Take-Away: In light of the ambiguity of how income is defined by federal courts when it comes to the right to tax income under the 16th Amendment, an expansive interpretation of income might actually be viewed as a taxation of accumulated wealth.

Background: A little over a year ago, Senators Sanders and Warren created quite a stir with their proposal to tax wealth instead of, or more accurately in addition, to taxing income. Their bills never became part of the Tax Code, so they were soon forgotten, and probably will not to be revisited so long as Republicans control the House of Representatives. Many who derided these ‘wealth tax’ proposals correctly pointed out that the U.S. Constitution prohibits the imposition of a tax on wealth. Specifically, the 16th Amendment to the U.S. Constitution authorizes the federal government to only tax income, not wealth. Consequently, any proposal to directly tax wealth is widely understood to be unconstitutional. Yet, coming as a surprise to many, Congress apparently may have passed something akin to a wealth tax in 2017, back when  Republicans controlled Congress and the White House.

2017 Tax Act: The 2017 Tax Act, aka the 2017 Tax Cuts and Jobs Act, imposed a one-time retroactive tax applicable to individual U.S. shareholders of foreign corporations. Under the prior law U.S. shareholders had to pay income taxes on overseas  corporate income, but only when that income was repatriated to the U.S. in the form of paid dividends. The 2017 Tax Act abolished this tax on overseas income, which was done in large part to make the U.S. tax system align with most other developed countries. However, the 2017 Tax Act also created a mandatory repatriation tax on the corporation’s undistributed income since 1986 (going back, in effect, 30 years) payable not by the corporation but by its shareholders. 

In effect, the result was that without selling their stock or receiving a dividend, U.S. investors were nonetheless deemed to have received ‘income’ and suddenly they became liable for this new tax without any transaction, exchange, or other taxable event. Was this new one-time retroactive tax unconstitutional as a tax on accumulated wealth and not a tax on income? A recent court decision seems to suggest at a tax on wealth is permissible, despite the limitations of the 16th Amendment to the Constitution, if an expansive definition of income is used by the court to reach that outcome.

Moore vs. United States, U.S. Ninth Circuit Court of Appeals, No. 20-36122 (June 7, 2022)

In a surprise court decision, the U.S. Ninth Circuit Court of Appeals dismissed a challenge to the 2017 one-time retroactive  tax, the Mandatory Repatriation Tax, or MRT, despite the fact that it seems to appear to be more of a wealth tax. The implication of this court decision is that it upends a formidable  principle of U.S. taxation, which is that to create taxable income there must be a transaction or realization event, which is what distinguishes an income tax from a tax on property, or wealth.

Facts: In 2005, the Moores invested $40,000 for 11% of common shares in KisanKraft, a tool and die company, which is located in India. KisanKraft never distributed any earnings, always reinvesting its earnings. With the adoption of the MRT, the Moores immediately owed in 2018 an additional $132,512 in MRT, based upon KisanKraft’s $508,000 in retained earnings.

Trial Court: The Moores challenged the additional MRT tax on the basis that it was unconstitutional. The District Court granted summary disposition. It found that the MRT taxed income, and while the tax was retroactive, it did not violate the 5th Amendment’s Due Process Clause.

Appeals Court: The Appeals Court sustained the District Court’s dismissal of the Moore’s complaint, The Court addressed several arguments raised by the Moores, but it ultimately held that the MRT is a tax on income, even though that income was not ‘realized’ in the conventional sense of that term normally encountered in the Tax Code. Some arguments addressed or principles asserted by the Court follow, as ‘snapshot’ observations (the decision is 17 pages long.)

Apportionment Clause Applied to Direct Taxes: This Clause in the Constitution  provides “No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.” This requirement means that any ‘direct tax’ must be apportioned so that each state pays in proportion to its population. The Apportionment Clause traditionally applies only to capitations (e.g. a direct tax paid by every person without regard to property) and land taxes.

Income Defined Expansively: “The Sixteenth Amendment, ratified in 1913, exempts from the apportionment requirement the expansive category of ‘incomes, from whatever source derived’. In U.S. v. James we noted the difficult of categorically defining everything that constitutes ‘income.’ The courts have given wide scope to the income tax, but have realized that the borderline content of income must be determined case by case. Despite the difficulty in defining ‘income’, courts have held consistently that taxes similar to the MRT are constitutional.”

Income Attribution Okay: “There is no blanket constitutional ban on Congress disregarding the corporate form to facilitate taxation of shareholders’ income. In other words, there is no constitutional prohibition against Congress attributing a corporation’s income pro-rata to its shareholders…And here, there is no dispute that KisanKraft [the foreign corporation] actually earned significant income, though all tax that the Moores’ owed the U.S. Government on their pro-rata share of KisanKraft was deferred until the MRT went into effect in 2017.”

Single Date of Repatriation Rational: The acceleration of the effective repatriation date of undistributed corporate earnings to a date after the passage of the 2017 Tax Act is a legitimate purpose of taxation. “Having a single date of repatriation is a rational administrative solution.”

Realization Not Necessary: “Whether the taxpayer has realized income does not determine whether a tax is constitutional… In a variety of circumstances it has been held that the fact that the distribution of income is prevented by operation of law, or by agreement among private parties, is no bar to its taxability. And the Supreme Court has made clear that realization of income is not a constitutional requirement: The rule that income is not taxable until realized is founded on administrative convenience and is not one of exemption from taxation where the enjoyment is consummated by some event other than the taxpayer’s personal receipt of money or property.”

Ignoring Corporate Form: “There is no blanket constitutional ban on Congress disregarding the corporate form to facilitate taxation of shareholder’s income. Nothing prevents Congress from bypassing the corporate entity in determining the incidence of Federal income taxation.”

Observation: These quotes from the Court’s decision give you a sense of what looks like a retroactive tax on accumulated wealth  is portrayed as merely accumulated income which Congress is free to tax at any time, in any manner, and despite who or what legally controls that accumulated income. Can the same be said for capital gains, i.e. wealth, which is not yet realized by the owner of the appreciated asset? If this case accurately describes the scope of Congress’ taxing power, will it be a ‘green light’ to tax every U.S. investor in a domestic corporation the same way? If this is an accurate description of Congress’ taxing power, then there would be no constitutional bar to require that shareholders pay income tax on their proportionate share of accumulated and undistributed earnings of every corporation in which they, or their 401(k) account hold stock.

Conclusion: I wonder if this case will be appealed to the U.S. Supreme Court, which might finally give us a clear definition of what the word income actually means when it comes to the 16th Amendment to the U.S. Constitution.