeting Tax On Unrealized Gains

The Supreme Court has added a new tax case to its docket for the 2023-24 term: Moore v. United States. As a result, the Court will consider whether a relatively new tax—the “mandatory repatriation tax”—created under a provision of the 2017 Tax Cuts and Jobs Act is unconstitutional under the Sixteenth Amendment. The case could have significance for future taxes, including the much-discussed tax on unrealized gains aimed at the uber-wealthy.

Facts

The petitioners, Charles and Kathleen Moore, own a 13% stake in an Indian corporation, KisanKraft Machine Tools Private Limited, formed by a friend of theirs, to supply affordable equipment to small farmers in poor regions of India. They made the investment—worth about $40,000—in 2005.

The business did well, earning a profit every year. The Moores were aware of this since they received regular updates from the company. They did not, however, receive any money or other payments from the company since KisanKraft reinvested all its earnings to grow the business, which expanded to serve farmers across India.

In 2018, the Moores learned that under the 2017 tax reform law, they were subject to a mandatory repatriation tax, or MRT. The result was that taxpayers like the Moores owed tax on those reinvested earnings. In the Moores’ case, they were subject to the tax going back to their original investment at a 15.5% tax rate—netting them a tax bill of $14,729.

The Moores paid the tax and sued for a refund, claiming that the tax is unconstitutional. Specifically, they argued that it imposes a direct tax that is not apportioned, rather than a permissible income tax which violates the Sixteenth Amendment. The district court disagreed, granting the government’s motion to dismiss, finding that the MRT is a “taxation of income” falling within Congress’s power under the Sixteenth Amendment.

The Ninth Circuit affirmed, holding that the MRT was a tax on income authorized by the Sixteenth Amendment. The Court found that “realization of income is not a constitutional requirement” for Congress to avail itself of the Sixteenth Amendment’s exemption from apportionment for “taxes on incomes.” That meant, it rationalized, that “there is no constitutional prohibition against Congress attributing a corporation’s income pro-rata to its shareholders.”

Mandatory Repatriation Tax

Before 1962, U.S. shareholders of foreign corporations (CFCs) were generally taxed on the earnings of those corporations only if the earnings were distributed to them as dividends. The result was an incentive to keep money offshore. The law changed to require U.S. shareholders owning 10% or more of CFCs to report and pay tax on their pro rata share of income, even if the company’s earnings were not distributed. Despite this provision, the government claims that by 2015, CFCs had accumulated more than $2.6 trillion in offshore earnings that had not been subjected to U.S. tax.

To stop that practice, Congress passed the 2017 tax law which did two things: (1) made clear that when certain foreign corporations, including CFCs, distribute their earnings as dividends to U.S. corporate shareholders, those earnings are generally no longer taxed and (2) included a one-time MRT so that the previously deferred income didn’t escape from ever being taxed.

The result was a one-time tax targeting U.S. shareholders who own 10% or more of foreign corporations primarily owned or controlled by U.S. persons. Under the new law, shareholders had to account for deemed income in proportion to their ownership interest back to 1986. It was a revenue-raiser intended to partially fund the shifting of U.S. corporate taxation from a worldwide system toward a territorial one where U.S. corporations are taxed only on their domestic-source income. According to the government, in 2018, U.S. multinational enterprises distributed approximately $777 billion to U.S. shareholders—the MRT is projected to generate approximately $340 billion in tax revenue.

Sixteenth Amendment

The Sixteenth Amendment states, “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

Historically, the Sixteenth Amendment is hugely significant. The U.S. had tried its hand at a federal income tax system in the 19th century, but the tax was found to be unconstitutional in 1895 in Pollock v. Farmers’ Loan & Trust Co.

Specifically, the Court found that income taxes on interest, dividends, and rents were direct taxes and violated the Constitutional provision that direct taxes be apportioned. The only way to “fix” the disparity was to have Congress amend the Constitution to tax income from any source without apportionment—and that’s what it did.

Congress passed the amendment, essentially a new income tax law, in 1909. Eventually, forty-two of the forty-eight states would ratify the amendment (Alaska and Hawaii didn’t exist, Florida and Pennsylvania refused to consider it, and Connecticut, Rhode Island, Utah, and Virginia voted no). By law, a proposed amendment becomes part of the Constitution once it is ratified by three-fourths of the states. At the time, just 36 states were needed—38 of 50 would be needed to ratify the Constitution today.

Petitioner’s Argument

The question raised by the petitioners in Moore isn’t so much what can be taxed so much as when it can be taxed—in other words, does income have to be realized to be taxed? The Moores argued that the MRT violates the Constitution’s apportionment requirements because it taxes them on ownership of personal property—their KisanKraft shares—and not on income they had realized or received.

The Moores argue that the Sixteenth Amendment refers to the ordinary meaning of income that typically requires realizing a gain. The Ninth Circuit’s decision, they claim, is at odds with historical decisions that have found the Sixteenth Amendment’s exemption from apportionment to be limited to taxes on realized gains.

And, they allude to a suggested wealth tax being touted by the White House, and some in Congress, as another example of an unconstitutional tax on unrealized gains.

Government Response

In response to the Moores’ petition, the government noted that the court of appeals advanced “three longstanding principles”, including “[w]hether the taxpayer has realized income does not determine whether a tax is constitutional.” The government also noted that the Supreme Court has consistently interpreted the phrase “gross income” rather broadly. And quoting Commissioner v. Glenshaw Glass Co., they note that the definition of income includes any “accessio[n] to wealth” (with apologies to my fellow tax lawyers just now for getting that phrase stuck in your head again all these years after law school).

In fact, they argue, the Sixteenth Amendment does not restrict Congress to taxing realized gains. By its terms, claims the government, the Sixteenth Amendment applies to “taxes on incomes, from whatever source derived” (and another one—my apologies, again). And, the government says, even if that were an issue, the gains were realized in this case—to the company.

As for the rumblings about the application of this argument to proposed wealth taxes on unrealized capital gains, referenced in the petitioner’s brief and raised in amici curiae (literally “friends of the court”) briefs? The government notes that traditionally, the Court doesn’t decide whether a tax is constitutional until it exists. And even if it did, those include speculations about a tax “on the net value of all taxable assets of the taxpayer on the last day of any calendar year,” which the government argues, is not the case here.

Supreme Court

The Moores filed a petition for a writ of certiorari (Latin meaning a written order “to be more fully informed”) in February of 2023. Parties do that when seeking a review of the case—typically, those are in response to an appellate court decision.

If the Supreme Court decides to hear the matter—as it did here on June 26, 2023—it’s called a grant of certiorari (by practice, at least four justices must vote to hear the case to be granted cert).

If the Supreme Court turns the petition down, it’s referred to as certiorari denied. A denial does not necessarily mean that SCOTUS agrees with the appellate court’s findings—it simply means that the appellate decision will stand.

When will we hear arguments? Not for a bit. By law, the Supreme Court’s term begins on the first Monday in October and goes through the Sunday before the first Monday in October of the following year—it’s typically in recess in summer.

The case is Moore v. United States.

Quick note: Don’t confuse this case with the other Moore v. United States that the Supreme Court recently turned down—that case focused on whether long-term police use of a surveillance camera at a person’s home constitutes a Fourth Amendment search requiring a warrant.