Moore to discuss: Supreme Court punts on taxation of unrealized gains, for now

The US Supreme Court delivered a limited ruling in Moore v. United States, No. 22-800 that rejected the taxpayers’ challenge to the one-time mandatory repatriation tax (MRT) imposed by IRC § 965 as part of the sweeping international tax reform of the 2017 Tax Cuts and Jobs Act, P.L. 115-97.

In a 7-2 decision, the Court affirmed the lower court’s judgment that the taxpayers in the case – US shareholders of controlled foreign corporations (CFCs) – are subject to the repatriation tax on income earned but untaxed and remaining undistributed by a CFC on the applicable date. The differing opinions issued by the seven Justices, however, highlight the uncertainty of future Supreme Court decisions on cases relating to the tax treatment of unrealized gains.

Background

The Sixteenth Amendment, upon which the taxpayers’ challenge relied, arose in direct response to the Supreme Court ruling in Pollock v. Farmers’ Loan & Trust Co., 158 US 601. In Pollock, the Court struck down a law that would have imposed an income tax at a rate of 2 percent on “gains, profits, and income” in excess of $4,000. The decision established that the imposition of a general income tax needed to be apportioned among the states according to their population because taxes on income from property equated to a tax on the property itself (a tax on property being a direct tax requiring apportionment). President William Howard Taft in 1909 publicly advocated for its overturn by constitutional amendment in response to the unpopularity of the decision.

In response to Pollock, Congress and the states passed the Sixteenth Amendment in 1913 which empowered Congress with the explicit ability to impose a comprehensive income tax. Specifically, the amendment grants Congress the power “to lay and collect taxes on incomes, from whatever source derived” without having to apportion the levy among the states as Pollock required.

The taxpayers in Moore argued that the MRT is unconstitutional because it taxes unrealized income to the shareholders. According to the taxpayers, the Constitution imposes a realization requirement under the Sixteenth Amendment with respect to any taxes on income, ie, there must be an income realization event before the income may be taxed without apportionment among the several states.

The question presented but not addressed

The Court, in an opinion authored by Justice Brett M. Kavanaugh, upheld the constitutionality of the MRT by posing and answering a new question, specifically “whether Congress may attribute an entity’s realized and undistributed income to the entity’s shareholders or partners, and then tax the shareholders or partners on their portions of that income,” and concluding that the “Court’s longstanding precedents, reflected in and reinforced by Congress’s longstanding practice, establish that the answer is yes.”

In a move that predicts cases the Court may take up in the future, the majority footnoted a list of issues that its narrow decision does not address: (1) taxes on both an entity as well as its shareholders/partners on the entity’s undistributed income, (2) taxes on “holdings, wealth, or net worth,” and (3) taxes on appreciation. In addition, numerous provisions of the Internal Revenue Code (IRC) create tax without realization outside of the context of the ownership of an entity (eg, the mark-to-market regime for dealers and ordinary issue discount debt instruments). The Court did not address these issues having decided as a threshold matter that the MRT taxes the CFC’s realized income and that longstanding precedent supported the idea that Congress may tax either an entity or its shareholders/partners. In so doing, the Court has left these questions and others to be answered another day.

Justice Clarence Thomas, in a dissenting opinion joined by Justice Neil M. Gorsuch, starkly disagreed with the majority’s reliance on attribution as the basis for upholding the constitutionality of the MRT. The dissent also firmly stated a realization requirement under the Sixteenth Amendment by stating that the taxpayers in Moore did not receive any of their investment gains, and therefore those gains did not constitute “income” which could be taxed under the Sixteenth Amendment.

In a concurring opinion in which she agreed with the judgment of the Court but not with its reasoning, Justice Amy Coney Barrett, joined by Justice Samuel A. Alito Jr., also wrote with a view to future cases. She and Justice Alito joined Justices Thomas and Gorsuch in asserting that the Constitution imposes a realization requirement, setting up a potential future confrontation on the issue.

Justice Barrett also suggested that a case with a slightly different set of facts – “for example, a tax on shareholders of a widely held or domestic corporation” – could result in a holding that diverges from that in Moore. The Justice goes on to indicate that any tax on “economic gains” – eg, “the increase in value between Time A and Time B” – would likely not pass muster under the Constitution. Justice Barrett even went as far as stating that “Subpart F and MRT may or may not be constitutional, nonarbitrary attributions of closely held foreign corporation’s income to their shareholders.”

But Justices Barrett and Alito ultimately agreed with the judgment of the Court on the basis that the taxpayers have conceded Subpart F is constitutional, and the Justices do not see subpart F to be meaningfully different from the MRT in how it attributes corporate income to shareholders.

Justice Ketanji Brown Jackson also wrote a concurring opinion in which she agreed with the majority in both its reasoning and judgment. Justice Jackson’s opinion pre-emptively rebuts arguments that seek to build on the taxpayers’ position in Moore. Despite the Court narrowing its ruling with a view to avoid addressing a realization requirement, Justice Jackson nonetheless rejected the requirement, again raising the possibility of a future confrontation between the justices on this question of realization.

The Justices also diverged in their views of the Sixteenth Amendment’s role in responding to Pollock, the case invalidating an income tax and prompting Congress to amend the Constitution to grant it this ability. The majority opinion presented the Pollock decision as “[holding] that a tax on income from property equated to a tax on the property itself, and thus was a direct tax that had to be apportioned among the States” which “sparked significant confusion and controversy throughout the United States” and required the Sixteenth Amendment to clear up this confusion. Justice Jackson’s concurring opinion went further in characterizing the Sixteenth Amendment as a direct rejection of the limitations the decision in Pollock placed on Congress.

On the other hand, Justice Barrett’s opinion left more room for Pollock to influence future decisions. In noting that the Sixteenth Amendment corrected the conflation of income from property with property itself, Justice Barrett observed that Pollock remained good law insofar as it affirmed that a tax on property was a direct tax. Meanwhile, Justice Thomas’s dissenting opinion takes an opposing view to the majority in reading Pollock and the history behind the subsequent drafting of the Sixteenth Amendment as indication that the Amendment includes a realization requirement.

What to watch

In reaching a narrow ruling in Moore, which explicitly did not answer the question before the Court, the Court has invited further litigation relating to realization. Four separate opinions issued in conjunction with the case provide indication of how the justices may align on related matters in the future. Justices Alito and Barrett sided with the majority in Moore, but Justice Barrett’s concurring opinion, which Justice Alito joined, explicitly recognizes a realization requirement and lays the groundwork for future taxpayer litigants. Since these Justices are joined by Justices Thomas and Gorsuch in this view, it remains an open question how the Court would rule when confronted directly with a question of taxation of unrealized gains. The Court has also signaled another possible question requiring resolution in the future when it noted that “[i]n this Court, the Moores have not raised a due process issue regarding the attribution of [the CFC’s] income to them.”

Taxpayers may want to heed the Court’s own musings when considering related cases that will reach its docket. Taxes that are vulnerable to a realization requirement, particularly those that do not deal with attribution of income from an entity to its owners, are likely to face scrutiny in the wake of Moore. The majority opinion includes “holdings, wealth, or net worth” among such taxes. While it remains unclear exactly how certain members of the Court would respond to attempts to strike down these taxes, it is clear that the Justices have more to say on the taxation of unrealized gains.

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