The Supreme Court turned back an effort to define when income is realized for tax purposes, but left the big questions for another day.
The Supreme Court turned back an effort to define when income is realized for tax purposes, but left the big questions for another day.
T here is nothing sure in this life but death and taxes. Don’t hold your breath waiting for the Supreme Court to stop either of them — for now.
The text and original meaning of the Constitution aren’t limited to the eras of the Founding Fathers or the Civil War. Twelve amendments were ratified in the 20th century, starting in 1913 with the 16th Amendment: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.” It has been some time since the Supreme Court has taken a close look at what the 16th Amendment means by “incomes.”
This morning’s decision in Moore v. United States turned away a challenge to an element of the 2017 Trump tax-cut bill. The challengers had hoped to get from the Court a ruling that would define the limits of taxation of unrealized income. But the 7–2 majority upheld the tax without reaching the central question of whether the 16th Amendment’s definition of “income” permits only realized gains to be taxed. Four justices, led by Justice Clarence Thomas’s dissent, signaled their willingness to consider such limits in the future. By contrast, Justice Ketanji Brown Jackson’s lone concurring opinion took the maximalist position that Congress had effectively unlimited taxing powers even before the 16th Amendment.
The Trump Tax Bill
Moore arose out of Donald Trump’s effort to “onshore” the investments of Americans in foreign corporations by removing tax incentives to keep the money overseas. For American-controlled foreign corporations (CFCs), in which the individual taxpayers owned more than 10 percent of the shares, the tax code since 1962 had considered the corporation’s income to be income to the shareholders, not the company — but only taxed it when that income was repatriated to the United States.
Investors, responding rationally to tax incentives, tended to keep a lot of the money in the company. That was good for the businesses, but was at odds with Trump’s goal of more investment at home. It also meant that trillions of dollars of CFC income (unlike the income of American corporations) was completely untaxed because the CFCs, being foreign, did not themselves pay American corporate taxes.
The 2017 Tax Cuts and Jobs Act made a number of changes to the tax treatment of CFCs, some of them favorable to CFC shareholders over the long term. But it paid for those changes in part by a one-time Mandatory Repatriation Tax on all undistributed earnings of CFCs since 1986. To CFC shareholders, the Mandatory Repatriation Tax smacked of a wealth tax, and they challenged it in court as an unconstitutional tax on money that was not yet “income.”
Income? Whose Income?
In Eisner v. Macomber (1920), a decision shortly after the passage of the 16th Amendment, the Court rejected a tax on stock dividends on the theory that simply giving out more shares in the same company didn’t actually “realize” any income because it did not create an “accession to wealth” on the part of the shareholders. The challengers argued that the Court should treat the tax on un-repatriated CFC earnings the same way, because “realization is not only what distinguishes income from property in general, but what makes income income.”
The Court didn’t buy it. Justice Brett Kavanaugh, writing for a five-justice majority including the three liberals and Chief Justice John Roberts, concluded that the case was decided by the fact that this was not a case of double taxation, and Congress has always had the authority to decide when a business’s income will be attributed to its shareholders, partners, or sole owners. As important as the separate corporate form is to business, it’s a creature of law. Indeed, in other areas such as the First Amendment guarantees of free speech and free exercise of religion, the case for allowing corporations (including newspapers and television stations) to sue to defend their rights as if they were real people depends in part on their creation as separate entities under state law, but also upon the fact that behind every corporate form are real human beings. For tax purposes, given the 16th Amendment’s broad “from whatever source derived” language, that gives a lot of latitude to Congress to decide when the income of a business is really the income of its owners the minute it is realized by the company — regardless of when it’s distributed.
The majority opinion is thus built entirely around why it saw CFCs as “pass-throughs.” The key case was Heiner v. Mellon (1938), which allowed taxation of partnerships on undistributed income. In Heiner, as in this case, there was no real question that the business had realized income, but the Moore challengers argued vigorously that corporations are different from partnerships, which have no separate legal personhood. (For jurisdictional purposes, for example, the Court’s precedents have long treated partnerships, unlike corporations, as having no citizenship separate from that of their partners). The Court rejected the distinction: “since [Heiner], it has gone without serious question in both Congress and the federal courts that Congress can attribute the undistributed income of an entity to the entity’s shareholders or partners, and tax the shareholders or partners on their pro rata share of the entity’s undistributed income . . . when dealing with an entity’s undistributed income, Congress may tax either (i) the entity or (ii) its shareholders or partners.” (Emphasis added.)
The Court observed that Eisner’s analysis of the issues of realization and accession to wealth were beside the point in Moore, because Eisner involved no income to either:
Eisner v. Macomber was not a case about Congress’s power to attribute the income of an entity to the entity’s shareholders or partners. Rather, the Court in Eisner . . . addressed a situation where a corporation created and distributed additional stock to existing shareholders. The corporation distributed the additional shares of stock in proportion to each shareholder’s percentage of ownership. So the actual value of the shareholders’ total stock holdings in the corporation did not change.
The question in Eisner . . . was whether the new stock was nonetheless taxable income for the shareholders. The Court said no. The Court reasoned that there was no change in the value of the shareholders’ total stock holdings in the corporation before and after the stock distribution. So the new stock did not represent any kind of economic gain to the shareholders. . . . Neither the corporation nor the shareholders had realized income from the corporation’s creation and distribution of additional stock. [Emphasis added; citations omitted.]
The Court did, however, warn that “there are due process limits on attribution to ensure that the attribution is not arbitrary — for example, limits based on the taxpayer’s relationship to the underlying income,” including retroactivity. But the parties did not present any due-process question in Moore, so the Court did not address the issue further.
Did You Realize?
For the majority, the attribution question settled the matter, and it would not resolve the parties’ efforts to settle the more fundamental question of the relationship between realization and income: “Because the [Mandatory Repatriation Tax] taxes realized income — namely, income realized by the corporation and attributed to the shareholders — we do not address the Government’s argument that a gain need not be realized to constitute income under the Constitution.”
Justice Amy Coney Barrett, joined by Justice Samuel Alito, agreed, but wrote an opinion concurring only in the result. Barrett noted that the Mandatory Repatriation Tax could not plausibly be defended — as the government defended it — as a tax on income of the shareholders themselves. (The majority ducked that question). It was, in her view, only taxable on the theory that the untaxed income of the CFC could be attributed to the shareholders — and even that was “more complex than the Court lets on.” But Barrett also warned that the government might get a different reception on another day:
A different tax — for example, a tax on shareholders of a widely held or domestic corporation — would present a different case. The question on which we granted review is “whether the Sixteenth Amendment authorizes Congress to tax unrealized sums without apportionment among the states.” The answer is straightforward: No. [Alteration and citation omitted.]
While Barrett emphasized the long line of precedents since Eisner that have made realization the touchstone of “income,” Justice Thomas (joined in dissent by Justice Neil Gorsuch) delved further:
Sixteenth Amendment “incomes” include only income realized by the taxpayer. The text and history of the Amendment make clear that it requires a distinction between “income” and the “source” from which that income is “derived.” And, the only way to draw such a distinction is with a realization requirement.
Thomas traced the history of the original federal taxing power and its relationship with the federal-state balance of power. After the Court in Pollock v. Farmers’ Loan & Trust Co. (1895), held that Congress lacked power to tax incomes, political pressure built to amend the Constitution. Eventually, support became bipartisan, and an income tax amendment was backed even by Republican president (and future chief justice) William Howard Taft. As Thomas observed:
The proposed amendment’s narrow focus on an income tax was significant. After all, a constitutional amendment could have easily eliminated Pollock’s obstacle to income taxation by removing the Constitution’s direct-tax provisions wholesale. . . . In fact, that possibility was suggested on the Senate floor as soon as the proposed amendment was read.
Crucially, Thomas argued that the original understanding of the amendment must be read in light of both the pre-Pollock constitutional rules and the reasoning of Pollock:
Against the background of Pollock, the “power to lay and collect taxes on incomes, from whatever source derived, without apportionment” under the Sixteenth Amendment has an obvious and narrow meaning. The only thing the Amendment changed about the Constitution was to abolish Pollock’s rule that an income tax is a direct tax if a tax on the source of the income would be a direct tax. The Sixteenth Amendment left everything else in place, including the federalism principles bound up in the division between direct and indirect taxes. . . .
The Sixteenth Amendment thus facilitated an income tax by creating a new constitutional distinction between “income” and its “source.” Under the Amendment, “from whatever source” income is “derived,” a tax on it is indirect and therefore not subject to the rule of apportionment. But, as to taxes on the sources of income, the restrictions imposed by the division between direct and indirect taxes continued to apply with full force. And, taxes on property continued to be classified as direct taxes.
Those first principles are where Jackson departed from Thomas, arguing that Pollock was wrongly decided and that “our Constitution grants Congress ‘plenary power’ over taxation. . . . The text supplies only two relevant conditions: Direct taxes must be apportioned among the States based on population; all other taxes must ‘be uniform throughout the United States.’” [Citations omitted.]
Thomas argued further that the pre-Pollock history of the income tax supports the centrality of the realization concept to the constitutional definition of “income”:
The idea of realization as the distinction between income and source long predates both Macomber and the Sixteenth Amendment. As the Government acknowledges, the concept of realization . . . was well established when the Amendment was adopted. The term “realized” appeared in several Civil War income tax provisions. . . . And, contemporaneous dictionaries defined “realize” as “to convert any kind of property into money.” . . . The Government argues that the decision to omit the often-used word “realized” from the Sixteenth Amendment is significant evidence that the Amendment does not require realization. . . . But, the choice to instead use the near-synonym “derived” merely reflects the repeated use of the word “derive” to describe the relationship of income to its source in Pollock, to which the Sixteenth Amendment was a direct response. [Quotations, citations, and alterations omitted]
All of these questions remain for the Court to revisit again — if Congress forces it to do so by passing something that looks more like a direct tax on wealth or property.