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Supreme Court Will Decide Whether Unrealized Income Is Taxable And The Decision Could Have Far Reaching Consequences

The Court will decide whether the Constitution itself has a say in how tax laws should be drafted.

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tax lawWhile the Supreme Court has not yet decided on whether to forgive student loans, it will one day decide whether to forgive a certain income tax paid. This week, the Court granted certiorari in Moore v. U.S. and the Court’s opinion can change the income tax law as we know it.

In this case, the taxpayers in 2005 invested $40,000 and became 13% shareholders in a corporation in India. While this corporation made a profit every year since it began, it always reinvested its earnings so the taxpayers never received any profit distributions from the corporation. Because they were minority shareholders, they had no power to demand dividends or other distributions from the corporation.

The taxpayers were shareholders of a controlled foreign corporation (CFC). A CFC is an offshore corporation where more than 50% of shareholders are U.S. citizens or permanent residents. Shareholders of CFCs are subject to special tax rules on income, even when it is not distributed to them. This is because, in the past, some people and businesses used to keep their money overseas to avoid or defer U.S. taxes. The Court noted that the taxpayers’ share of income is not subject to tax under the CFC rules.

But in 2017, the Tax Cuts and Jobs Act implemented the Mandatory Repatriation Tax (MRT) which was a one-time tax where all shareholders of CFCs are taxed on its profits after 1986, even if the profits were not given to the shareholders. Thus, shareholders had to pay income taxes on earnings going back over 20 years.

The Moores paid $14,729 in taxes and then sued the U.S. government in a refund claim arguing that the MRT is unconstitutional because they did not personally receive the income subject to the tax. Or in tax terms, their income was unrealized. They also claimed that the MRT was an unconstitutional retroactive tax which is not being addressed by the Supreme Court.

To understand this case, a little tax history is in order. The U.S. Constitution gives Congress the power to tax and take all necessary and proper measures to exercise this power. But it also stated that any direct taxes must be apportioned so that each state pays in proportion to its population. Considering the administrative difficulty in determining how taxes can be apportioned and the courts overruling tax laws for violating the apportionment requirement, Congress passed the 16th Amendment which exempts income taxes from the apportionment requirement.

The Supreme Court has opined on what is taxable income. The most recognized rule was stated in Commissioner v. Glenshaw Glass where the Court stated that income is defined as an accession to wealth, clearly realized, under the taxpayer’s control. While two of the requirements are easy enough to understand, the third requirement of realization is unclear and the courts have taken the lead in determining when a realization event occurs. The leading case in realization was Eisner v. McComber where it ruled that a realization event occurs when there is gain from capital, labor, or both.

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Since McComber, there has been no formal definition of a “realization event,” but I have understood it to mean a transaction that makes wealth accession real.

For example, if I purchase $50 of shares in a particular stock, but next week the value of those shares rises to $500 because a multibillionaire wants to purchase the company so he can use it as his personal megaphone, my wealth will increase by $450. But when I sell the stock at the higher price, that is when my wealth accession is realized, or made real. Alternatively, suppose I purchased a cryptocurrency for $1,000 because its founder posted a video on Instagram while driving a gold-plated Bugatti Chiron stating that the crypto will be worth $4 billion in two days because its blockchain protocol can cure cancer, HODL, FUD, and YOLO. Assuming his word alone increases my wealth, it is not realized until someone actually gives me the $4 billion when I sell the cryptocurrency.

The Moores’ case went to the Ninth Circuit, which held that there is no constitutional requirement of realization. It cited to previous Supreme Court precedent stating that the realization requirement was created as a matter of administrative convenience and that the Court’s holdings in Macomber and Glenshaw Glass did not provide a definitive rule on what constitutes income and realization.

The Moores appealed for an en banc rehearing. Although it was denied, three judges issued a dissenting opinion stating that the 16th Amendment adopted the ordinary meaning of income — thus it requires the realization of gain. It stated that while the Supreme Court did not establish a final meaning of what constitutes income, future cases still required realization before income becomes taxable.

The Supreme Court will decide whether the 16th Amendment allows the taxation of unrealized income.

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The goal of the realization rule is to ensure that people have the money to pay the income taxes due. The problem is that some people may abuse the rule to defer taxes, pay at a lower tax rate in the future, or avoid them altogether. Where to draw the line on realization has been debated by both the legislature and the courts.

The Court will have to find a way to ensure that people like the Moores do not have to worry about having to pay taxes on income they did not receive dating back to 1986, but also ensure that others do not have the ability to defer their taxes until 2086 unless approved by Congress.

The Court’s decision can disrupt many income tax rules that do not require realization. For example, S-corporations and businesses taxed as partnerships pass income onto their shareholders or partners personally. They are taxed even if the profits are not given to them personally. This can affect limited partners or minority shareholders who may not have rights to demand distributions of profits.

And of course, the CFC rules which are at issue in this case may have to be changed.

Or for holders of cryptocurrencies or game currencies that can be redeemed into real money (i.e., Second Life), the Court’s ruling can invalidate existing guidance. This includes Notice 2014-21 which generally states that sales and exchanges of virtual currencies are taxable transactions. Will there be a realization event if one virtual currency is exchanged for another when both have little to no value?

Finally, while unrelated, a carefully worded dicta or footnote can signal to states that they will give closer scrutiny to tax cases where the constitution is involved. For example, in California, the state legislature is considering imposing a wealth tax and an exit tax where the state can tax people who leave the state for 10 years. Will the Court overturn this tax as a violation of the Commerce Clause?

Also, some have thought that this case will give hints on whether a future wealth tax would be unconstitutional.

We won’t get the Court’s decision on this case until sometime next year. There will be lots of debate and amici filings arguing for one side or another. But the Court will decide whether the Constitution itself has a say in how tax laws should be drafted.

Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at stevenchungatl@gmail.com. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.

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