The U.S. Supreme Court ruling in a closely watched case with potential far-reaching impact on taxpayers may embolden policymakers who seek tax increases on wealthy individuals, including unrealized gains on assets such as stocks and real estate. The high court's ruling last month on Moore v. United States favored the government 7-2, even as opinions firmly imply that it could rule in favor of taxpayers under different circumstances. The court failed in its decision to specifically and definitively determine "whether the Sixteenth Amendment authorizes Congress to tax unrealized sums [on stock ownership] without apportionment among the states."
The court was asked to decide whether the plaintiffs, Charles and Kathleen Moore, could be taxed on income earned by an Indian farm equipment company, KisanKraft, in which they invested $40,000 in 2005, in exchange for 11% of the company's equity. KisanKraft has earned a profit every year and has reinvested in the business rather than distributing earnings to shareholders.
Before the Tax Cuts and Jobs Act (TCJA) of 2017, taxpayers could defer taxes on foreign earnings of businesses like KisanKraft until the income was repatriated. Income unrepatriated as of enactment of the TCJA, is taxed under a provision called Section 965 deemed repatriation. The Moores claimed the provision was unconstitutional, arguing that the Sixteenth Amendment allowed taxation only of realized income, and they had not yet realized the income.
"The Court's holding is narrow and limited to entities treated as pass-throughs. Nothing in this opinion should be read to authorize any hypothetical congressional effort to tax both an entity and its shareholders or partners on the same undistributed income realized by the entity. Nor does this decision attempt to resolve the parties' disagreement over whether realization is a constitutional requirement for an income tax," Justice Brett Kavanaugh wrote in the majority opinion.
The court upheld one minor tax law, and the Moores will not receive a $14,729 refund from the tax they challenged, but the ruling is open to broad interpretation and potential policy changes for taxing wealthy Americans. One potential expansion of the breadth of the Sixteenth Amendment is a proposed net wealth tax, which could impact unrealized and undistributed income. Moreover, a proposed billionaire minimum tax would effectively tax unrealized and undistributed income one time. To a lesser degree, interpretation of the Sixteenth Amendment could affect the corporate income tax inclusion of global intangible low-tax income (GILTI), and the new corporate alternative minimum tax, which may include unrealized income.
Court decisions pre-dating and leading to the Sixteenth Amendment, adopted in 1913, distinguish between taxes on property, including stock ownership, versus taxes on income that is "derived or realized from that property," such as capital gains.
A tax on stock ownership is a direct tax on property which is subject to apportionment among the states, while a tax on realized income falls under the Sixteenth Amendment and is not subject to apportionment. Taxes that are required to be "apportioned [equally] among the states" may have been feasible when the Constitution was ratified in 1788, but would be nearly impossible to implement today.
Bottom line: Policymakers now argue that there is no "realization" requirement in the Sixteenth Amendment, and they had hoped the court would address that concern definitively in the Moore case. The case instead affirmed that a closely held foreign company could attribute its untaxed income to its shareholders.
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