Congress wins a tax battle but could lose the war

This week, the U.S. Supreme Court denied shareholders Charles and Kathleen Moore a $15,000 refund for taxes they paid on their share of undistributed profits from an offshore company. The court affirmed Congress’s tax authority, at least as it relates to taxing undistributed offshore profits. But what about Congress’s authority to tax other unreceived profits, such as unrealized capital gains or other investment income? Because of the court’s limited jurisdiction and divided opinions, a cloud of uncertainty now hangs over our tax code.

The scope of Moore v. United States is narrow.

As part of the 2017 restructuring of international tax rules, Congress imposed a one-time tax on profits hoarded abroad by U.S. companies and investors. Without this temporary mandatory repatriation tax, about $2.6 trillion in offshore profits would have permanently escaped U.S. tax due to other changes in the 2017 law. But the Moores argued that Congress could not tax U.S. shareholders on the undistributed income of offshore companies because the shareholders had neither received nor “realized” the income.

To ordinary taxpayers, the idea of ​​taxing income not received may seem unfair and unconstitutional. Wages are not taxed until they are received, and capital gains are generally not taxed until interest or dividends are paid or the investment is sold at a profit.

And indeed, Congress generally waits to tax income until it is actually received—because Congress views this as an “administrative convenience” (it is easier to calculate) rather than a constitutional requirement. But sometimes Congress also taxes “book profits” and other forms of unreceived income because this is the only way to fairly tax certain economic events. Such cases include many capital market and international transactions, including, as in Moore’s case, unreceived profits attributed to shareholders of offshore companies.

Justice Brett Kavanaugh, writing for the majority, affirmed Congress’s authority to tax undistributed profits. He noted that since the creation of the income tax, Congress has taxed the owners of certain corporations (so-called pass-through corporations) on the income of those corporations rather than taxing the corporations themselves. But Kavanaugh stopped short of holding that the practice of deferring taxation until realization is based on administrative expediency rather than a constitutional requirement, notwithstanding previous court rulings.

The constitutional requirement that income must be “realized” remains unresolved but will resurface.

Kavanaugh distinguished between the case at hand—taxing undistributed offshore corporate profits—and taxing unrealized gains from the appreciation of private assets, a distinction he said the government had recognized. He and three other justices who joined him (Chief Justice John Roberts and Justices Elena Kagan and Sonia Sotomayor) did not take a position on whether such appreciation was taxable. Only Justice Ketanji Brown Jackson, in a concurring opinion, said that realization was not a constitutional requirement.

But four justices (Amy Coney Barrett, Samuel Alito, Clarence Thomas and Neil Gorsuch) explicitly stated that the finding Is a constitutional requirement. President Biden and Senate Finance Committee Chairman Ron Wyden (D-OR) have proposed taxes on the unrealized gains of the nation’s wealthiest households. In their opinion, these four justices would find taxing billionaires’ unrealized gains unconstitutional. So if either Roberts or Kavanaugh (the most likely nominees) were to join them in a case challenging a billionaires’ tax, the tax would fail.

And Moore will certainly pose new challenges to existing tax laws, particularly to the tax rules for capital gains, many of which are based on accounting gains (such as zero-coupon bonds, contingent debt, forward contracts, swaps, and constructive sales). Without these rules, savvy taxpayers could structure their investments to achieve economic benefits without encountering realization events that normally trigger tax liability. How would Kavanaugh and his co-authors respond to these new challenges to the tax law?

Only Congress, with its resources and expertise, can balance revenue needs, administrative convenience, and equity in designing taxes, including taxes on unrealized gains. And Congress, after careful consideration over the decades, has identified certain types of such income that must be taxed in order for the nation’s tax system to function properly.

Despite the decision in favor of Congress’s tax sovereignty in Moorethe Court could still undermine Congress’s taxing authority. More litigation is likely—and the Court could well violate Congress’s prerogatives in future similar cases.