Daniel A. Sievert
In December, the highest court in the land will hear oral arguments to decide whether a taxpayer will owe a $14,729 tax bill, a relatively insignificant amount but for the potential to require a $271 billion refund to taxpayers and call into question chapters of the Internal Revenue Code (IRC) that affect millions of Americans.
In this article, we will discuss why Moore v. United States is a critically important tax case and its implications on the lives of everyday Americans. Charles and Kathleen Moore (The Moores) are challenging the Mandatory Repatriation Tax (MRT) enacted as part of the Tax Cut and Jobs Act of 2017 (TCJA), a cornerstone achievement of the previous administration.
Before discussing the MRT, it is important to briefly discuss the TCJA. From a macro-perspective, the TCJA sought to incentivize corporations to stay in the United States and repatriate foreign-sourced earnings and profits by lowering the corporate tax rate to 21% and using a territorial tax system. The territorial system taxes income based on where it is earned. In this way, if a U.S. corporation repatriates foreign-sourced earnings and profits, it would not owe additional taxes on those amounts. An estimate by the Joint Committee on Taxation valued the accumulated foreign-sourced earnings and profits at $2.6 trillion as of 2015.
However, to prevent a substantial windfall to U.S. corporations, the TCJA instituted a one-time tax on undistributed foreign earnings and profits. The deemed repatriation, or the MRT, affects U.S. shareholders who own 10 percent or more (by value or voting power) of a controlled foreign corporation (CFC)—a foreign entity with over 50% American ownership. The tax is assessed against the shareholders pro rata share of the CFC’s relevant income on a 15.5% rate and payable over an eight-year period, interest-free. Therefore, from a micro-perspective, the TCJA classified undistributed earnings and profits by foreign-sourced corporations as realized taxable income.
In 2005, the Moores invested in KisanKraft, an Indian corporation that supported small farmers, and received 11% of the company’s shares with no role in decision making. After the TCJA enactment, and by extension the MRT, the Moores were apportioned a share of KisanKraft’s accumulated earnings, leaving them with an additional $132,512 in 2017 taxable income and an additional $14,729 in income taxes.
The Moores challenged the constitutionality of the MRT, but the district court dismissed the action for failure to state a claim. The Moores appealed the lower court’s ruling to the 9th Circuit, arguing the MRT violates the Appointment Clause and the Fifth Amendment’s Due Process Clause. However, the 9th Circuit affirmed the lower court’s ruling, stating that the MRT was permissible under the Sixteenth Amendment and “[w]hether the taxpayer has realized income does not determine whether a tax is constitutional.” However, a dissenting opinion from the 9th Circuit argued that realization was an element of income and without it, the Appointment Clause is effectively a dead letter, a right only “the people have the power to declare.”
The Supreme Court granted cert and is scheduled to hear oral arguments in December. While the Moores presented multiple questions before the Court of Appeals, their brief to the Supreme Court only considers whether the Sixteenth Amendment authorizes Congress to tax unrealized sums without appointment among the states.
However, before discussing the arguments and their nuances, it is important to state the Sixteenth Amendment.
“Congress shall have the 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.”
Simply put, the Moores argue that the Sixteenth Amendment requires income to be realized before it may be taxable. Because the MRT assessed a tax on the Moores share of the foreign corporation’s income, without regard to whether the Moore’s realized that income, the MRT is an unconstitutional tax under the Sixteenth Amendment.
The Moore’s foundational argument—income must be realized—comes from Eisner v. Macomber, a Supreme Court decision from 1920, which stands for the proposition that “mere growth or increment of value in a capital investment is not income” but, rather, income from property is that which is “received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal.” In other words, income must be realized.
The Moores support this argument with references to historical definitions of income at the time the United States ratified the Sixteenth Amendment, including a Supreme Court decision four years after ratification, which understood income to be “actual cash as opposed to contemplated revenue due but unpaid.” They also reference dictionaries and academic writings.
These historical definitions and academic writings help support the claim that Congress’s power to tax without apportionment is limited to taxing incomes. If income was only understood to mean that which is realized, then an original intent interpretation would require holding the MRT as an unconstitutional tax on unrealized gains.
In response, the United States argues that while income under the Sixteenth Amendment may include a realization event, income has a broader definition thus allowing Congress to tax unrealized gains.
The United States’s argument relies more heavily on a Supreme Court decision from 1955, Commissioner v. Glenshaw Glass, for the proposition that “gross income” includes “any ‘accessio[n] to wealth.’” Within that vein, it argues Congress has a long history of similarly structured income taxes that do not require realization. For instance, the Supreme Court upheld a tax on “the proportionate share of the net income of [a] partnership,” even when the share was not “currently distributable, whether by agreement of the parties or by operation of law.” Indeed, a shareholder in an S Corporation is taxed on the shareholder’s pro rata share of the corporation’s items of income.
But even if the Supreme Court were to hold that income requires realization, the United States offers an alternative argument for why the MRT is constitutional. If realization is a requirement of income, then all the Court need do is look to the corporation, instead of the Moores. Neither party disputes that KisanKraft had realized gains, not merely increased in the value of its assets, and Congress has a long history of disregarding the corporate form to facilitate the taxation of a shareholder’s income. Thus, while the Moores can be displeased that the corporate form was disregarded, it is ultimately a policy decision by Congress.
The alternative argument by the United States leads to a broader and less defined discussion of the implications in how this case is decided. If the Supreme Court were to fully embrace the Moore’s argument, and carry it to its logical conclusion, additional sections of the Internal Revenue Code would be vulnerable to similar claims of being unconstitutional under the Sixteenth Amendment.
Pass-through entities, such as limited liability companies, partnerships and s-corporations, arguably represent the workforce of America. Together, they employ over 60% of Americans, generate a greater amount of net income, and pay a greater share of federal business income taxes than c-corporations. However, the collective force of pass-through entities overshadows the fact that the vast majority of these are small business which rely on a predictive tax structure.
The governing taxation chapter for partnerships, limited liability companies (Subchapter K), and s-corporations (Subchapter S) shares many of the same characteristics as the MRT. In each structure, individual owners are taxed on their share of the entity’s income, regardless of whether the income is distributed. If the Supreme Court were to adopt the Moore’s reasoning—undistributed business income cannot be taxed under the Sixteenth Amendment—this would undoubtedly trigger uncertainty of Subchapters K and S. It is not beyond the realm of possibility that were these chapters successfully challenged, small-business may be required to convert from a single-tax structure to a double-tax structure.
Moore v. United States challenges a key component of the American tax system and threatens to trigger greater uncertainty in the future. If the MRT is unconstitutional and the concept that a company’s gains not otherwise distributed to shareholders or members cannot be taxed, the American tax system would undergo a profound change. While this issue may have begun with a tax bill for less than $15,000, the implications stretch into the billions.
The TCJA was passed through the process known as reconciliation. This required it not increase the deficit beyond the 10-year budget window. The MRT was one of several provisions necessary to offset to decrease in collected tax revenue. Pub. L. 115-97.