Supreme Court hears arguments in challenge to Sec. 965 transition tax

Supreme Court justices hearing arguments Tuesday in a tax case involving the constitutionality of the Sec. 965 transition tax and the definition of realized income asked attorneys for the taxpayers and the government the same question: What are the consequences if you win?

Charles and Katherine Moore sued over the Sec. 965 transition tax, which they say increased their tax liability for 2017 by about $15,000. The Moores in their lawsuit argued the tax, established in 2017 by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, is unconstitutional, saying income must be realized before it can be taxed (Moore, No. 22-800 (U.S. 6/26/23) (cert. granted)).

Income realization

The plaintiffs’ attorney, Andrew M. Grossman of Baker & Hostetler, argued on Tuesday that the taxpayers’ interest in the corporation is solely a capital interest, and while the value of their investment has increased, the taxpayers, as shareholders, have not “realized any income.”

The justices questioned that argument. “What do you do with Subpart F or Subpart S or all of the other ways in which we have attributed corporate income to individuals?” Justice Sonia Sotomayor asked the plaintiffs’ attorney.

Those are “long-standing, taxing mechanisms by the government. Your theory would undermine those as well, wouldn’t it?” she asked.

Grossman disagreed.

At stake is up to $340 billion in tax revenue, which is the government estimate of monies that would be added to the federal coffers from the Sec. 965 transition tax.

“You’re asking us to just announce what realization is out of context. And for the last hundred years, we’ve been studiously avoiding doing that because we recognize that it’s dangerous to do that,” Sotomayor said. The court would “have to come up with a working definition that applies to every piece of property and every way in which people gain wealth,” she said.

Meanwhile, one back-and-forth discussion between the justices and Solicitor General Elizabeth B. Prelogar, who represented the government, focused on her argument in the government’s brief that there is no requirement that income be realized to be taxable; that, for example, Congress could tax unrealized gains in retirement investment accounts.

“I’m just asking what the limits of your argument are. And it seems to me, there are none,” Justice Neil Gorsuch stated, adding that Prelogar was asking the court to overturn 100 years of precedent.

Prelogar said she was not asking the court to overturn any precedent but rather to follow its own precedent in later decisions limiting the scope of Eisner v. Macomber, 252 U.S. 189 (1920), in which the Court had held that a shareholder who received a stock dividend did not realize income.

Background

In 2005, the Moores invested $40,000 in exchange for 11% of the common shares of KisanKraft, a company that a friend owned in India. KisanKraft is a controlled foreign corporation (CFC), which means U.S. persons own 50% of its ownership or voting rights.

At that time, U.S. taxpayers did not generally pay U.S. taxes on foreign earnings until those earnings were distributed to them.

But Sec. 965, as amended by the TCJA, imposed a one-time transition tax on untaxed foreign earnings — either at 8% or 15.5%. The tax applies whether the foreign earnings are distributed or not — they are deemed repatriated. The tax is imposed on U.S. persons owning at least 10% of a CFC. Undistributed earnings from after 1986 and prior to 2018 were deemed distributed and taxable in tax year 2017.

The Moores challenged the constitutionality of the transition tax, arguing that it is an unapportioned direct tax and not a tax on income because income must be realized before it can be taxable.  Under Article 1, Section 9, of the U.S. Constitution, any “direct tax” must be apportioned so that each state pays the tax in proportion to its population; however, the Sixteenth Amendment exempts from this apportionment requirement “incomes, from whatever source derived.”

The U.S. Supreme Court granted the Moores’ petition for certiorari challenging the constitutionality of the transition tax after a three-judge panel of the Ninth Circuit dismissed their challenge (Moore, 36 F.4th 930 (9th Cir. 2022)).

Citing Macomber and Glenshaw Glass Co., 348 U.S. 426 (1955), the Moores had urged the Ninth Circuit to apply the definition of income used in Glenshaw Glass: (1) an undeniable accession to wealth, (2) clearly realized, (3) over which taxpayers have complete dominion. Because the transition tax apples to undistributed earnings, the Moores argued that it was not taxing income.

The Ninth Circuit held that the transition tax is an income tax and does not violate the Constitution’s apportionment requirement. The court  noted that courts have consistently upheld the constitutionality of taxes like the transition tax notwithstanding any difficulty in defining income; that the realization of income does not determine the tax’s constitutionality; and that no constitutional ban exists on Congress’s disregarding the corporate form to facilitate taxation of shareholders’ income.

The Ninth Circuit also held that, assuming without deciding that the transition tax is retroactive, the tax does not violate the Fifth Amendment’s Due Process Clause.

The transition tax serves the legitimate purpose of preventing CFC shareholders who have not yet received distributions from obtaining a windfall by never having to pay taxes on their offshore earnings that have not yet been distributed, the panel said.

The Supreme Court is expected to issue its decision before the end of its term in June 2024.

— To comment on this article or to suggest an idea for another article, contact Martha Waggoner at Martha.Waggoner@aicpa-cima.com.