The Supreme Court heard argument last month in Moore v. United States, a case with potentially broad implications for the income tax system. The case involves a challenge by the Moores, two individual taxpayers, to 26 U.S.C. 965, known as the Mandatory Repatriation Tax (“MRT”), which is a provision of the 2017 tax reform legislation. As the justices seemed to appreciate in the oral argument, however, a decision in the case could have effects far beyond that provision – and has the potential to undermine large swaths of the existing tax code enacted on a bipartisan basis over decades.
At oral argument, justices from across the ideological spectrum seemed focused on avoiding that outcome. However, even as the justices for the most part approached the petitioners’ claim skeptically, they raised questions for both sides in the case as to the appropriate limiting principle for determining what Congress can tax as income under the 16th Amendment.
In our amicus brief submitted to the Court, we explained why the Court does not have to define a limiting principle for the income tax in order to resolve this case. Whatever those limiting principles could or should be, the tax at issue here is well within those boundaries. The petitioners claim that the MRT is a tax on property rather than on income since, they say, it taxes value that the petitioners did not directly realize. But, in fact, the income was realized at the corporate level by their company KisanKraft and then attributed to the petitioners as its owners. This attribution of an entity’s income to its owners is consistent with many other provisions in the income tax code governing the taxation of entities and their owners. The Court need only decide that this widespread form of taxation is well within the bounds of the 16th Amendment.
The justices should proceed with extreme caution in drawing new boundaries to the 16th Amendment that are unnecessary to resolve this case. In our amicus brief, we explain why, and the oral argument further evidenced the dangers of the Court engaging in line drawing that could undercut the income tax code in ways that the Court may not fully appreciate. The Court may eventually decide to address those boundaries, but it should wait until there is a case squarely presenting the issue and that allows the Court to fully wrestle with the implications.
In this post, we analyze several “limiting principles” to the 16th Amendment that were discussed in oral argument, and explain how many–though not all–of these could significantly undercut the income tax.
Limiting Principles Discussed in Oral Argument
As highlighted in the oral argument, a key challenge for the petitioners’ position is that their definition of the 16th Amendment’s boundaries is inconsistent with the taxation of business entities in many parts of the existing tax code. Specifically, they claim that, for income to be taxed to a business owner, the income must be directly realized by the owner themselves, and they point to the 1920 case, Eisner v. Macomber, as the key decision undergirding their argument. In Macomber, the Court held that Congress could not tax a shareholder upon the receipt of a corporate stock dividend because it did not represent a change in the shareholder’s economic interest in the corporation.
To try to save this argument from the obvious objection that it would undercut vast and long-standing swaths of the tax code, the petitioners emphasize in their briefing and in oral argument a concept called “constructive realization.” The basic idea is that, while many parts of the tax code look through business entities and tax income at the entity level to the owners, there is still some “constructive” realization of the income by the entity’s owners, in cases where they have sufficient control over the entity’s income.
Constructive realization simply cannot do the work petitioners say it can. If realization by an entity’s owners, whether constructive or not, is really required, then much of the existing business tax code would still be brought into question. Constructive realization could potentially be used to justify provisions that look through the business entity if the owners have sufficient ownership and control of the entity, such as in the case of the subpart F rules and, ironically, the MRT, the very provision at issue in this case, which both only apply to shareholders owning at least 10% of the entity. But this minimum “control” standard could not justify the myriad rules providing for “pass through” taxation under subchapter K and subchapter S, not to mention other parts of the code. As Justice Barrett rightly observed at oral argument, requiring “control might go a little bit too far”; this standard was not the “linchpin” of the Court’s previous cases.
Let’s focus for a moment on partnership taxation under subchapter K, which applies to millions of business entities in the United States. Subchapter K works on a pass-through basis, and taxes partners with respect to their share of the partnership’s income, irrespective of their ownership stake in the partnership. The petitioners try to explain this away by claiming that partnerships, unlike corporations, are not legally distinct from their owners under state law – and so income isn’t attributed to the partners; it’s simply the partners’ personal income to begin with. But, this claim is simply false under modern partnership law, which treats partnerships as legally distinct from their owners. Further, Limited Liability Companies (LLCs)–which are clearly legally distinct from their owners just like corporations–are also taxed as pass-throughs under subchapter K. The petitioners don’t even attempt to explain how the taxation of LLCs is consistent with their vision of constructive realization doctrine, preferring to pretend as if those entities don’t exist.
To be sure, the petitioners could fairly read Macomber – if interpreted broadly – as requiring realization, whether constructive or direct, by the owners of business entities for the income to be taxed to them. But, as explained in our brief and in many others, Macomber has been narrowed to its facts over the decades and for good reason: Applying its logic broadly is inconsistent with how aspects of the income tax code operate now and arguably even at the time it was decided.
Another possible limiting principle implicit in some of the questioning in oral argument might require “realization somewhere along the chain by a corporation antecedent to the taxpayer” in the words of Chief Justice Roberts.
As Chief Justice Roberts identified at the outset, and as other justices later noted as well, KisanKraft, the foreign company in which the petitioners had invested, clearly realized the income subject to the MRT. And attributing this income to the owners should be well within the bounds of the 16th Amendment consistent with the functioning of much of the income tax code. The Court can thus easily dispose of the case without further determining the outer bounds of the income tax.
We agree that the “realization somewhere” principle is sufficient to resolve this case, and to conclude that the MRT therefore uses a form of taxation that is clearly within the bounds of the 16th Amendment. But the Court should not confuse this principle for being a necessary prerequisite for defining the outer bounds of the taxing power under the 16th Amendment. In our brief, we explain how the Court has rightly left it to Congress to determine when and how income gets measured; realization is then defined by Congress in a variety of ways throughout the code as a matter of administrative convenience. Further, there are cases when Congress taxes income where there hasn’t been a “realization event” other than Congress deeming a point in time to be an appropriate moment to measure and tax income.
This last observation is crucial. Moving beyond the Moore case, where there was undoubtedly a realization event, even if only at the entity level, there are several pieces of the code that don’t work this way, and do not require a realization event when determining the base of taxable income. Many of these provisions tend to provide benefits to taxpayers, in reducing their tax liabilities, though not always. For instance, the code provides for depreciation schedules that require depreciation of property according to certain schedules each year without any intervening realization event. Depreciation of course tends to help taxpayers by allowing them to recover their business expenses sooner, but, depending on their tax rates over the years, that won’t always be the case.
Other such provisions that do not rely on a realization tend to increase a taxpayer’s liabilities. For instance, bondholders are effectively taxed on an “accrual basis” – when interest accrues rather than when it is paid – under the “original issue discount rules.” Similarly, certain investment positions and dealers are taxed on a “mark-to-market” basis, based on the change in the value of their investments during the taxable year without any other intervening realization event. A number of experts have cataloged these kinds of rules in the tax code, and identified how they would be threatened by adopting a limiting principle that requires realization “somewhere along the chain”.
The Court may wish to eventually answer the question of whether income taxation is allowable under the 16th Amendment without a realization event somewhere along the chain, but, if it were to do so, it should fully wrestle with the implications including the existing tax provisions that would be threatened by such a principle, and how this principle could actually be applied throughout the intricate income tax rules.
The petitioners’ briefing on the issue illustrates the danger and confusion inherent in this limiting principle. They try to justify “original issue discount” as consistent with their definition of income under the 16th Amendment by claiming that this rule is simply a method of accounting that affects only the timing of when income is includible (making it includible before realization) rather than never requiring realization at all. However, the same could be said for mark-to-market systems generally, including the very Biden minimum tax proposal that the petitioners have claimed would be inconsistent with their theory of the limits of the income tax. In effect, the petitioners themselves seem unwilling in their briefing to live with the implications of requiring “realization somewhere along the chain” – unless the rule is interpreted so narrowly and inconsistently as to still preserve the existing accrual systems, which are hard to distinguish from proposed ones that are seemingly problematic for the petitioners.
Before taking on these issues, the Court should have this limiting principle squarely presented before it, and work through the implications of striking down provisions like original issue discount – and whether or not that and other provisions that tax unrealized income would survive.
A Realization Requirement – But with a “Fraud or Abuse” Exception
Both the petitioners and some of the justices, perhaps recognizing the poor fit of various limiting principles with the existing tax code, explored drawing a line that requires realization by a taxpayer but then allowing an exception for “fraud” or “abuse.” For example, Justice Barrett asked petitioners’ counsel whether he was proposing a “fraud overlay”that would allow exceptions to a strict realization requirement when an entity or transaction was “really functioning as a tax shelter[.]” Under this view, Congress could enact rules that tax income prior to a realization event, but only when necessary to prevent fraud or abuse. To be sure, a poorly-fitting line with a poorly-defined exception would be better than a poorly-fitting line with no exception at all. But, that does not make it an appealing option, and it would come with its own serious challenges. The answer is to not draw a poorly-fitting limiting principle to begin with.
First off, the “fraud overlay” presents a doctrinal puzzle: If it is assumed that the Constitution only allows Congress to tax “realized” income pursuant to the 16th Amendment, then it is not clear that Congress could exceed its constitutional powers in order to protect the tax base that it can constitutionally tax.
But, even if the Court could overcome that challenge, there’s a larger problem looming: It is clear from oral argument that no one had a clear sense of what scenarios would be sufficient to qualify for this exception. Petitioners’ attorney and a number of the justices mentioned in the abstract a possible exception to the realization requirement for “fraud.” But the problem of tax avoidance and abuse is much broader than outright fraud or abuse. If a type of tax avoidance or sheltering is already illegal, there’s generally less need for a new provision to prevent it. While the petitioners did not hinge their argument about a fraud or abuse exception on illegality, the imprecision shows that no one involved in this case knew how to evaluate whether a certain tax rule responded to abuse. Imagine the litigation that could ensue. Taxpayers could “latch on to” the Court’s statements about limitations of Congress’s powers to challenge any anti-abuse rules. Courts adjudicating such cases would have few guidelines to determine whether or not a provision’s link to tax avoidance or abuse is sufficient. Even if courts upheld much of the existing tax code in part using the “fraud or abuse” exception, it could take years of litigation to reach that outcome, and the inherent uncertainty involved could obstruct Congress’s flexibility to respond to new and emerging tax avoidance strategies.
Take the MRT itself as an example of the challenge here. The petitioners’ counsel, despite having offered what Justice Barrett termed a “fraud overlay,” presumably would say that the MRT doesn’t qualify for this exception. This is despite the fact that the MRT was specifically responding to corporations shifting profits out of the United States and then never repatriating them – with something in the range of $3.5 trillion in profits building up overseas by the time the 2017 law was enacted. It was tax sheltering on a massive scale. But, this apparently is insufficient to trigger the exception under the petitioners’ conception. And, if the MRT doesn’t qualify as addressing abusive tax sheltering then many other provisions in the code, such as Subpart F on which the MRT is based, presumably wouldn’t either. Of course, a fraud and abuse exception could be read broadly enough to encompass provisions like the MRT. But what exactly are the factors that would differentiate constitutionally appropriate measures to address fraud and abuse like the MRT versus those that aren’t appropriate? Courts – and tax writers – would be left at sea.
Government’s Proposed Limiting Principle – The Distinction Between a Property and Wealth Tax
In sum, the limiting principles offered by the petitioners would do considerable damage to the tax code as it now exists, and the Court should be just as skeptical of those theories as they seemed to be of the petitioners’ challenge to the MRT.
To emphasize once more: The Court does not need to and should not use this case to draw the outer boundaries of Congress’s power to tax income. But, if the Court feels like it must articulate some boundaries, the government offered a workable limiting principle on the income tax power under the 16th Amendment.
As the government explained, there is a distinction between a property or wealth tax and an income tax permitted under the 16th Amendment, and this distinction has nothing to do with realization. If someone owns property, Congress cannot tax the total value of the property as a tax on income, but only the change in the property’s value over some specified period of time. And because an income tax only taxes gain, unlike a property tax, an income tax does not repeatedly tax a taxpayer each year with respect to the same asset value.
For example, if a taxpayer buys stock for $1 million, Congress cannot impose a tax on that $1 million of stock value (such as by levying a tax equal to 10% of the $1 million in stock value) and call it an income tax. However, if the stock appreciates in value (say, to $3 million in value), that appreciation of $2 million is income, per the government’s definition, and it is then up to Congress as to how and when that income gets taxed under its 16th Amendment powers.
To be sure, the tax on stock value itself might be constitutionally justifiable under Congress’s taxing power outside the 16th Amendment. Our point here is only that the government’s definition pertains to the ambit of the 16th Amendment, which unambiguously allows Congress to tax income without apportioning the burden of the tax among the states.
This distinction between an income tax and a wealth or property tax applies regardless of the timing of the tax, or the duration of years across which the income is calculated. Back to our stock example: When Congress taxes gain, it does not matter whether Congress taxes the $2 million appreciation in the stock value across a period of one year or across multiple years. In either case, Congress is still taxing income. By contrast, a tax applied to the amount of stock owned, rather than the appreciation, would not be a tax on income.
The Solicitor General clearly distinguished a deferred income tax from a tax on property or wealth, which looks at the“total value of the asset,” rather than at gain between two points in time. The Solicitor General clarified that “the length of the lookback period here can’t change the underlying character or classification of what’s being taxed as income” and that “it would be anomalous for Congress to lose its ability to tax that as income just because it’s granted a period of tax deferral.”
The government’s limiting principle gives Congress flexibility to choose the accounting system to determine when gains should be taxed. However, the government’s approach does not allow Congress to tax wealth or property as income.
Some, including the petitioners’ counsel at oral argument, have pushed back against the government’s limiting principle by arguing that, if this income concept alone limits Congress’s constitutional power, then existing law would require taxing all property transactions on a mark-to-market basis and all business entities, including corporations governed by subchapter C (C Corporations), on a pass-through basis–which no one intends.
This argument confuses constitutional limitation with statutory limitation. The government’s argument concerns the outer bounds of the constitutional taxing power, and does not suggest that the Treasury Department could tax all unrealized income under the existing statutory provisions in the tax code, nor tax the owners of C Corporations on the retained profits of the corporation since subchapter C instead provides for entity-level taxes and taxes on the owners only upon distribution. To expand taxation of unrealized income and pass-through taxation of business entities, there would need to be express legislation by Congress.
This false argument goes as follows: Section 61(a) of the code defines taxable “gross income” as “all income from whatever source derived.” The 16th Amendment gives Congress the “power to lay and collect taxes on incomes, from whatever source derived” without apportionment. Therefore, according to this argument, if the Supreme Court doesn’t read a realization requirement into the 16th Amendment, there would be no realization requirement under existing law since Section 61(a) parallels the language of the amendment itself, which would make all unrealized gains already taxable on an annual basis. Further, the argument goes that, if Congress can under the 16th Amendment attribute profits realized at the entity level to the owners, then Section 61(a) would require that treatment for all entities under current law.
In a series of posts, George Callas–who helped draft the MRT while serving as a congressional staffer for the House Committee on Ways and Means and later as Senior Tax Counsel for Paul Ryan–has nicely illustrated the fallacy at the core of this argument, and we agree. To restate why this argument is wrong: If Section 61(a) was the only provision governing how Congress has defined income, this argument might have legs. But, that is not the case. Even Section 61(a) provides that Congress will have more to say on how income is defined, as it prefaces its general income definition with the clause “except as otherwise provided in this subtitle.”
Section 1001 of the code explicitly governs sales or dispositions of property and defines the amount of taxable gain to be included in income as only the excess of the“amount realized” from a sale or disposition over the taxpayer’s cost basis in the property sold. As the Court recognized in Cottage Savings, this section of the code “defers the tax consequences of a gain or loss in property value until the taxpayer ‘realizes’ the gain or loss.” This provision explicitly qualifies, for statutory purposes, the definition of taxable income as it applies to gains from investments.
While certain provisions of the code–such as existing mark-to-market provisions and the original issue discount rules–are themselves exceptions to the code’s general statutory realization requirement, Congress enacted these exceptions as specific provisions providing for taxation before realization, or deeming certain income to be realized. A ruling in favor of the government would not automatically expand the taxation of unrealized gains. An expansion of mark-to-market would be subject to the not-insignificant checks and restraints inherent in lawmaking and the political process.
Similarly, C corporations’ taxable gains would not suddenly pass through on a current basis to shareholders if the Court were to accept the government’s limiting principle. In specifically providing which distributions result in taxable income for the shareholder, subchapter C makes clear–both explicitly and implicitly–that gain is not generally taxable to shareholders of C corporations prior to a distribution. This is in contrast to the treatment of owners of S corporations governed by subchapter S and owners of partnerships governed by subchapter K where the law explicitly provides for such pass-through treatment. Adopting the government’s limiting principle on constitutional power does not override Congress’s detailed statutory scheme differentiating these forms of business entities–and, in fact, allows Congress to make such distinctions.
Freezing the Tax Code in Amber?
Throughout the petitioners’ briefing and then at oral argument, there was another limiting principle – if it can be called a principle – offered: draw a constitutional boundary around income as the Code treats it now (or prior to 2017 per the petitioners’ argument), but don’t allow further, significant reforms to how income is measured for tax purposes.
For the petitioners, this may be the only consistent principle given their inability to otherwise distinguish pre-existing parts of the Code, even as they argued for those parts to be preserved and the MRT (and reforms under consideration) to be struck down. This position was made explicitly by the petitioners’ counsel when he suggested that the tax code reaches“the full extent of Congress’s authority under the Sixteenth Amendment” such that new categories of income could not possibly be taxable as income. But, even the government may have alluded to a principle like this at oral argument. When asked by Justice Alito whether Congress could tax accrued but unrealized gain on stock, the Solicitor General, while not conceding that this was beyond Congress’s powers, suggested that was a “harder question” because there wasn’t the same “tradition” for doing so as, for instance, attributing gains realized at the entity level to owners (although there are some targeted provisions that, in fact, tax in similar ways).
Although preserving longstanding taxes is preferable to dismantling them, the Court should not fall prey to the idea that the Code as it is written now represents the outer bounds of Congress’s tax powers. The tax code should not be constitutionally frozen in amber. The Court should instead allow Congress the flexibility it has had up until this time to tax income under the Sixteenth Amendment. Nothing in the Sixteenth Amendment requires policy stasis of Congress and indeed its text plainly indicates the opposite, namely Congress can tax income “from whatever source derived.” Indeed, at oral argument, Justice Alito expressed doubt that “Congress’s failure to enact a tax in the past brings [the tax] outside the Sixteenth Amendment if the tax would otherwise fall within the Sixteenth Amendment.” Moreover, if anything is constant in tax law it is that it is constantly changing. To constitutionally restrict Congress from adapting the Code to an evolving world (what is the traditional way to tax digital assets?) and to taxpayer ingenuity would radically undermine the Code’s relevance and efficacy, and Congress’s powers under the 16th amendment to effectively tax income.
Because all of the petitioners’ proposed limiting principles on Congress’s ability to tax income under the 16th Amendment would do harm to the tax code, a number of justices seemed to circle back to what many tax experts have been saying for months. The best way to avoid damage is to recognize that the MRT taxes income that was realized and appropriately attributed to the owner, and that the Court therefore does not need to reach the question presented or to determine the outer boundaries of the 16th Amendment. Following this reasoning would result in a narrow but unqualified win for the government.
The Court should not try to deal with issues not before it and define a limiting principle which could threaten the very kind of damage to the tax code that a majority of the Court seemed to wish to avoid in oral argument, or that even threatens to roll back the 16th Amendment. The time to define a limiting principle would be when there is a tax before the Court requiring it to define the outer boundary of the income concept. Only in such a case could the Court appropriately wrestle with the implications of creating a new constitutional limitation on Congress’s longstanding power to tax income.
Ari Glogower is a Professor of Law at Northwestern Pritzker School of Law. David Kamin is the Charles L. Denison Professor of Law at NYU Law School. Rebecca Kysar is a Professor of Law at Fordham Law School. Darien Shanske is the Martin Luther King Jr. Professor of Law at UC Davis School of Law. Thalia T. Spinrad is a Tax Law and Policy Fellow at the Tax Law Center at NYU Law.