On June 20, 2024, the Supreme Court rendered its highly anticipated ruling in Moore v. United States, 602 U.S. ___ (2024), addressing the constitutionality of Internal Revenue Code (“Code”) section 965. This alert provides an immediate summary of the highlights, the case’s background, and initial analysis.
Highlights
By taking up the question of whether section 965 exceeded the taxing power of the U.S. Congress, there existed a possibility that the Court would render a decision with far-reaching implications. Ultimately, however, the Court decided the case narrowly, leaving open several critical questions that may arise in future disputes. Here are the key highlights of the decision:
- The Supreme Court held that section 965 is constitutional.
- The Court’s analysis focused on Congress’s constitutional authority to attribute the realized and undistributed income of a U.S.-controlled foreign corporation to the entity’s U.S. shareholders, who would then pay tax on that income. The Court found that attribution of income to shareholders, partners and other equity holders of certain entities is a key feature of partnership taxation, S corporation taxation, and subpart F U.S. tax regimes that courts have long held as constitutional. The Court analogized section 965 to these other regimes for attributing income to U.S. equity holders and imposing tax thereon.
- However, the Court narrowly tailored its decision to avoid addressing issues related to realization, including whether the Sixteenth Amendment requires realization for a tax to be a valid income tax even though this was the question on which the Court granted certiorari.
Legal Framework
Under the U.S. Constitution, “direct taxes” must be apportioned among the states. On this basis, the Supreme Court struck down as unconstitutional several early versions of federal income taxes because they were not apportioned among the states based on population. The Sixteenth Amendment allows Congress to “collect taxes on income, from whatever source derived, without apportionment.” More recent case law, including Moore, has focused on the definition of “income” under the Sixteenth Amendment.
Case Background
The Moores invested $40,000 in an Indian start-up company, KisanKraft, in 2005. This investment gave the Moores an ownership interest of about 11% in KisanKraft, which by 2017 had appreciated in value to over $130,000. Because the company never made any distributions during that time, the Moores had never been subject to U.S. tax on these earnings.
Enacted as part of the 2017 Tax Cuts and Jobs Act (“TCJA ”), Pub. L. No. 115-97, section 965 required 10-percent or greater U.S. shareholders of controlled foreign corporations to pay tax on the untaxed earnings in such entities over the prior 30 years, as if those earnings had been repatriated to the United States as dividends. The Moores were U.S. shareholders of KisanKraft, which was an entity subject to section 965. As a result, the Moores were required to pay about $15,000 in U.S. income tax on their share of the accumulated earnings of KisanKraft, notwithstanding that these earnings were not actually distributed to the Moores.
In 2019, the Moores filed a complaint with the U.S. District Court for the Western District of Washington, arguing that U.S. tax imposed under section 965 was not a tax on income because it was imposed on unrealized gain. They argued that the tax was therefore unconstitutional because it was not apportioned among the states. In its decision, the District Court acknowledged the realization requirement, citing Eisner v. Macomber, 252 U.S. 189 (1920). In that case, the Supreme Court held that it is only when a stockholder “realizes a profit [that] such profit . . . is income, and so far as it may have arisen since the Sixteenth Amendment is taxable by Congress without apportionment.” Nevertheless, the District Court agreed with the government that section 965 is constitutional, relying on case law upholding the constitutionality of subpart F and stating that “[s]ubsequent decisions dealing with foreign income have routinely departed from Macomber’s realization standard.” Moore v. United States, 2020 WL 6799022 (W.D. Wash. Nov. 19, 2020).
The Moores appealed the District Court’s decision, arguing that Macomber and Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955), require income to be realized before an income tax can be imposed under the Sixteenth Amendment. Affirming the district court decision, the Ninth Circuit rejected this argument. Moore v. United States, 36 F.4th 930 (9th Cir. 2022). The Ninth Circuit explained that these cases have been interpreted much more narrowly than the strict requirement asserted by the petitioners. The court also relied on case law upholding the subpart F and partnership tax regimes to conclude that income need not be realized by the taxpayer to be taxed at the taxpayer level, noting that both regimes involve the attribution of undistributed income to the taxpayer, like section 965.
The Supreme Court granted the Moores’ petition for certiorari, indicating it would address “whether the Sixteenth Amendment authorizes Congress to tax unrealized sums without apportionment among the states.”
Analysis
The Supreme Court held that section 965 is constitutional. The Court emphasized that section 965 “does tax realized income—namely, income realized by the corporation.” Thus, the majority opinion of the Court did not need to discuss whether realization is a constitutional requirement. The Court instead focused on “whether Congress may attribute an entity’s realized and undistributed income to its shareholders or partners, and then tax the shareholders or partners on their portions of that income.” The Court concluded that Congress does have this authority and that section 965 is a valid exercise of that authority.
More specifically, the Court explained that both a long line of Supreme Court precedent and longstanding practice by Congress support the authority of Congress to tax the realized income of a closely held entity by taxing either the entity itself or the shareholders or partners on their share of the entity’s income. The Court emphasized that challenges to the constitutionality of subpart F have been viewed as “border[ing] on the frivolous” in light of Heiner v. Mellon, 304 U.S. 271 (1938), which upheld a tax on partners for the undistributed income of the partnership even where state law did not allow that income to be distributed to the partners. The Court further noted that the Moores’ reliance on Eisner v. Macomber was misplaced because that case “does not proscribe attribution and thus has no bearing on the attribution issue in this case.”
The Court also reviewed each of the Moores’ purported distinctions between the tax imposed by section 965 on the one hand and the partnership, S corporation, and subpart F regimes on the other. The Court found those distinctions irrelevant in light of the rule established by the precedent discussed above. The Moores’ concession that subpart F is constitutional significantly undermined their argument.
Because the Court found that section 965 does tax realized income, albeit income attributed from a foreign entity to its U.S. shareholders, the Court limited the scope of its holding. Its opinion does not address whether gain must be realized in order to constitute income under the Sixteenth Amendment. As pointed out by the concurring and dissenting opinions, the Court did not specifically address the issue on which the Court granted certiorari—whether realization is or is not a constitutional requirement. Instead, the Court emphasized the narrow scope of its holding, applying it only to “(i) taxation of the shareholders of an entity, (ii) on the undistributed income realized by the entity, (iii) which has been attributed to the shareholders, (iv) when the entity itself has not been taxed on that income.”
Implications
The Court’s holding is narrow and for the moment does little to fundamentally alter the U.S. tax system. In discussing the validity of the partnership, S corporation, and subpart F tax regimes as acceptable forms of pass-through taxation, the Court also notes other tax regimes in the Code that would have been called into question by the Moores’ arguments: deemed stock distributions (section 305(c)), accrual accounting (sections 446 and 448), GILTI (section 951A), certain futures contracts (section 1256(a)), OID (section 1272(a)), and gift taxes (sections 2501-2524).
Although Moore resolves the constitutionality of section 965 and similar regimes, such as subpart F and GILTI, the Court included caveats that leave open the possibility for potential future challenges to “taxes on holdings, wealth, or net worth” or “taxes on appreciation.” And, while the Court emphasized that “nothing in this opinion should be read to authorize any hypothetical congressional effort to tax both an entity and its shareholders or partners on the same undistributed income realized by the entity,” (i.e., a so-called wealth tax), the Court nevertheless agreed in principle with the Ninth Circuit’s decision, which stated that realization is not required for a tax to pass constitutional muster. Thus, the Court’s decision in Moore seems unlikely to be the last word on the definition of an income tax.
If you have any questions concerning the material discussed in this client alert, please contact the members of our Tax practice.
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