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Legal Docket: Unrealized expectations


WORLD Radio - Legal Docket: Unrealized expectations

At stake in Moore v. United States is whether the government can tax unrealized gains on investments

A sign outside the Internal Revenue Service building Associated Press/Photo by Patrick Semansky, File

NICK EICHER, HOST: It’s Monday morning, January 8th, 2024. You’re listening to The World and Everything in It from WORLD Radio.

Good morning! I’m Nick Eicher.

MARY REICHARD, HOST: And I’m Mary Reichard. It’s time for Legal Docket.

The Supreme Court usually hears at least one tax-law case each term. And this year is no exception.

Interest in tax cases tends to be limited to inside the tax community. But this year’s tax case has generated a lot of interest outside the accounting world, as well.

EICHER: It has. And today, legal correspondent Jenny Rough is here to fill us in on what’s going on.

Good morning, Jenny.

JENNY ROUGH: Good morning to both of you.

EICHER: Yeah, so the name of the tax case is Moore v. United States. That is, taxpayer versus tax collector.

ROUGH: That’s a good way to put it.

Now, both of you know this, but one of the biggest reasons the Supreme Court agrees to hear a case is because there’s a circuit split in the lower courts: two conflicting views about one legal issue.

REICHARD: A “circuit split” meaning, various circuit courts within the U.S. Courts of Appeals issue different decisions on the same question of law. It takes the Supreme Court to resolve the conflict.

ROUGH: Right, but in today’s case, there is no circuit split. There’s been only one decision on this legal question, and it came out of the Ninth Circuit.

It’s the first case challenging a new tax law.

REICHARD: That’s brought about speculation as to why the Supreme Court has decided to step in here. Perhaps the court wants to weigh in here because—as you mentioned—this case involves a new and unusual type of tax.

ROUGH: I’ve certainly heard that, and what we talked about moments ago about the level of interest has to do with the possibility of an open door for more taxes.

Some see this as a lead-in to the possible institution of something called a wealth tax, meaning a tax on the net worth of the “ultra-rich”—a political term, not a legal one.

EICHER: Senator Elizabeth Warren proposed a wealth tax four years ago when she ran for president in 2020. A wealth tax would go beyond taxing income. It’s a tax on assets for households with a net worth above $50 million.

So let’s dive in and see if there’s anything to this.

ROUGH: Sounds good. But if you don’t mind, instead of diving in, let’s wade in. Begin with some foundational principles of tax law that will help us better understand our case today.

GIL ROTHENBERG: The income tax really didn’t start to hit the middle class or upper middle class until World War I.

That’s Gil Rothenberg. He’s the former appellate chief for the Department of Justice’s tax division.

ROTHENBERG: And that’s when the income tax first became a serious revenue raiser.

REICHARD: But even before World War I, Congress had imposed some income tax. The first, during the Civil War.

And the power of Congress to do so comes from the original Constitution. Article 1 says Congress has the power to lay and collect taxes. But it also says it does not have the power to lay direct taxes.

ROTHENBERG: Basically a direct tax has traditionally been understood as a head tax or a tax on property. So, for example, a Virginia resident who owns property pays property tax. There is no such thing as a federal property tax, because that would be a direct tax. That would be unconstitutional.

EICHER: In the 1890s, a question arose that asked whether the federal government could tax income on property, whether that’s income derived from tangible property, like rental income or income derived from intangible personal property, like interest and dividends.

ROUGH: That dispute led to a constitutional amendment. The 16th Amendment.

ROTHENBERG: The 16th Amendment essentially made income taxes on the fruits of owning property, such as rents, to be constitutional.

The 16th Amendment clarified that Congress can “collect taxes on incomes, from whatever source derived.” That’s the wording.

And our case today centers on what those words mean.

So we’ve talked about the tax collectors. Let’s now talk about the tax payers. We’ll begin in the year 2005. That’s when Charles and Kathleen Moore invested in a company called KisanKraft.

REICHARD: A friend of theirs started the business to provide equipment to impoverished farmers in rural India. The company’s based in Bangladesh. So it’s an American-owned foreign company.

Specifically, the Moores invested $40,000 in exchange for 13 percent of the common shares.

ROUGH: Let’s go back to Rothenberg who knows the ins and outs of tax law. He says certain tax rules do apply to foreign corporations like the one the Moores invested in.

ROTHENBERG: And one of the rules that applied to almost all foreign corporations was that you could earn income, and until you repatriated, meaning sent the money back into the U.S., it was not currently taxed.

EICHER: The Moores’ company did well. But instead of distributing dividends to its shareholders, the company reinvested its profits back into the business.

Because none of the money from the Indian company came back into the Moores’s pocketbook in the U.S., they got the advantage of the tax law. Their earnings weren’t subject to U.S. tax.

ROUGH: A legitimate tax shelter.

REICHARD: But just to be clear, if the Moores had received distributions or dividends, they’d have owed U.S. taxes on the income then.

ROUGH: Correct. At least, that was the case until 2017 and a change in the law. Congress passed the Tax Cuts and Jobs Act. It rejiggered the rules about how taxes would be imposed on foreign earnings.

Now when foreign earnings are repatriated back to the U.S. the Moores can take a 100 percent deduction. In other words, going forward they don’t have to pay taxes on dividends.

ROTHENBERG: So that was the new rule...

for income going forward.

ROTHENBERG: Now, what about income for previous years? What do you do with the transition situation?

EICHER: The Act imposed a transition tax—a one-time tax that went backward.

That meant the Moores had to pay a prorated share of the company’s profits from the time they first invested to the day in 2017 that the new rules took effect. It added up to about $15,000 in tax liability.

REICHARD: The Moores paid their taxes. But then they sued the government for a refund. They claimed the transition tax was an unconstitutional direct tax on their property.

But the Moores lost in lower court. The Ninth Circuit held that the 16th Amendment does allow the transition tax here.

Now, as a reminder, the constitutional amendment says Congress can tax “incomes, from whatever source derived.”

The Moores appealed to the Supreme Court.

ROUGH: Andrew Grossman was their attorney at oral argument, and he argued that the word “incomes” in the 16th Amendment means realized incomes. In other words, think of the word income as two words, “in” and “come,” meaning, gains that “come … in” to the taxpayer, like wages, rents, and dividends.

ANDREW GROSSMAN: It is undisputed that the Petitioners realized nothing from their stock investment. They were taxed not because they had any income but because, in 2017, they happened to own shares in a corporation carrying retained earnings on its books. This is a tax on the ownership of property.

But Justice Sonia Sotomayor disputed that realization was required:

JUSTICE SOTOMAYOR: But the amendment does not reference realization. All that the drafters had to do was add the word "realize" after "income" to lay and collect taxes on income realized, but they never used the word "realize."

Chief Justice John Roberts said income has been realized here by the company. Earnings went into its coffers.

JUSTICE ROBERTS: It isn't a case like appreciation of property where nothing has happened. You know, you buy a property, you're holding it for 20 years, you haven't sold it, nothing has happened. Here, something has happened, and income has gone to the corporation, isn't that right?

GROSSMAN: Yes. The corporation has income. But I think it really is like the instance of simply appreciation of property from the point of view of the shareholders. The value of their capital has increased. It has appreciated. But, as shareholders, no, they have not realized any income.

REICHARD: Solicitor General Elizabeth Prelogar advocated for the government. She argued that the drafters of the 16th Amendment would have had no problem with this tax.

ELIZABETH PRELOGAR: That's confirmed by the very first income tax Congress enacted under the Sixteenth Amendment. That 1913 law taxed certain shareholders on their pro rata shares of undistributed corporate earnings.

She made an analogy here to taxes Congress imposes on other organizations … like “S-corps” and partnerships. Individuals owe taxes on money the business earns whether or not a single dime is sent to their own bank accounts.

But Justice Neil Gorsuch saw a difference. Because with partnerships and S corps—

JUSTICE GORSUCH: —there's some enjoyment that the taxpayer has over that money, some control. He may assign it elsewhere. He may choose to keep it in the S Corp, whatever, but he controls it. But that argument, that this taxpayer had that kind of enjoyment, isn’t in the briefs before us.

EICHER: Gorsuch was probing to find out the limits to the government’s argument. Would allowing this tax open the door to all sorts of appreciation-based taxation?

JUSTICE GORSUCH: In your brief at least, you confronted the question whether Congress could tax millions of Americans who hold small amounts of stock in their retirement investment accounts, and you say yes. But you then say that would be administratively unworkable.

Justice Samuel Alito posed a similar question. He pointed out that the government defined “income” as economic gain between two points of time. So a tax on mutual funds that went up in value even though people hadn’t sold their shares?

JUSTICE ALITO: That would probably be permissible under your interpretation of the 16th Amendment?

PRELOGAR: I think it probably would. But I think the Court could draw lines based on history, and if there truly were a widespread tax on all amount of appreciation for every taxpayer, that wouldn't look like anything Congress has done before.

ROUGH: So in theory, sure. But in practical terms, not really. Tax expert Rothenberg, whom you heard from earlier, explained it this way:

ROTHENBERG: Practically, why I think that would never happen, well, if you want to do that on the upside, you have to also do it on the downside. It would cost a lot of money for people to figure out, what are my assets worth every December 31? An incredible administrative burden on the average American taxpayer.

To allay the wealth-tax concerns, the government pushed for a narrow ruling. One that Justice Brett Kavanaugh suggested. One that might not even need to address the 16th Amendment question about realized income.

JUSTICE KAVANAUGH: Because even assuming or leaving open whether realization is a constitutional requirement, there was realized income here to the entity, and then it's attributed to the shareholders in a manner consistent with how Congress has done that and this Court has allowed.

So perhaps that’s the route the court will go.

Taxes are the price we pay for a civilized society. So we have street lights, schools, and aircraft carriers. Pros and cons will apply to all forms of tax. But a wealth tax seems fraught with constitutional problems.

And that’s this week’s Legal Docket. I’m Jenny Rough.

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