On June 20, 2024, the U.S. Supreme Court ruled that the TCJA section 965 transition tax imposed on certain U.S. shareholders is constitutional in Moore v. United States. While the ruling was limited in scope and widely anticipated, the justices' perspectives regarding the taxation of unrealized income could precipitate constitutional challenges to certain tax regimes and influence future tax reform. In this alert, we focus on the broader legacy that Moore may leave as businesses and individuals consider the implications of the Court's analysis and decision.
The Case in Point
A Washington couple (the Moores) owned approximately 13% of KisanKraft, an Indian corporation that was classified as a controlled foreign corporation (CFC) for U.S. federal income tax purposes. KisanKraft generated certain earnings that, at the time, would be subject to U.S. tax only if, and when such earnings were distributed to its U.S. shareholders. The earnings were never distributed. As part of the TCJA, by the end of 2017, the transition tax — sometimes referred to as the mandatory repatriation tax — became effective, resulting in the Moores being taxed on their pro rata share of KisanKraft's undistributed accumulated earnings from 2006 to 2017. The Moores paid the tax and sued for a refund claiming that the transition tax was unconstitutional. The Ninth Circuit disagreed, opining that "realization of income is not a constitutional requirement" for taxation, spurring a nationwide interest in the Moores' case.
Under Article I of the U.S. Constitution, Congress has the power to levy and collect taxes. This authority encompasses both direct taxes (on persons or property) and indirect taxes (on activities or transactions), as affirmed by Supreme Court precedents. Direct taxes must be apportioned among the states based on population, whereas indirect taxes must be "uniform throughout the United States" and do not require apportionment. The 16th Amendment further allows the federal government to impose income taxes without apportionment among the states. The Moores argued that the transition tax is a tax on property (their shares of KisanKraft stock), and therefore unconstitutional without apportionment. According to the Moores, what distinguishes an income tax from a property tax is a realization event, and the transition tax did not tax any income realized by the couple.
And the Supreme Court Ruled . . .
According to the majority opinion, the transition tax was imposed on the foreign corporation's realized income, obviating the need to address the realization question. That left the Court to decide whether Congress may attribute a corporation's realized and undistributed income to its shareholders and tax them on their pro rata share of that income. That attribution, the majority said, is no different than current passthrough tax regimes that the Court and the lower courts have long held to be constitutional (such as tax regimes for partnerships, S corporations, and subpart F income). Thus, the Court ruled that the transition tax is constitutional but emphasized that its ruling is limited to taxing shareholders on an entity's realized and undistributed income that has been attributed to the shareholders and the entity was not otherwise taxed on such income.
The Moores could not convince the Court that the transition tax was different from other forms of passthrough taxation, including under subpart F, which the Moores conceded is constitutional. Subpart F and the global intangible low-taxed income (GILTI) regime subject U.S. shareholders (defined as certain U.S. persons who hold at least a 10 percent direct or indirect interest in a CFC) to current taxation on certain income of the CFC. After 2017, the income of a CFC is subject to tax under either the subpart F or GILTI regimes, unless an exception applies.
The All-Important Non-Decision
In the Court's 7-2 decision supporting the constitutionality of the transition tax, the justices in dicta were divided on ruling on a constitutional income realization requirement but have paved the way for future debates:
- Justice Kavanaugh, who wrote the majority opinion (joined by Chief Justice Roberts and Justices Sotomayor, Kagan, and Jackson) declined to rule on the constitutional issue of income realization but left hints suggesting that Congress's taxing power is not unlimited (e.g., constitutional challenges to taxes on wealth and appreciation may be successful).
- Justices Barrett and Alito in a concurring opinion on the judgement and Justices Thomas and Gorsuch in a dissenting opinion, contended that realization is a constitutional requirement for unapportioned income taxes, generally arguing that Congress has broad authority to impose taxes, subject to a limitation on whether the taxes are imposed on income or the source from which the income was derived.
- Justice Jackson wrote a concurring opinion proclaiming that no realization requirement exists under the Constitution, suggesting Congress's taxing power is far-reaching and may extend to taxes on wealth.
Looking Ahead: Potential Looming Challenges
As noted above, the posturing of the justices in the Moore case could prompt taxpayers to challenge the constitutionality of a variety of tax provisions. Potential challenges include the following:
Arbitrary Attributions of Undistributed Income? The Moores did not raise their due process claim regarding the retroactivity of the transition tax before the Supreme Court. However, the majority opinion noted that attributing a corporation's income to its owners must adhere to due process limits, ensuring a sufficient relationship between the taxpayer and the underlying income. Justices Barrett and Alito argued that Congress has limited powers to disregard the corporate form, treat a corporation's shareholders like partners, and tax the shareholders on a corporation's undistributed income.
All justices agreed that attributing income to shareholders in a CFC regime could be considered arbitrary under certain circumstances. Justices Barrett and Alito suggested factors that might be useful as courts apply Moore to taxes that attribute income from corporations to individuals, including:
- Whether a shareholder has sufficient power and control over the corporation's income to reasonably treat the shareholder as receiving the income;
- Whether the shareholder receives a special privilege or benefit from the entity earning the income; and
- Whether the corporation is foreign, and thus not subject to an accumulated earnings tax.
Because the Moores conceded that subpart F is constitutional, it is not clear how the Court would rule if the CFC tax regime (including GILTI) were challenged under the due process clause. Although a constitutional challenge to the CFC regime in their entirety might be far-reaching, courts could consider invalidating specific aspects, potentially dismantling the CFC regime.
Taxes on Asset Appreciation? By not addressing the income realization requirement, the Court left open questions about the constitutionality of the taxation of unrealized gains or income. This includes, for example, a mark-to-market regime applicable to securities dealers (section 475) and to certain futures contracts (section 1256), and the income inclusion rules for original issue discount instruments (section 1272).
Double Taxation Regimes on Undistributed Income? The Court did not address the issue of taxing both an entity and its shareholders or partners on an entity's realized and undistributed income that was subject to U.S. tax. The majority opinion implies that such a tax, based on the Court's ruling in Moore, would not be permissible, as it would not align with the traditional passthrough concept.
Taxes on Individual Wealth and Net Worth? Proposals to tax individual wealth and net worth, such as Senate Finance Committee Chair Ron Wyden's "Billionaire's Income Tax" that would tax unrealized gains under a mark-to-market regime, could face significant challenges. It remains to be seen whether Moore will impede the advancement of wealth taxes, although Senator Wyden remains firm on the constitutionality of his proposal.
A&M Tax Says
The Supreme Court's decision in Moore provided less guidance than some had hoped for on several important issues. Although limited in scope, this decision will likely be of great significance in the coming years as lawmakers consider tax reform and the broad implications of Moore, even beyond those discussed in this alert. Whether Congress will debate what Moore could mean for current and proposed tax laws depends largely on the outcome of the upcoming presidential and congressional elections. Taxpayers may want to consider how the potential direction of the Supreme Court might affect positions they have taken or future tax planning. If you would like to discuss the potential implications of Moore, please feel free to reach out to Kevin M. Jacobs, Josh Goldstein, or Logan M. Kincheloe of our National Tax Office.
Originally published 25 June 2024
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