U.S. Supreme Court Decision Upholds Constitutionality of Transition Tax. Originally published on WealthManagement.com

Jun 25

On June 20, the U.S. Supreme Court issued its decision in Moore v. United States, upholding the constitutionality of the Mandatory Repatriation Tax under the 2017 Tax Cuts and Jobs Act. The Moore decision is one high-net-worth individuals and their advisors don’t want to ignore. If nothing else, the ruling reaffirms Congress’ broad taxing authority but leaves open significant questions about the future of wealth taxation in the United States.

Background

Charles and Kathleen Moore invested $40,000 in KisanKraft Tools, an American-controlled foreign corporation based in India. From 2006 to 2017, KisanKraft generated substantial income but didn’t distribute it to shareholders. Under TCJA, the MRT imposed a one-time tax on the undistributed earnings of American-controlled foreign corporations, attributing this income to American shareholders and taxing them accordingly. The Moores faced a tax bill of $14,729 on their pro-rata share of KisanKraft’s accumulated income, prompting them to challenge the MRT as an unconstitutional direct tax.

Legal Precedents and Court Analysis

To understand the decision, let’s look at the historical precedents that shaped the Court’s interpretation of the constitutionality of the MRT. The Court’s analysis relied heavily on prior rulings that distinguished between direct and indirect taxes and reaffirmed Congress’ broad taxing powers under Article I of the Constitution.

Here are the key cases that played a significant role in the decision:

Brushaber v. Union Pacific R. Co. (1916): This case affirmed that the 16th Amendment allows Congress to tax incomes from any source without apportionment. The ruling emphasized the broad taxing power of Congress and reinforced the distinction between direct and indirect taxes.
Burnet v. Leininger (1932): The Court reiterated that Congress could tax either the partnership or the partners on the partnership’s undistributed income. This decision established that taxing the income attributed to partners is constitutionally permissible.
Helvering v. National Grocery Co. (1938): This decision confirmed that Congress may tax shareholders on a corporation’s undistributed income, aligning corporate tax principles with those applied to partnerships.
Eisner v. Macomber (1920): Although this case discussed the realization of income, it didn’t specifically address the attribution of income, which later cases clarified. Eisner defined income for tax purposes as “the gain derived from capital, from labor, or from both combined” and emphasized that income must be realized before it can be taxed. This case set the groundwork for debates on income realization in tax law, influencing how later courts viewed the distinction between realized and unrealized income.

These precedents, while dated, collectively shaped the Court’s approach in Moore and provided a legal framework for assessing the constitutionality of taxing undistributed corporate earnings attributed to shareholders.

Constitutionality of MRT

The decision in Moore focused narrowly on the constitutionality of the MRT as an income tax. The majority opinion, delivered by Justice Brett Kavanaugh, held that the MRT doesn’t exceed Congress’ constitutional authority. The decision emphasized that the MRT taxes “realized” income—specifically, the income realized by KisanKraft, which is attributed to its American shareholders.

Kavanaugh highlighted that Congress has historically taxed entities’ undistributed income by attributing it to shareholders or partners and then taxing them. The Court has consistently upheld this approach, aligning the MRT with precedents regarding subpart F income, S corporations and partnerships. The Court affirmed that such taxation methods are constitutional, underscoring that Congress may attribute an entity’s realized and undistributed income to the shareholders and tax them accordingly.

Implications for Wealth Tax

The Moore decision, while narrow, opens the door to significant discussions about a wealth tax. One of the key elements of the decision is its interpretation of income and the realization requirement. By affirming that the MRT taxes realized income that’s attributed to shareholders, the Court upheld Congress’ power to tax undistributed corporate income as realized by shareholders. This leaves room for further judicial interpretation and legislative action regarding a wealth tax, specifically the definition and taxation of income.

The Moore ruling sets the stage for a potential shift in how wealth tax is approached in the United States, especially in an election year. With one party potentially gaining control of the House, Senate and White House, the possibility of passing significant tax legislation, including a wealth tax, becomes more feasible.

The government’s need to generate revenue to address budget deficits and fund public programs is a significant motivation. A wealth tax could provide a substantial source of revenue by targeting the unrealized gains and accumulated wealth of HNW individuals. The ruling supports the continuation and potential expansion of taxing undistributed corporate income, which could play a crucial role in fiscal policy. Additionally, the ruling provides a constitutional framework that could be leveraged to justify such legislation, making it a focal point of political campaigns and policy discussions.

The dissenting opinions and concurrences in Moore suggest that future efforts to impose a wealth tax in the United States would need careful legal structuring to withstand scrutiny. The challenge is clearly and consistently defining what constitutes income versus wealth and ensuring that any new tax regime aligns with established constitutional principles.

Indirect vs. Direct Taxation

The decision reinforces the notion that income taxes are indirect taxes. If a wealth tax was structured similarly to the MRT, which attributes increases in the value of assets (akin to gains or income) to taxpayers and then taxing them, it might be argued that the tax is indirect, thus not requiring apportionment. This interpretation could provide a pathway for implementing a wealth tax without running afoul of the constitutional requirement for apportionment.

Realization Requirement

A critical aspect of the Moore decision is the discussion of realized income. The Court emphasized that the MRT taxes realized income—income earned by the corporation and attributed to shareholders. This precedent could impact the structure of a wealth tax, impacting many of your clients. If a wealth tax involved attributing increases in asset value to taxpayers, whether these increases must be realized to be taxable (that is, through a sale or other conversion to cash) remains an open question. Future cases will need to address whether realization is a constitutional requirement for taxing income and how this principle might apply to wealth taxes.

How Advisors Can Adapt

Introducing a wealth tax would present new challenges and opportunities for advisors to help their clients. A wealth tax could be similar to the estate tax in broad strokes. Proactive estate planning strategies could help mitigate a wealth tax as well. Additionally, the absence of a comprehensive framework of service providers to address wealth tax compliance and planning presents a significant challenge.

Advisors must adapt and potentially expand their service offerings to meet these new demands. They must develop expertise in new areas of tax law to navigate the complexities of wealth tax, including the challenges of taxing unrealized gains. They will need to collaborate with technology providers to create effective compliance tools. An integrated approach involving legal, financial and technological experts is essential for providing comprehensive solutions. This collaboration will help address regulatory scrutiny and administrative burdens while optimizing tax outcomes for clients.

Questions Remain

The ruling underscores the complexities of the U.S. taxation system and the constitutional challenges surrounding the imposition of new tax forms, such as a wealth tax. While the decision upholds the MRT as a legitimate income tax, it leaves significant questions about the future of wealth taxation open. HNW individuals and their advisors must navigate these uncertainties, understanding that any future wealth tax proposals will likely face rigorous legal and constitutional scrutiny. This decision prompts a need for careful planning and adaptation to ensure compliance and optimize tax outcomes for clients.

Anthony Venette, CPA/ABV is a Senior Manager, Business Valuation & Advisory, DeJoy & Co., CPAs & Advisors in Rochester, New York. He provides business valuation and advisory services to corporate and individual clients of DeJoy.

Anthony Venette, CPA/ABV