Almost exactly a year after it shook the tax world by granting certiorari, on June 20, 2024, the Supreme Court issued its opinion in Moore v. United States, No. 22-800. By a vote of 7-2, the Court upheld the constitutionality of the section 965 transition tax.
The section 965 transition tax, which was enacted in the Tax Cuts and Jobs Act of 2017, deems the accumulated post-1986 deferred foreign income of certain foreign corporations, including controlled foreign corporations (CFCs), to be Subpart F income for 2017 (or 2018, depending on the foreign corporation’s taxable year-end). Thus, section 965 may impose a tax on income that was earned by the foreign corporation decades ago which has been retained at the foreign corporation level and has not been distributed to the US shareholder.
The taxpayers in Moore were 11% owners of KisanKraft, a CFC that supplied modern tools to small farmers in India. KisanKraft had accumulated earnings of approximately $508,000 as of the relevant date in 2017, meaning that the taxpayers’ tax liability was increased by roughly $15,000 under section 965. The taxpayers paid their liability and sued for a refund in the US District Court for the Western District of Washington. The District Court granted the government’s motion to dismiss the Moore’s complaint, and the dismissal was affirmed by the Ninth Circuit on appeal. Following the Ninth Circuit’s decision, the taxpayers petitioned the Court for certiorari to determine the constitutionality of the section 965 transition tax, which the Court granted on June 26, 2023. For additional background, see our June 27, 2023 Legal Alert.
At oral argument on December 5, 2023, the Court seemed disinclined to invalidate the section 965 transition tax. The primary uncertainty seemed to be the extent to which the Court would address certain issues not raised in Moore, for example the constitutionality of a wealth tax or whether the Sixteenth Amendment included a “fairness” requirement. See our December 11, 2023 Legal Alert for additional details. The Court’s narrow holding in Moore leaves many of these issues unanswered, but the opinions provide some indications of how the Court could grapple with these issues in future cases.
1. A Constitutional Realization Requirement?
At oral argument, the parties presented diametrically opposed and somewhat absolutist views of the meaning of two century-old cases, Pollock v. Farmers’ Loan & Trust Co.1 and Eisner v. Macomber2. In Pollock, the Court held that a tax on income from personal property was a direct tax on property which was required, under the Apportionment Clause, to be apportioned among the States in proportion to their respective populations. Pollock was the impetus for the adoption of the Sixteenth Amendment. Two decades later and shortly after the Sixteenth Amendment was ratified, Macomber held that a tax on a stock dividend was not an income tax and was a direct tax required to be apportioned.
The taxpayers in Moore argued that Macomber clearly established a constitutional realization requirement and has never been overruled, and any contrary conclusion would create chaos in the tax law. The government argued that there has never been a constitutional realization requirement, either in Macomber or in subsequent cases, and that imposing one now would also create havoc with well-settled tax law.
The majority opinion by Justice Kavanaugh, joined by Chief Justice Roberts and Justices Sotomayor, Kagan and Jackson, focused on the “precise and narrow” question of whether Congress could attribute the undeniably “realized” income of KisanKraft to the taxpayers. The majority expressly disclaimed any views on the “distinct” issues of whether Congress could constitutionally tax both the entity and its shareholders on undistributed income, tax “holdings, wealth, or net worth,” or tax appreciation.
The majority relied on a series of Supreme Court precedents culminating in Helvering v. National Grocery Co.3, which concluded that the controlling shareholder of a corporation could not, by operating a business through a corporation, prevent Congress from taxing him individually on the profits, and observed that these precedents directly contradicted the taxpayers’ argument. The majority believed that there was “no serious question” that Congress can attribute a corporation’s undistributed income to its shareholders. The majority noted that lower courts have repeatedly upheld Subpart F, of which the section 965 transition tax is a part.
The majority declined to address either the taxpayer’s argument that Macomber requires realization or the government’s argument that Macomber’s “purported” realization requirement had been abrogated by later decisions, noting that this was unnecessary in a case where only attribution was involved. The majority described as dicta Macomber’s characterization of a shareholder’s share in the accumulated profits of a corporation as property, possibly motivated by the fact that the corporation in Macomber had already been taxed on its income and intended to cast doubt on the legality of taxing both the corporation and shareholder on the same income. Both before and after ratification of the Sixteenth Amendment, the majority noted that Congress often taxed shareholders or partners of a business entity on undistributed income, a practice that the majority believed reflected and reinforced the Court’s precedents.
The majority rejected the taxpayers’ attempted distinctions of the section 965 tax from taxes attributed to partners or S corporation shareholders or to US shareholders of foreign corporations under Subpart F. The taxpayers’ “ad hoc” attempted distinctions did not undermine the clear rule of the Court’s precedents that Congress can choose either to tax the entity on its income, or to tax the entity’s partners or shareholders on their share of its undistributed income. Nor were these distinctions correct as a matter of fact, for example because contrary to the taxpayers’ assertion, partnerships were considered separate legal entities when the Sixteenth Amendment was ratified and not all S corporation shareholders need to consent to being taxed on their share of its earnings (and in any event shareholder consent cannot validate an unconstitutional tax).
With respect to Subpart F, which the taxpayers had conceded is constitutional, the majority noted the taxpayers’ use of “constructive realization,” which it characterized as a “one-off label woven out of whole cloth” and not supported by any existing precedents or the Code. In addition, the majority viewed Subpart F and section 965 as responding to similar concerns, i.e., the owners of American-controlled foreign corporations keeping money offshore to defer taxation. Noting that the section 965 transition tax is “integrated into subpart F’s framework” and “has the same essential features as subpart F,” the majority determined that there was no meaningful distinction between the two.
Finally, the majority noted that the taxpayers’ argument, taken to its logical conclusion, could render vast swaths of the Code unconstitutional, including section 305(c) deemed stock distributions, accrual accounting, partnership tax, GILTI, taxation of futures contracts under section 1256, OID, S corporations and gift taxes, resulting in trillions in lost revenue and a “fiscal calamity.”
Justice Jackson joined the majority opinion in full but concurred separately to emphasize that, in her view, the Sixteenth Amendment does not contain a realization requirement and “any litigant seeking to sustain her case on the basis of Macomber would have to bring back from the dead its Court-created limit on Congress’s power.” Moreover, even if a tax on unrealized gains were to violate the Sixteenth Amendment, it would still be necessary to analyze whether the tax is a direct tax, or instead was a constitutional excise tax. In her view, the Court’s role in tax disputes should be limited and they should be resolved through the political process.
Justice Barrett, joined by Justice Alito, concurred in the judgment only, agreeing with the narrow holding of the majority, i.e., that income clearly realized by a closely held foreign corporation can be constitutionally attributed to its shareholder. However, Justices Barrett and Alito would not have side-stepped the issue of realization in deciding Moore. The concurring justices took the position that the Sixteenth Amendment’s use of the term “derived,” together with the Court’s precedent (including Macomber), reflects a constitutional requirement that income must be, at least in substance, realized before it is subject to tax without apportionment, and that the taxpayers had not realized income from KisanKraft. Justices Barrett and Alito specifically criticized the government’s position that a tax on the increase in property value between two points in time (i.e., appreciation), absent some realization event, could be distinguished from a direct tax on the property itself, agreeing with the Ninth Circuit dissent that the Court “has never abandoned the core requirement that income must be realized to be taxable without apportionment” and noting that the majority opinion did not cast doubt on Macomber’s holding that appreciation is not income. As discussed below, the concurrence criticized the majority opinion for being too quick to bless the attribution of corporate income to shareholders, but noted that in the narrow circumstances presented, attribution was permissible.
The dissent by Justice Thomas, joined by Justice Gorsuch, criticized the majority for avoiding the question on which certiorari had been granted – whether the Sixteenth Amendment authorizes Congress to tax unrealized sums without apportionment among the States. Based on the historical context, the dissent determined that because the Sixteenth Amendment reversed Pollock’s rule that an income tax must be classified as direct or indirect based on whether a tax on the source of the income would be direct or indirect, it created a constitutional distinction between income and its source which was critical to federalism. In the dissent’s view, this necessarily meant that the Sixteenth Amendment was limited to taxes on realized income. All taxes on the source of income must be analyzed under the direct tax clause, a view the dissent contended was adopted by the Court in Macomber as well as earlier precedents.
With respect to the section 965 transition tax, the dissenting justices did not find the majority’s rationale for its attribution theory justified in the Court’s precedent or Congressional practices. In their view, longstanding portions of the Code that operate largely by attribution, such as taxation of partnerships and S corporations, can be meaningfully distinguished from the transition tax. The dissent also distinguished the section 965 transition tax from Subpart F on grounds that the transition tax does not require the taxpayer to have been a shareholder of the CFC at the time the CFC earned the income being taxed and the section 965 tax “offered no rational basis for Congress to attribute income to a taxpayer.” Because the section 965 tax was imposed merely based on ownership of shares in a corporation, the dissent concluded that it does not operate as a tax on income. The dissent would have invalidated the tax for failing to meet the realization requirement.
Eversheds Sutherland Observation: Although the narrow holding of the Court with respect to section 965 was supported by seven justices, the broader question of whether Macomber prohibits a federal tax on appreciation was not addressed by the majority. Four justices (Barrett, Alito, Thomas and Gorsuch) emphasized that, in their view, Macomber does prohibit a federal tax on appreciation. Two justices (Thomas and Gorsuch) would have applied a realization requirement.4
2. Is There a Sixteenth Amendment Limitation on Attribution?
Several justices were interested in whether the fairness of attributing the CFC’s income to the taxpayers was a question solely implicating due process (a question not before the Court), or whether the Sixteenth Amendment had a role to play.
Taxpayers’ counsel suggested that something extra, for example tax avoidance or a high level of control, was necessary to attribute income from a CFC to a shareholder. The Solicitor General suggested that it was perfectly fine to look at the question through the lens of the Sixteenth Amendment because the question would be the same, i.e., could income be fairly attributed to the taxpayer, a question she suggested should be answered in the affirmative unless the attribution chosen by Congress was “unrelated to any privilege or benefit.”
The majority acknowledged (as had the government previously) that due process imposes a “nonarbitrary” requirement on attribution and indicated that the Court might determine that a hypothetical tax on undistributed income imposed on both an entity and its owners exceeds such limits.
Justice Barrett’s concurrence focused considerably more on the requirements for attribution and the statement in Macomber that the Court would not ignore the “substantial difference between corporation and stockholder” or treat the corporate form as “unreal” or analogous to a partnership. The concurrence addressed the Court’s attribution precedents, particularly National Grocery, and concluded that the significance of that case was that Congress could, if it chose, look through the corporation to tax the shareholder on income that was in substance that of the shareholder. But, the concurrence warned, Congress should not be considered free to wholly disregard the corporate form. In the concurrence’s view, that would permit Congress to tax the shareholder without regard to the substance of her relationship to the corporation and would contradict Macomber, which held that the corporation’s income could not be attributed to its shareholders. “Carte blanche” to disregard the corporate form through attribution should not be permitted.
The concurrence posited that there is an “implicit” limit within the Sixteenth Amendment that would supplement the due process “arbitrariness” analysis, but because the parties had not raised the fairness of attribution, the issue was not ripe for decision. The concurrence noted that there was no precedent for applying the due process test to attribution and commended to lower courts considering similar issues the factors posited by the government at oral argument, including the taxpayer’s power and control over the income to be attributed, receipt by the taxpayer of special privileges or benefits from the entity earning such income, or whether the corporation is foreign.
The dissent, like the concurrence, focused on National Grocery and posited that it involved a tax avoidance scheme, rather than approving the ability to freely attribute corporate income to shareholders. In the dissent’s view, at most, Congress may attribute income to the entity or individual who actually controlled it when necessary to defeat attempts to evade tax liability. In the dissent’s view, Congress may not freely choose whether to impose an income tax on a corporation or its shareholders.
Eversheds Sutherland Observation: Although the majority seemingly would be content to rely on due process for a determination of whether an attribution of income from a corporation to a shareholder is constitutionally permissible, four Justices (Barrett, Alito, Thomas and Gorsuch) would impose additional limits under the Sixteenth Amendment. In an appropriate case, this could conceivably affect both Subpart F and GILTI.
1 Pollock v. Farmers’ Loan & Trust Co., 158 US 601, 618 (1895).
2 Eisner v. Macomber, 252 US 189 (1920).
3 Helvering v. National Grocery Co., 304 U. S. 282 (1938).
4 The direct tax clause applies only to federal taxes. Wealth tax bills have been introduced in several states, including California, Connecticut, Hawaii, Illinois, Maryland, New York, Pennsylvania, Vermont and Washington. See David W. Chen, Vermont Becomes Latest State to Propose Wealth Taxes, N.Y. Times, Jan. 23, 2024, https://www.nytimes.com/2024/01/23/us/wealth-tax-vermont-legislature.html.
[View source.]
