By Tim Shaw
Tax and legal analysts are forecasting a possible chaotic domino effect should the Supreme Court rule in favor of a married couple’s challenge to the so-called transition tax enacted under the Tax Cuts and Jobs Act (TCJA; PL 115–97), even if the decision is narrowly-tailored.
The case, Moore v. United States (No. 22-800) was accepted by the Supreme Court late June and revolves around Charles and Kathleen Moore’s $15,000 tax payment in addition to their tax year 2017 liability as a result of their pro rata share in a controlled foreign corporation’s earnings. This payment stemmed from the one-time mandatory repatriation tax, commonly referred to as the TCJA transition tax,” under Code Sec. 965.
The Moores had a 13% stake in the CFC and sued the government first in the U.S. District Court for the Western District of Washington and then the Ninth Circuit arguing the transition tax is an unconstitutional tax on unrealized income under the Sixteenth Amendment. Both courts disagreed and held that Congress did not overstep its authority and that whether income is realized does not affect a tax’s validity. For more background, see Supreme Court Takes Up Constitutional Challenge to TCJA Transition Tax (06/27/2023).
Although several amicus briefs were filed in the Supreme Court in support the Moores, panelists at a September 21 virtual event hosted by the Urban Brooking Tax Policy Center and New York University School of Law’s Tax Law Center warned it may hard to fully anticipate the economic implications of a favorable ruling for the petitioners.
Tax Policy Center Institute fellow Eric Toder, who moderated one of the event’s three panels, provided examples under current law in which taxes exist on unrealized income besides the transition tax on accrued foreign profits. These include, but are not limited to, Subpart F income, global low-tax intangible income, the corporate alternative minimum tax on book income, undistributed partnership and S corporation income, and accrued interest on original issue discount bonds. Toder projected annual receipts from these revenue sources will yield in $125.5 billion in 2028, up from $87.1 billion in 2024.
Should the Court find the transition tax to be unconstitutional, other unrealized income taxes could be in jeopardy, Toder illustrated in a graphic showing how wealthier taxpayers rake in exponentially more income from capital gains, partnerships, and S Corps.
“[T]hese are the sources of income that would not be taxed,” he explained. “This [shows]… the top 1% of taxpayers, who have about 16% of all income, pay about 50% of tax on interest income, about 77% on realized capital gains, about 78% on partnership income, and about 73% of S Corp income.”
“If any of these sources” of income were to no longer be taxed, the tax system “would be very regressive,” he concluded.
Kyle Pomerleau, senior fellow at the American Enterprise Institute, said “realization-based income taxation is not necessarily economically coherent,” and that “the timing of taxation is neither consistent with an income tax [nor] a consumption-based tax.” A realization-based tax differs from a “pure” consumption tax where an individual is only taxed when they “consume,” or an income tax where an individual is taxed “when their ability to consume” rises, because “if someone holds on to an asset that appreciates and does not sell it, they’re not facing taxation, even though their ability to consume has increased.”
Pomerleau’s takeaway on what’s at stake with the Moore case comes down to the policy rationale behind taxes on unrealized income, which is “to prevent companies from aggressively shifting profits or locating profits and low tax jurisdictions.” The risk of a petitioner friendly ruling, he theorized, is an uptick in litigation against the government, or “a lot of these provisions going away.” He believes Congress, and not the Court, should be “in control of these decisions” and the judicial branch should not tell lawmakers “what sort of limits they have in terms of taxation.”
Natasha Sarin, associate professor of law at Yale Law School, said next that Moore poses a “significant challenge of uncertainty.” The term “unrealized” itself, she added, is “laden with uncertainty” because “there are some constitutional questions that the Court is going to have to grapple with at some point… with respect to things like wealth taxes” and the “market-to-market taxation of capital gains.”
Given the specific facts of the Moore case, Sarin thinks it is “pretty bonkers” that it is being used as a vehicle for debate about the constitutionality of unrealized income taxes. But as an economist, she also appreciated how even those most ideologically opposed tax experts seem to be aligned “with the broad view that it would be immensely problematic with respect to tax administration, tax compliance, [and other] broader fiscal implications” should the Moores win.
Adding that there is “no way for a ruling to be drafted” to resolve the “cloud of uncertainty” surrounding the issue, Sarin agreed there would be “lots of litigation going forward” if the conversation eventually became if entities like partnerships to even be taxed at all, disturbing “areas of the Code that have been settled for decades based on a shared and correct understanding of what the Constitution allows for.” This, Sarin said, is a bigger gray area than just the revenue implications.
George Callas, who heads the public finance team at Arnold Ventures, piggybacked off Sarin’s points, agreeing potential “legal chaos” is in play depending how the Court rules. He does not expect the Court to go through the Tax Code “provision by provision” and apply their ruling. Instead, he projected, “everybody would be left to interpret it and apply it to other provisions of the Code as they see fit.” Supposedly, even if the decision were narrow in focus, there is still the potential for “economic disruption from people interpreting the decision in different ways,” according to Callas.
“You could have everything from partnership agreements being rewritten, to global supply chains being restructured, to debt instruments being completed,” he predicted.
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