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Moore v. United States: a crucial test of taxing unrealized gains
ARTICLE | September 07, 2023
In an upcoming Supreme Court case, Moore v. United States, the fundamentals of U.S. tax law are set to be put to a crucial test. The central question is relatively simple: can the federal government impose an income tax when no income has been received?
For Charles and Kathleen Moore, owners of a small stake in an Indian company, KisanKraft, this is not a hypothetical question. It's their reality.
How income on overseas investments is and was taxed
Before the Tax Cuts and Jobs Act (TCJA) of 2017, U.S. taxpayers and companies with ownership in a foreign entity only had to pay taxes on earnings or dividends that were repatriated (transferred back to the United States). The repatriated dividends were subject to U.S. taxes at a rate up to 35%, with a credit for any foreign taxes paid. This usually resulted in a net tax obligation because the U.S. tax rate was typically higher than most foreign tax rates. For this reason, many U.S. taxpayers and companies would opt to leave cash in a foreign bank account instead of paying dividends.
The Trump administration sought to encourage companies to repatriate funds and improve domestic profits. To accomplish this, the TCJA amended the treatment of earnings from certain foreign business activities and introduced a modified dividend-received deduction to help reduce taxes on repatriated foreign earnings. The modified dividend-received deduction went into effect starting in 2018. However, the administration also needed to address previous years' earnings that had accumulated and were still held in foreign bank accounts. For those earnings, the TCJA introduced the Mandatory Repatriation Tax (MRT). The one-time MRT is a tax that applied to U.S. taxpayers with a 10% or greater share in a controlled foreign corporation (CFC). The tax was assessed on all overseas earnings that accrued between 1986 and December 31, 2017, and were still held overseas. It imposed a 15.5% tax for cash assets and an 8% tax for non-cash assets. Because this one-time levy was applied to all deferred overseas earnings as of the end of 2017, it created an immediate and significant tax liability for many U.S. taxpayers.
Background on the Moore's investment in KisanKraft
In 2005, the Moores invested in KisanKraft, a startup designed to bring affordable tools to rural Indian farmers. Over the years, the Moores maintained their 11% ownership in the company, never selling any equity. Further, KisanKraft reinvested all its earnings back into the firm and never distributed any funds or dividends to the Moores. As a result, the Moores never received any funds from their investment.
The Moores, despite never receiving a dollar from their investment in KisanKraft, were confronted with a sizable tax bill because of their ownership stake. Under the MRT, they were taxed as though they had received a 2017 dividend equivalent to 11% of KisanKraft's earnings since 2005, corresponding to their ownership percentage.
The legal battle
The dispute at the heart of Moore v. United States rests on a key interpretation of the Sixteenth Amendment, which defines the federal government's authority to levy income taxes. In lay terms, the Sixteenth Amendment gave the U.S. government the authority to collect taxes on all money earned by individuals and businesses, regardless of where or how the income was earned. It also eliminated the need for tax amounts to be equally distributed among states based on their populations. Essentially, it's the constitutional foundation for the federal income tax system we have today.
The Supreme Court typically categorizes taxes as either "direct" or "indirect" when deciding if they are constitutional. Indirect taxes, such as duties and excise taxes, don't need to follow the rules of the Sixteenth Amendment. On the other hand, direct taxes, including income taxes, need to follow these rules.
The Moores' argument
The Moores argue that the MRT is an unapportioned direct tax, not an income tax, hence violating the Sixteenth Amendment. Central to this dispute is the definition of "income." The Moores assert that, historically, the Supreme Court has interpreted "income" as realized gains or money a taxpayer has actually received or earned. To support this argument, the Moores pointed to a precedent set by the Supreme Court in Eisner v. Macomber (1920), where it was affirmed that an increase in the value of stock holdings, without a monetary dividend, is considered capital and not income. It's worth noting that the last time the Supreme Court invalidated a federal tax on constitutional grounds was the Macomber case more than 100 years ago.
The government's argument
In rebuttal, the government contends that the Moores' reliance on Macomber is misplaced, as subsequent decisions have severely curtailed its relevance as precedent. They explained that stock dividends (which were at issue in the Macomber case) merely represented a book adjustment without increasing the value of the stock holdings. Essentially, they argue that the Macomber case should not matter, but even if it does, it differs greatly from the Moores' situation.
Further, it is the government's position that the MRT is indeed an income tax. To support their argument, the government has noted numerous provisions in the Tax Code which apply to unrealized amounts, or phantom income, which have either been upheld on constitutional grounds or have never been challenged. For instance, the government explains that the Supreme Court upheld the taxation of an individual partner's "proportionate share of the net income of a partnership," even if that share was not distributable at the time. This principle has been applied similarly to shareholders of S corporations for the past 65 years. In the government's view, nothing in the text or history of the Sixteenth Amendment suggests that the undistributed income of a CFC should be treated differently from the undistributed income of a partnership or S corp.
Lower court rulings
To date, both the federal district court and the Court of Appeals for the Ninth Circuit sided with the government, affirming that the MRT is an income tax. The Ninth Circuit even explicitly stated that the realization of income is not a necessary condition for an income tax.
The fact that the Supreme Court has granted certiorari to Moore v. United States is a major development. The Court's decision to do so is significant as it reviews only a small number of the cases it is petitioned to hear each year. The acceptance of a case typically implies that the Court believes the case presents an important legal question or may have broader implications for the interpretation of law and policy.
Adopting the Moores' position could potentially have far-reaching implications for tax law in the United States. If the Supreme Court agrees with the Moores' argument that the MRT violates the Sixteenth Amendment, it will call into question the constitutionality of numerous other tax provisions and could pave the way for further tax reforms.
Many of these provisions have been in place for decades, forming a central part of the U.S. tax code. These include various forms of unrealized income that are currently taxed, similar to the MRT.
On the other hand, a decision that upholds the Ninth Circuit's ruling that income need not be realized to be taxable could potentially broaden the scope of taxable "income." This could also open the door for further tax reforms, including the potential for other taxes that aren't necessarily tied to realized income.
This article is intended to provide a brief overview of the upcoming Supreme Court case Moore v. United States. It is not to be construed as legal advice, nor is it a substitute for speaking with one of our expert advisors. For more information, please contact our office.
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