The U.S. tax system developed in response to colonial opposition to taxation without representation. As such, Article I of the Constitution provides that Congress may not impose a “direct tax” unless the tax is “apportioned” to each state based on relative population, which would be practically and politically infeasible in most cases. Direct taxes include property taxes and also taxes imposed on the income derived from property. The Sixteenth Amendment was enacted to give Congress the power to tax “incomes, from whatever source derived, without apportionment” (emphasis added). As to the meaning of income, one landmark case strongly suggests that Congress’s power to tax income is limited by a requirement that such income must be “realized”, although the breadth of any purported realization requirement has yet to be articulated by the Supreme Court.
“Indirect” taxes — specifically, “duties, imposts and excises” — are not subject to the rule of apportionment, but are instead subject to the rule of uniformity, meaning that the tax must be consistently applied to all the states. As such, many taxes, such as inheritance taxes, have survived constitutional challenges when they are viewed as indirect taxes. Further, there is no realization requirement for indirect taxes.
Moore involves a husband and wife who invested in a friend’s startup in India. The company had been profitable since 2006, but it never paid any dividends and reinvested all of its earnings back into the business. As a result of a TCJA provision that imposed a one-time transition tax on undistributed earnings accumulated overseas, the Moores paid a $14,729 tax attributable to their share of the Indian company’s undistributed earnings and sued for a refund. The Moores maintain that the transition tax is not an income tax authorized under the Sixteenth Amendment because there had been no realization and instead the tax is a “direct tax” that is unconstitutional for lack of apportionment. The docket for the upcoming October 2023 term states the issue before the Supreme Court as “whether the Sixteenth Amendment authorizes Congress to tax unrealized sums without apportionment among the states” and specifically on the constitutionality of this transition tax.
The Supreme Court could decide Moore narrowly, simply holding that the transition tax is not an income tax, but is constitutionally valid on some other ground (for example, as an indirect tax in the nature of an excise). However, if the Supreme Court affirms that Congress’s power to tax income is limited by a realization requirement, then numerous provisions of the tax law could be called into question for (seemingly) imposing taxes on unrealized income. Examples include: the original issue discount rules for debt instruments, which require a lender to accrue for discount as interest income prior to receipt; the taxation of pass-through vehicles generally, with respect to income allocated to owners prior to (and notwithstanding) the actual receipt of cash; the Subpart F regime, which requires significant U.S. shareholders of foreign corporations to include certain items in income prior to distribution; the mark-to-market rules under Section 1256 for certain futures contracts; the mark-to market rules under Section 475 for dealers of securities; and the marking-to-market of assets under Section 877A for expatriates.
The real reason for the Moore challenge may be to stifle recent proposals for wealth taxes, taxes on unrealized gains with respect to derivatives, or other capital gains. Nonetheless, if the transition tax is declared an unconstitutional tax on unrealized income, there will almost certainly be challenges to these (and other) well-settled areas of the tax law, and until these challenges are resolved, the U.S. tax system could be plunged into chaos. Tax practitioners and taxpayers will anxiously await the Supreme Court’s decision.
