The Supreme Court will hear oral argument on Tuesday in a challenge to the constitutionality of a provision of a 2017 corporate tax reform law. A Washington State couple went to court to challenge the law after it increased their tax bill by a one-time payment of roughly $15,000. The federal government says that if the tax is struck down, it could cost the government hundreds of billions of dollars in revenue over the next decade. But lawyers on both sides of the case contend that the broader stakes in the case could be even higher.
The events giving rise to the dispute now before the court began in 2005, when Charles and Kathleen Moore invested $40,000 in KisanKraft, an Indian corporation that supplies small farmers in India with modern tools. In exchange for their investment, the Moores received approximately 13% of the shares in the company, which is a “controlled foreign corporation” – a foreign corporation in which U.S. shareholders own at least 50% of the stock.
Over the years, KisanKraft reinvested its profits in the business, expanding to over 14 regional offices. During this time, the Moores did not receive any distributions or dividends from the company.
Until 2017, nothing in U.S. tax laws authorized the federal government to tax a controlled foreign corporation’s foreign income unless and until that income came to the United States – for example, through a distribution to U.S. shareholders. But in 2017, Congress enacted a one-time tax, known as the mandatory repatriation tax, on a controlled foreign corporation’s earnings after 1986, regardless of whether they were distributed to shareholders or whether the shareholders owned the shares when the corporation made the earnings on which they are being taxed. The tax was a provision of then-President Donald Trump’s plan to overhaul the tax code and was included, in part, to fund the plan. The mandatory repatriation tax was estimated to raise some $300 billion over 10 years, with billions already paid.
For the Moores, the mandatory repatriation tax meant an increase in their taxable income of $132,000 for 2017, raising their tax liability by $15,000. The Moores went to federal court, seeking a refund of the additional taxes that they paid. They argued that the mandatory repatriation tax violates the Constitution’s apportionment clause, which requires taxes to be imposed so that each state’s share is proportional to its population, because it taxed their personal property – the shares in KisanKraft – rather than any income from the corporation.
A federal district court in Washington State rejected the Moores’ challenge to the tax’s constitutionality. The U.S. Court of Appeals for the 9th Circuit upheld that decision. It explained that the constitutionality of a tax does not hinge on whether a taxpayer has realized – that is, received – income. And it noted that if it were to strike down the tax as unconstitutional, it would “also call into question the constitutionality of many other tax provisions that have long been on the books.” The Moores then came to the Supreme Court, which agreed in June to weigh in.
In the Supreme Court, the Moores point to the Supreme Court’s 1920 decision in a case called Eisner v. Macomber, which they say stands for the idea that income is something that a taxpayer receives for his own use. The court made clear in Eisner, the Moores continue, that a taxpayer does not receive income simply because his property or investments increase in value. But the mandatory repatriation tax clearly taxes property that shareholders own in 2017, rather than income.
The court reaffirmed its rule that income is something that a taxpayer realizes 35 years later, the Moores argue, in Commissioner v. Glenshaw Glass Co., in which it ruled that punitive damages awards are taxable income because they are “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.”
The Supreme Court’s decisions holding that incomes must be realized are consistent with the text of the 16th Amendment, which carves out an exemption to the apportionment clause only for “taxes on incomes, from whatever source derived,” the Moores write. The fact that income must be “derived” from a “source,” the Moores emphasize, suggests that it must be realized. And indeed, the Moores note, when the 16th Amendment was drafted and ratified, the term “income” was understood to be limited to the funds that taxpayers received, as compared with funds that they were owed but had not yet been paid.
If the 9th Circuit’s decision is allowed to stand, and Congress can impose taxes on gains or property even when a taxpayer has not actually realized them, the Moores caution, Congress could effectively circumvent the apportionment clause’s requirement that direct taxes be divided evenly among the states simply by defining them as “income.”
The Moores push back against the 9th Circuit’s suggestion that if the mandatory repatriation tax were deemed unconstitutional, the constitutionality of other taxes might also be questioned. They explain that the income taxes that the 9th Circuit cites all involve situations in which a taxpayer either receives income or “constructively” receives it – that is, could have received it but opted not to. By contrast, they stress, they never received any income from KisanKraft – a fact that, as the Washington Post recently reported, is one of several disputed in the case.
Defending the mandatory repatriation tax, the federal government points first to the text and history of the 16th Amendment. When it was adopted in 1913, the government writes, the drafters understood the phrase “taxes on incomes” to allow Congress to tax an individual’s proportional share of undistributed corporate earnings – including because Congress had passed (and the Supreme Court had upheld) laws in the 19th century taxing corporate gains, even when they had not yet been distributed. Moreover, the government adds, soon after the 16th Amendment was adopted, Congress passed laws that confirm that the government can tax shareholders on their shares of business earnings, even if they have not yet been distributed.
And contrary to the Moores’ contention, the government continues, nothing in the text of the 16th Amendment requires income to be realized before it can be taxed. When the 16th Amendment was adopted, its drafters were already familiar with the concept of realization, but they failed to include any reference to it in the amendment. Instead, the amendment simply refers to “income,” which can refer to all economic gains.
Although the Moores rely on language from Eisner v. Macomber to argue that shareholders can only be taxed on corporate earnings that are actually distributed to them, the government contends, that language was dictum – that is, not part of the court’s legal reasoning and therefore not binding on future courts. And that dictum, the government continues, was “misconceived,” because it rested on a “novel reading of income” that “contradicted ‘the common understanding’ of the term” when the 16th Amendment was adopted.
The government argues that the mandatory repatriation tax is also constitutional for the separate reason that it is an excise tax – a tax on the privilege of doing business through a controlled foreign corporation. At the very least, the government contends, the justices should send the case back to the 9th Circuit so that it can consider that argument, “rather than prematurely invalidating the MRT, which could cost the government hundreds of billions in revenue.”
“Friend of the court” briefs supporting the Moores warn that a ruling that upholds the 9th Circuit could have “profound” implications for the U.S. economy. One brief, from the Atlantic Legal Foundation, cautions that if the mandatory repatriation tax is allowed to stand, it could open the door for Congress to pass a “wealth” tax – that is, a tax on the value of assets and other investments. And that in turn, the group argues, could affect everything from the value of retirement accounts to family businesses, investments in start-ups and real estate, and the ability of multinational corporations to compete with the foreign counterparts.
The federal government resists any suggestion that allowing the 9th Circuit’s decision to stand could lead to a wealth tax. Dismissing the idea as “implausible in today’s economy because it would be administratively unworkable,” the government characterizes the difference between a wealth tax and an income tax as a temporal one: A wealth tax would focus on a taxpayer’s property or wealth at a fixed period in time, while an income tax “targets economic gain ‘between two points of time.’”
And groups supporting the government’s position caution that a ruling for the Moores would have its own negative effects. Echoing the 9th Circuit, the American Tax Policy Institute tells the justices that striking down the lower court’s decision would be “profoundly destabilizing” because it will lead to a “flood of litigation about the constitutionality of a host of other provisions.”
A decision is expected by June 2024.
This post is also published on SCOTUSblog.
