Can Congress Tax Unrealized Gains?

In a case to be argued on December 5, 2023, Moore v. United States, the question presented is whether the Sixteenth amendment authorizes Congress to tax unrealized sums without apportionment among the states. The case concerns Congressional taxation under the 2017 Tax and Jobs Act (TCJA) which imposed a mandatory repatriation tax on pre-2018 profits that companies and some U.S. shareholders stored abroad. The reason this case is interesting is because, the “Supreme Court has maintained since 1920 that income must be “clearly realized” for it to be taxable.” The current Court seems to be enamoured with originaliism and text of the Sixteenth Amendment, as well as established precedence, in light of recent decisions, could have the Court taking a contortionist (and somewhat hypocrtical) approach in finding a way to uphold the law. The Hill writes: “Justices are going to want to uphold tax law to avoid the disastrous consequences they’ve already been briefed on, but originalism and wealth tax will bar their way.”

If unrealized gains cannot be taxed, which seems to be the claim Moore is making, then what about partnership law and the law relating to other pass-through entities where income is taxed even though it is never realized?

The facts, as set for in Moore’s brief, are as follows:

Charles and Kathleen Moore are a retired couple residing in Washington State, where Charles worked in software development. Pet.App.70. In the early 2000s, Charles’s friend and former coworker, Ravindra “Ravi” Kumar Agrawal, had the idea of starting a business to supply farmers in India’s most impoverished regions with basic tools and equipment that were readily available in the United States, but not in India. Pet.App.70. The Moores were moved by Ravi’s vision of empowering India’s rural farmers to improve their livelihoods. Pet.App.71. They contributed $40,000 to help Ravi found KisanKraft Machine Tools Private Limited, an Indian corporation. Pet.App.71. In exchange, they  received about 13 percent of KisanKraft’s common shares. Pet.App.74 KisanKraft’s rapid growth confirmed that Ravi had identified a genuine need. It was profitable almost from the start, and its revenues increased every year since its founding. CA9.ER.38. True to Ravi’s original business plan, KisanKraft reinvested all its earnings to grow the business, which has expanded to serve farmers across India. Pet.App.71, 73; CA9.ER.37–38. By 2017, it employed over 350 representatives in 14 regional offices serving 2,500 local dealers. CA9.ER.38. The Moores received regular updates from Ravi on KisanKraft’s activities, as well as annual financial statements. Pet.App.72. Charles visited India several times and was impressed with the difference that KisanKraft was making in the lives of India’s rural poor. Pet.App.72. The Moores never received any distributions, dividends, or other payments from KisanKraft. Pet.App.73. And as minority shareholders without any role in KisanKraft’s management, they had no ability to force the company to issue a dividend. Pet.App.73. For the Moores, it was payment enough that they were able to support KisanKraft’s “noble purpose…to improve the lives of small and marginal farmers in India” and see the good that it was doing. Pet.App.71. In 2018, the Moores discovered that they were liable for taxes on KisanKraft’s reinvested earnings going back to 2006 under the MRT. Pet.App.74. Ultimately, the Moores had to declare an additional $132,512 as taxable 2017 income and pay an additional $14,729 in tax. Pet.App.74–75.

The Sixteenth Amendment states: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.” Citing Eisner v. Macomber, 252 U.S. 189, 207 (1920), Moore argued that that tax payer did not receive any profits reinvested by the foreign corporation and “mere enrichment through increase in value of capital investment is not income in any proper meaning of the term.” Among those briefs filed in support of Moore’s position, an Amicus Brief of the U.S. Chamber of Commerce argues there is an unbroken line of precedent confirming that the 16th Amendment requires realization before income can be taxed. It argued the Ninth Circuit erred in finding that realization of income is not a constitutional requirement. Another Amicus Brief raises the issue of “what if” a tax on unrealized gains forced the tax payer to sell property so he or she could pay the tax. Citing Kelo v. City of New London, Conn., 545 U.S. 469 (2005), the writer, L.E. Simmons, notes a Fifth Amendment “taking” issue could be implicated if unrealized income is taxed. In Kelo, the Court stated it would address the hypothetical cases of government-compelled sales to raise taxes if and when they arise, and the writer suggests this may be the case to take up that issue. The reason?: “Kelo suggests that the government is not supposed to have the right to compel a sale (even at fair market value) just to generate more tax revenues. A substantial tax on unrealized capital gains would thus implicate, and in some cases could abridge or violate, this Fifth Amendment right.” As significant, L.E. Simmons calls this type of taxation, the taxation of imaginary income. A tax on unrealized gains would “arbitrarily tax temporary upticks in valuation at year end without an assured refund mechanism if the asset declines in value in a later year.” This potential result, however, seems exaggerated since “capital gains are usually taxable only when realized by sale or other disposition.” See E. Toder, Examining the Tax Rules at Risk in SCOTUS Moore v. US Case.

Although most commentators believe the Supreme Court will find a way to uphold the constitutionality of the TCJA, the Tax Foundation writes that the “most extreme outcome would see the Supreme Court striking down taxes on all undistributed business earnings, whether earned domestically or from foreign sources.” Toder says “any Court decision in Moore that casts doubt on the constitutionality of taxing unrealized income will create considerable uncertainty for taxpayers and the government. It could lead to substantial revenue losses and embolden taxpayers to take more aggressive positions on their unrealized income, in the hope that future court rulings sanction their tax planning choices.”

This case will not be argued until December and it’s unlikely a decision would be issued this year. We will have to await an outcome that could turn tax law on its head.