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U.S. Supreme Court rules narrowly in case raising major tax issues for investors

ARTICLE | June 21, 2024

Authored by RSM US LLP

Executive summary

Supreme Court upholds repatriation tax in Moore v. United States but declines to resolve realization question

The U.S. Supreme Court on June 20 decided in Moore v. United States to uphold the right of Congress to tax U.S. shareholders on the undistributed operating income of their foreign corporations. It issued the ruling on very narrow grounds, avoiding the constitutional issue both sides hoped the Court would resolve.

The narrow question in Moore was whether Congress had the constitutional power—on a one-time basis in 2017 as part of a reform to certain foreign tax rules—to require U.S. shareholders in foreign corporations to pay tax on their share of the foreign company’s accumulated and undistributed earnings without any actual dividend being declared or paid. It is sometimes called the mandatory repatriation tax.

What was the constitutional issue that the Supreme Court avoided?

The issue the Court avoided was whether there is a “realization” requirement in the Constitution. The government had argued there is no such requirement. The taxpayers had argued there is such a requirement; that economic income or gain must be “realized” before taxing it.

What lower court decision was under review?

The Supreme Court was reviewing the 9th Circuit opinion, which was controversial and broad. The 9th Circuit had ruled that there is simply no realization requirement in the Constitution, and its ruling opened the door to a mark-to-market tax on unrealized capital gains. The Court cast shade on this view but did not explicitly reject it.

Does that mean Congress may tax a corporation and its shareholders on the same income?

In its decision, the Court may have revived a distinction between corporate and pass-through taxation. Justice Brett Kavanaugh's opinion suggested—without fully adopting—that Congress may decide to either tax an entity as a corporation or as a pass-through, but cannot tax the same income to both the entity and its owners. This may revive a point from the Macomber case.

What is the Macomber case?

Eisner v. Macomber is a 1920 case in which the Supreme Court seemed to say that “realization” was a constitutional requirement. In squaring that decision with later Supreme Court decisions, some argue that Macomber stands for the proposition that Congress must either decide to tax an entity as a corporation or as a pass-through—but not as both.

What was the Supreme Court's reasoning for upholding the repatriation tax?

The Court reasoned that the tax was permissible even assuming that there is a realization requirement because a foreign company’s operating income is clearly “realized” by the foreign company. In passing the repatriation tax, Congress was merely attributing or passing through that income to the U.S. shareholders.

What is the significance of the Supreme Court's opinion?

The Court's opinion is significant because it upheld the right of Congress to tax U.S. shareholders on the undistributed operating income of their foreign corporations, but avoided addressing the constitutional issue of realization. The opinion opens the door to argue that Congress cannot simultaneously tax the same corporate or entity income to the corporate entity and its owners. The opinion further signifies significant wariness by the Court regarding the constitutionality of certain tapes of taxes such as a wealth tax.

Detailed analysis of Moore v. United States

In the 2017 Tax Cuts and Jobs Act, Congress enacted a one-time “mandatory repatriation tax.” This was part of a general reform of the rules governing foreign corporate investments and was viewed by many as a favorable change, even though some taxes were accelerated by a “mandatory repatriation” or “deemed dividend.” That provision required U.S. shareholders who own 10% or more of a foreign corporation to pay a one-time tax (spread over a number of years and applied at a reduced rate in many cases) reflecting their share of the corporation’s accumulated post-1986 income. Essentially, the tax requires 10% shareholders to pay a tax on their share of the corporation’s retained earnings even though that money was not actually distributed to them.

Mr. and Mrs. Moore, who were required to pay a tax of approximately $15,000, sued for a refund. They asserted that the tax was unconstitutional. They cited a 1920 Supreme Court case, Eisner v. Macomber, that invalidated a somewhat similar tax on accumulated corporate earnings, imposed on shareholders of domestic corporations even though they received no cash dividend, only a valueless “stock dividend” tantamount to a stock split.

In Moore, there is little question that the taxpayers were wealthier on account of the accumulated earnings. Their shares presumably were worth more. Why do provisions like this raise constitutional issues?

Under Article I of the Constitution, Congress can only impose “direct taxes” if they are apportioned among the states in proportion to their populations, a requirement that makes any “direct tax” almost impossible to enact. The 16th Amendment, passed in 1909, created an exception that permitted Congress to impose an income tax without apportionment. Congress proceeded to enact an income tax in 1913, which is the precursor to our current federal income tax. However, Eisner v. Macomber and several other Supreme Court cases (dating back to 1920 and 1955) suggest that the 16th Amendment only permits income to be taxed if the income is “realized,” a term whose meaning is less than entirely clear. In the Macomber case the Court said there was no “realization” because the corporate earnings there were not actually distributed to the shareholders. Many believed that the same principle prohibits Congress from taxing unrealized capital gains on a long-term investment in stocks, real estate or other property until the property is actually sold (or exchanged for materially different property).

The Moores asserted that: (i) realization remains a constitutional requirement to this day and (ii) the 2017 repatriation tax constitutes a tax on unrealized gains. The government responded that realization is not a constitutional requirement. Some suggested a middle ground: Although realization remains a constitutional requirement, the 2017 repatriation tax does not constitute a tax on unrealized gain, for any of several reasons.

What did the Court decide with regard to the repatriation tax?

The Court ruled that the repatriation tax is constitutionally valid. The majority opinion explained that there is no logical way to distinguish between the repatriation tax and other longstanding taxes imposed on owners of business entities. Many provisions that are part of the Tax Code for many decades impose a tax on income that is not received in cash. For example:

  • Partners are taxed on their share of a partnership’s income;
  • Shareholders are taxed on their share of an S corporation’s income; and
  • Under subpart F, shareholders are taxed on their share of certain income of certain foreign corporations.

Although the Moores had suggested distinctions between each of these types of taxes and the repatriation tax, the Court rejected all those distinctions. The Moores had argued that partnerships, unlike corporations, are viewed under the tax law as “pass-through” entities; the Court responded that partnerships constitute separate legal entities from their owners under state law, much like corporations. The Moores had argued that shareholders of S corporations consent to be taxed on the S corporation’s income; the Court responded that consent alone cannot justify Congress’s authority to impose this tax. And the Court further noted that no distinction between the repatriation tax and subpart F (which the Moores agreed is a constitutionally valid tax) withstands scrutiny.

What did the Court decide with regard to the question of realization?

The Court declined to rule on the question of whether the constitution permits taxing income that has not been realized. The Court stated that it does not need to resolve that question to rule on the validity of the repatriation tax—even if the Constitution does impose a realization requirement, the repatriation tax would be a tax on realized income because it taxes shareholders on the realized income of the corporation, and that income can be attributed to the shareholders.

The Court’s decision with regard to the realization question was a split decision. The decision—which was written by Justice Kavanaugh and in which four other justices joined, stated that it is not ruling on the realization requirement question. Of those five justices, one of them (Justice Kentanji Brown Jackson) stated that she would have ruled that realization is not required.

The remaining four justices all opined that realization is required. Accordingly, with regard to the realization question, the decision was 4-4-1 (four said they aren’t ruling on the issue; four said realization is required, and one said realization is not required).

Did the Court provide any hint as to how it might rule on related questions—such as a shareholder-level tax on the income of a domestic corporation?

Yes. Although the Court declined to explicitly rule on these issues, the Court made clear that it was not sanctioning these types of taxes. Some might go further and say the Court signaled a yellow light regarding the constitutionality of these types of taxes.

Moreover, the decision breathes life into a point that some saw as an important takeaway from Macomber. Some interpreted Macomber as stating that Congress may tax an entity either as a corporation or as a pass-through entity (As a corporation, the entity may be taxed, while the owners may not be taxed absent a distribution; as a pass-through, the owners may be taxed but not the entity). Congress cannot, however, simultaneously tax an entity and the entity’s owners on the entity’s income. One amicus brief filed with the Supreme Court cited articles by Don Susswein and Ramon Camacho of RSM US LLP explaining this as the only logical approach to square Macomber with subsequent Supreme Court decisions.

Although not fully embracing this rule, the majority opinion was clearly influenced by this argument, as seen by numerous statements in the opinion emphasizing this distinction. For example, Kavanaugh’s opinion noted that “our holding applies when Congress treats the entity as a pass-through . . . 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. In such a scenario, the entity would not simply be a traditional passthrough.”

The opinion also stressed that it is not giving Congress cart blanche to impose any sort of tax. For example, it stated that “we emphasize that our holding today is narrow. It is limited to: (i) taxation of the shareholders of an entity, (ii) on the undistributed income realized by the entity, (iii) which has been attributed to the shareholders, (iv) when the entity itself has not been taxed on that income. In other words, our holding applies when Congress treats the entity as a pass-through.”

The fourth caveat—that the Court’s ruling does not open the door to a tax on an entity and its owners simultaneously—suggests that Congress must tread very carefully when considering any tax that might constitute a tax on a corporation on its undistributed income and on its shareholders on the same income (by attributing the income to the shareholders).

What did the Court’s ruling indicate about a potential wealth tax?

The opinion noted that the Biden administration’s solicitor general had openly stated that a wealth tax (whether on real estate or on personal property) would be unconstitutional unless subjected to a completely impractical apportionment requirement. That statement suggests that the Court, although not directly ruling on the validity of a wealth tax, considers its constitutional validity to be in serious doubt.

The decision was signed by five justices. What were the positions of the other justices?

The decision was written by Justice Kavanaugh and joined by Chief Justice John Roberts and Justices Sonia Sotomayor, Elena Kagan and Jackson. That majority opinion stated that it is not deciding whether the Constitution requires realization, and that even if the Constitution does require realization the repatriation tax constitutes a tax on realized income.

Justice Jackson’s concurrence states that in her opinion realization is not a constitutional requirement. Accordingly, it follows that the repatriation tax is valid.

Justice Amy Coney Barrett’s concurrence, joined by Justice Samuel Alito, states that that in her opinion realization is a constitutional requirement. For that reason, subpart F and the repatriation tax might both be unconstitutional. However, since the Moores conceded that subpart F is constitutional, and there is no meaningful constitutional distinction between the two, the Moores cannot contest the repatriation tax given their concession regarding subpart F.

Justice Clarence Thomas’s dissent, joined by Justice Neil Gorsuch, states that in his opinion realization is a constitutional requirement, and the repatriation tax is therefore unconstitutional. The repatriation tax differs from subpart F, he explained, because the latter taxes income only of the current year, while the repatriation tax taxes income of prior years.

Certain statements in the majority opinion, concurrences, and dissent suggest that the majority opinion may have been the subject of intense negotiation among the justices.

What are the broader takeaways from this decision?

Some were hoping this case would uphold an almost unlimited Congressional taxing power, including a wealth tax and a tax on unrealized appreciation in real, personal and intangible personal property like stocks and bonds. Some of these supporters of a broad Congressional power had warned the Court that a decision supporting the notion of a Constitutional “realization” requirement would wreak havoc on the tax system.

The Court evidently agreed that it would be dangerous to strike down the repatriation tax. But four justices stated there was, in fact, a realization requirement (of uncertain scope). Only one justice adopted the view of the 9th Circuit that there is no realization requirement. Moreover, it is quite possible that at least one of the remaining justices could hold in a future case that a more dramatic piece of legislation—such as a mark-to-market tax on the unrealized “paper” profits of millionaires and billionaires—would be unconstitutional.

No one scored a knock-out, despite the fact that the government “won” the case. Even scoring on points, it is hard to tell which side really got more out of the case.

On balance, it seems that the Court sent a strong message that this particular tax (and other longstanding tax rules some said would be in jeopardy) are perfectly OK, but that Congress and the administration should tread very carefully in considering wealth taxes, taxes on unrealized appreciation, or measures to tax an entity and its owners on the same income without an actual dividend or other distribution.

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This article was written by Joseph Wiener, Don Susswein and originally appeared on 2024-06-21. Reprinted with permission from RSM US LLP.
© 2024 RSM US LLP. All rights reserved.

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