A tax on 'unrealized' income? A test for wealth laws at the Supreme Court

December 28, 2023 2:40 PM

For roughly a couple of hours earlier this month, the justices of the Supreme Court sounded like a group of financial advisors or tax professionals.

The slideshow below contains more than a dozen excerpts from the Dec. 5 arguments in Moore v. U.S. In the case, which revolves around the extent to which the 16th Amendment gives the federal government the "power to lay and collect taxes on incomes, from whatever source derived," two investors in an India-based corporation are challenging a provision of the 2017 Tax Cuts and Jobs Act called the "mandatory repatriation tax" (MRT) that imposed a one-time duty on the earnings of foreign companies. The petitioners, a Washington state couple, argue that their $14,729 payment is unconstitutional because they never realized the earnings in a distribution.

That nominal sum could carry massive implications, if the Court were to hand down a decision defining "unrealized" income that is no longer subject to taxes or prohibiting the idea of a wide-ranging federal toll on wealth. Based on their questions and observations in discussions with Andrew Grossman — the lawyer representing the Moores — and U.S. Solicitor General Elizabeth Prelogar, speaking on behalf of President Joe Biden's administration and the federal government, most experts said the justices sounded unlikely to deliver sweeping tax changes.

"While many lawyers and economists feared that a far-reaching opinion in an otherwise insignificant dispute could undermine the foundations of much of U.S. tax law, the justices seemed to realize they had fired up an earthmover when a shovel would do," Urban Institute and Brookings Institution Tax Policy Center Senior Fellow Howard Gleckman wrote in a blog post.

The following lightly edited excerpts from the official transcript include questions and statements for Grossman and Prelogar from Justices Sonia Sotomayor, Brett Kavanaugh, Elena Kagan, Neil Gorsuch, Samuel Alito and Amy Coney Barrett. While part of the arguments dealt with precedent case law and legal distinctions, advisors and tax professionals will easily recognize terminology from their industry, such as the structure of companies known as S-corporations, references to mutual funds and retirement investment accounts, and the rules for foreign income under Subpart F of the Tax Code. The Court will decide the case in late spring or early summer.

To see more than a dozen excerpts from the Supreme Court arguments in Moore v. U.S., scroll down the slideshow. For a summary of the key takeaways from the case's day at the Court, click here. And, for a look at the potential stakes of the case, follow this link.

The case for a ‘limiting principle’ on taxes

Grossman: "Dispensing with the need for realization sweeps away what the framers regarded as the essential check on Congress's power to tax property. The government cannot identify a single thing that Congress couldn't tax as income under its position that realization is unnecessary. Without realization, there is no limiting principle. Accepting the government's position on income would make a hash of the current law. The Tax Code's gateway definition of 'gross income' exerts the full measure of Congress's taxing power under the 16th Amendment by reaching all income from whatever source derived."

What would be the impact of defining ‘realization’ in this case?

Sotomayor: "If what we do is to think about a particular tax — which seems to be what we've been doing for over a hundred years — to see whether that tax is income as understood by attribution or as an excise tax or by other principles, we would consider each tax on its own form. You're asking us to just announce what 'realization' is out of context. And, for the last hundred years, we've been studiously avoiding doing that because we recognize that it's dangerous to do that. To state a word like 'realization,' we then have to come up with a working definition that applies to every piece of property and every way in which people gain wealth. It doesn't seem logical to me."

Petitioners’ argument for their case’s distinction with other taxes on corporate income

Grossman: "The difference is that those provisions have typically addressed things like passive income and related-party transactions that are properly attributable to, say, a parent corporation. In other words, a parent corporation could own an income-generating asset itself, or it could simply shift that into a corporation, into a foreign corporation, and thereby avoid the income. And what the law has recognized is that just as in cases like Horst and Banks, that's effectively an assignment of income and that it can be attributed to the parent corporation for that reason because the parent corporation is the one that controls the flow of the income as it's coming in. The MRT, by contrast, operates as a tax on property. It doesn't take account of any power that the shareholder had over the income as it was coming in the door to the corporation. It only takes account of the ownership in 2022."

‘The only real wrinkle’ in this case

Kavanaugh: "That seems to be an argument about timing. In other words, we have realization in this case. The entity realized income. The question then is attribution, and we've long held that Congress may attribute the income of the company to the shareholders or the partnership to the partners. And the only real wrinkle, I think, here is that it goes back and captures prior years' income."

‘Established taxation schemes’ at risk?

Kagan: "It seems to me that there are four principal — there may be others — but there are four principal kinds of taxation that Congress has repeatedly countenanced and that this Court certainly has done nothing to get in the way of, that you have to distinguish here, and I just want to make sure I understand your distinctions and whether there's a single distinction that sort of covers all of these or whether each one has a different explanation. So here are my four: It's Subpart F, it's S-corporations, it's partnerships and it's taxing on an accrual basis. So give me why it is that you think we can decide for you without putting any of those kinds of very established taxation schemes at risk."

The crux of the case

Gorsuch: "I think the argument we've kind of heard from the other side involves, 'OK, if there is a realization requirement, it's met here because the corporation realized the income,' and then it just becomes a question of attribution of that realized income. And Congress has a free hand there, and the 16th Amendment says nothing. Your response?"

Grossman: "My response is that income is — I mean, the Court has always looked at questions of income from the point of view of the shareholder. If you point to a 16th Amendment case or a case involving gross income under the Tax Code, the Court has always looked at the individual circumstances of the shareholder to ascertain whether or not that shareholder has actually realized a gain."

The federal government’s case

Prelogar: "We think that, here, the constitutional question is actually quite easy and it doesn't require the Court to consider some of the foundational questions about the meaning of the 16th Amendment in other contexts because, here, we have paradigmatic realized income at the entity level, and this functions just like the pass-through taxes on partnerships, the taxes on other types of corporate shareholders, S-corporation shareholders, and, particularly in the context of foreign corporations, the tax under Subpart F, of which the MRT is just a part."

Testing the limits of the government’s argument

Alito: "I understand you want to talk about this case, and, ultimately, we have to talk about this case, but I just want to understand how far your argument goes, how far does it logically go? So, under your argument, the 16th Amendment allows the taxation of income, and you define 'income' as an economic gain between two points in time. So let's say that somebody graduates from school and starts up a little business in his garage, and 20 years later, 30 years later, the person is a billionaire. Under your argument, can Congress tax all of that on the ground that it's income?"

Prelogar: "I think that's a harder question, and here's why: I do think that that would fit within an ordinary conception of income as covering economic gain between two points of time and focusing on the increment of gain, but we don't have the same tradition to support Congress levying income taxes in that manner."

Taxing retirement investment accounts?

Gorsuch: "I understand your argument is a little bit different here today, but, in your brief at least, you confronted the question of whether Congress could tax millions of Americans who hold small amounts of stock in their retirement investment accounts. And you say, 'yes,' and you point to the 1864 Civil War laws. And then you say, 'But that would be administratively unworkable.' So, as I understood, at least in your brief, the answer to Justice Alito's question, I think, is, 'Yes, that could happen.'"

The Subpart F concession

Barrett: "What do you think is the significance of petitioners' concession that Subpart F is constitutional to your point?"

Prelogar: "I think that that is an incredibly significant concession here because it demonstrates that, even if the Court were to apply a lens of control or influence, I think the right word to use would be 'relationship' to the income, petitioners have acknowledged that 10% [of] U.S. shareholders have the requisite level of relationship in order to properly have income attributed to them. Now my friend suggested that there's some fundamental difference with Subpart F because it taxes different types of income. I think he said it's income where you can interpose the corporate form. I don't understand that distinction because, of course, the 16th Amendment says that Congress can tax all income from whatever source derived. So the 16th Amendment's text by its own terms makes clear that the different forms of income being taxed don't make a relevant constitutional difference. And even if you look at it as a factual matter, my friend's argument doesn't withstand scrutiny because he suggested that, for example, all of this income could have been earned by the taxpayer himself. But that doesn't explain many important features of Subpart F, like ensuring risks outside the country of incorporation for the [controlled foreign corporation] or doing business in countries that are subject to U.S. sanctions. Those are parts of Subpart F income, and I don't think that there is a relevant distinction with respect to whether it could be properly attributed to the taxpayer."

What about mutual fund holdings?

Alito: "I still want to understand the limits of your argument. I am quite concerned by the potential implications of petitioners' argument, and you stress that in your brief. You say that if we rule in petitioners' favor, then large, important pieces of the Tax Code will also logically fall. And I think that's a fair argument. But I think it's also a fair argument to do the same thing with your position, and I want to understand the limits of your position. Now, coming in, I understood your position to be that realization is not required and ,therefore, the 16th Amendment allows the taxation of income. And you seem to define 'income' in your brief as economic gain between two points in time, and you say it is that well-established principles distinguish income taxes from property taxes. So, if that is correct, then what about the appreciation of holdings in securities by millions and millions of Americans, holdings in mutual funds over a period of time without selling the shares in those mutual funds? Can those be taxed under the 16th Amendment?"

Prelogar: "I think, if Congress actually enacted a tax like that, and it never has, that we would likely defend it as an income tax."

Simplifying the government’s defense

Prelogar: "I don't think the Court needs to resolve anything about whether the 16th Amendment requires realization. Here, we happen to have it, and this kind of tax corresponds to pass-through taxes we've had through history, and that suffices to resolve this case."

Is the government’s case opening the door to retirement-account taxes?

Gorsuch: "If the only bar to Congress from enacting a tax on millions of Americans' retirement accounts and mutual funds is administrability, they're pretty clever over there, aren't they? … They know how to get around administration concerns pretty well, don't they?"

Prelogar: "I think you have covered the waterfront of the things that have already emerged in the case law. I guess, if I step back to a 30,000-foot level, the one thing I would say is that I would urge the Court not to try to set down an explicit set of principles to govern all cases for the very reasons I was describing earlier, that we have seen taxpayers latch onto that and then seek to avoid taxation."

Petitioners’ closing appeal to the Court

Grossman: "The government's recalibrated position, as explained by my friend, is not narrow and the Court should not mistake it as such. The government's view that a corporation's earnings can simply be attributed to any corporate shareholder is staggeringly broad. Corporations like Microsoft and ExxonMobil have hundreds of billions of dollars of retained earnings on their books that they've invested in corporate assets, research and development, and other activities. And, in some cases, those retained earnings exceed the current value of shares. Under the government's view and I think as demonstrated by the MRT, apparently, Congress could simply tax backwards, reaching back as far as it would care to do so, to attribute those retained earnings going back many years to current shareholders, again, in some instances in excess of the value of their current holdings."