The 16th Amendment authorizes the federal government only to tax income, but some members of Congress would love to tax wealth as well. That is widely understood to be unconstitutional, but a recent ruling from the Ninth U.S. Circuit Court of Appeals upholding a form of wealth tax could upend that conventional wisdom if it is allowed to stand.
The case, Moore v. U.S., involves a unique provision of the 2017 Tax Cuts and Jobs Act, which imposed a one-time retroactive tax applicable to individual U.S. shareholders of foreign corporations. Under previous law, U.S. taxpayers had to pay taxes on overseas corporate income when that income was repatriated to the U.S. in the form of dividends. The 2017 act abolished the tax on overseas income, bringing the U.S. tax system into line with those of most other developed countries. But it also created a “mandatory repatriation tax” on the corporation’s undistributed income since 1986, payable not by the corporation but its shareholders.
The result was that without selling their stock or receiving a dividend, U.S. investors were deemed to have received “income” and suddenly became liable for the new tax.
The plaintiffs are a couple, Charles and
who purchased 11% of a small foreign corporation in 2005. The Moores were passive investors, never participating in management of the corporation. The corporation never paid dividends. More than a decade after their investment, they suddenly became liable for a hefty tax bill under the new law, which applied to any shareholder with an interest of more than 10%.
The Ninth Circuit’s three-judge panel ruled that it didn’t matter that the Moores never received any money from their investment. A dividend, stock sale or other realization event wasn’t necessary, the court said, because there is “no set definition of income under the Sixteenth Amendment.” That is a remarkable concept: The operative word in a key provision of the Constitution has no fixed meaning. The ruling upends a bedrock principle of taxation, which is that to create taxable income, there must be a transaction, or “realization.” That’s what distinguishes an income tax from a tax on property or wealth.
The Moores petitioned for a rehearing by an 11-judge panel of the Ninth Circuit but were denied. Four judges dissented from the denial, noting that based on Supreme Court precedent, federal case law and the history of the 16th Amendment, ordinarily a realization event must occur in order for there to be taxable income. The Moores plan to seek Supreme Court review.
Much hangs on the future of this case. If Moore is allowed to stand, Congress would have a green light to tax every U.S. investor in a domestic corporation in the same way. There would be no constitutional bar to requiring that shareholders pay income tax on their proportionate share of accumulated and undistributed earnings of every corporation in which they, or even their 401(k) plan, hold stock.
That isn’t all. With Moore as precedent and no realization requirement to bound the meaning of “income,” Congress could extend the income tax to include unrealized asset appreciation of any kind. Stamp collections, coin collections, art on the living-room wall—all suddenly would be sources of “income” without yielding the taxpayer a cent. What’s more, since appreciation, unlike realization, is a constantly changing process, the frequency of measurement of the “income” would be at the whim of Congress and the Internal Revenue Service.
Moore provides the Supreme Court the opportunity to rule that when the states ratified the 16th Amendment in 1913, they didn’t give Congress unchecked authority to tax. Accepting the case for review would also permit the justices to address the Constitution’s limits, if any, on retroactive taxation. The Ninth Circuit’s three-judge panel ruled that even though the mandatory repatriation tax reaches back to 1986, it doesn’t violate the right to due process under the Fifth Amendment. In 1938 and again in 1994, the Supreme Court upheld tax laws that reached back one year, but the justices have never considered decadeslong retroactivity.
The Ninth Circuit approved of the extraordinary retroactivity of the Mandatory Repatriation Act because otherwise, in its view, shareholders of corporations with undistributed earnings would achieve a “windfall” by not paying taxes on “earnings that have not yet been distributed.”
Yet the long-established rationale for a separate corporate-level tax is that it prevents undistributed earnings from going untaxed. Further, those earnings would be taxed again whenever paid to shareholders, just as are dividends of all companies.
There is one more extraordinary feature of the tax law at issue in Moore. The rate of tax varies depending on the corporation’s balance-sheet liquidity. The greater the ratio of liquid to illiquid assets, the higher the tax rate. That distinction gives away the game. Liquidity is unrelated to income—it is solely a function of assets and liabilities. This is a tax on a corporation’s balance sheet, passed through to individual shareholders.
The Moore case will solidify, revitalize or obliterate the long-established norm of federal income taxation that a realization event is required before there is taxable “income” in the constitutional sense. If the justices accept the case for review, they can finally lay to rest the notion that the 16th Amendment is based on a term with “no set definition.”
What if they decline? The Ninth Circuit’s dissenters answered that question: “Divorcing income from realization opens the door to new federal taxes on other types of wealth without the constitutional requirement of apportionment.”
Mr. Cox served as chairman of the Securities and Exchange Commission, 2005-09, and a U.S. representative from California, 1989-2005. Mr. Adler is a professor of accounting at Chapman University.
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