On June 20, the US Supreme Court issued its decision in Moore v. United States, upholding the constitutionality of the Mandatory Repatriation Tax under the Tax Cuts and Jobs Act of 2017. The Moore decision is one high net worth individuals and their advisors do not want to ignore. If nothing else, the decision reaffirms Congress' broad taxing authority, but leaves open important questions about the future of wealth taxation in the United States.
Background
Charles and Kathleen Moore invested $40,000 in KisanKraft Tools, an American-controlled foreign corporation based in India. From 2006 to 2017, KisanKraft generated significant income but did not distribute it to shareholders. Under the TCJA, the MRT imposed a one-time tax on the retained earnings of American-controlled foreign corporations, attributing this income to American shareholders and taxing them accordingly. The Moores faced a tax bill of $14,729 on their pro rata share of KisanKraft's accumulated earnings, prompting them to challenge the MRT as an unconstitutional direct tax.
Legal Precedents and Court Analysis
To understand the decision, let's look at the historical precedents that shaped the Court's interpretation of the constitutionality of the RTM. The Court's analysis relied heavily on earlier decisions that distinguished between direct and indirect taxes and reaffirmed Congress' broad taxing powers under Article I of the Constitution.
Here are the main cases that played an important role in the decision:
- Brushaber v. Union Pacific R. Co . (1916): This case held that the 16th Amendment allows Congress to tax income from any source without apportionment. The decision emphasized the broad taxing power of Congress and reinforced the distinction between direct and indirect taxes.
- Burnet v. Leininger (1932): The Court reiterated that Congress can tax either the partnership or the partners on the undistributed income of the partnership. This decision determined that the taxation of the income attributed to the partners is allowed by the Constitution.
- Helvering v. National Grocery Co . (1938): This decision confirmed that Congress can tax shareholders on a corporation's retained earnings, aligning corporate tax principles with those applied to partnerships.
- Eisner v. Macomber (1920): Although the realization of income was discussed in this case, it did not specifically address the attribution of income, which later cases clarified. Eisner defined income for tax purposes as “profit derived from capital, labor, or both” and emphasized that income must be realized before it can be taxed. This case set the stage for debates over income realization in tax law, influencing how later courts viewed the distinction between realized and unrealized income.
These precedents, albeit dated, collectively shaped the Court's approach in Moore and provided a legal framework for evaluating the constitutionality of taxing corporate retained earnings attributable to shareholders.
Constitutionality of RTM
The decision in Moore focused narrowly on the constitutionality of the MRT as an income tax. The majority opinion, delivered by Justice Brett Kavanaugh, held that the MRT does not exceed the constitutional authority of Congress. The decision stated that the MRT taxes “realized” income, specifically the income realized by KisanKraft, which is attributed to its American shareholders.
Kavanaugh pointed out that Congress has historically taxed entities' retained earnings by attributing it to shareholders or partners and then taxing them. The Court has consistently supported this approach, aligning the MRT with precedents regarding subpart F income, S corporations, and partnerships. The Court held that such methods of taxation are constitutional, pointing out that Congress can attribute an entity's realized and retained earnings to shareholders and tax them accordingly.
Implications for wealth tax
Moore's decision, while narrow, opens the door to important discussions about a wealth tax. One of the key elements of the decision is its interpretation of income and the realization requirement. In holding that MRT taxes realized income attributable to shareholders, the Court upheld Congress's power to tax undistributed corporate income realized by shareholders. This leaves room for further judicial interpretation and legislative action in relation to a wealth tax, particularly the determination and taxation of income.
Moore's decision sets the stage for a potential shift in the way estate taxes are approached in the United States, especially in an election year. With one party potentially gaining control of the House, Senate and White House, the possibility of passing significant tax legislation, including an estate tax, becomes more feasible.
The government's need to generate revenue to address budget deficits and finance public programs is an important motivation. A wealth tax could provide a significant source of revenue by targeting the unrealized gains and accumulated wealth of HNW individuals. The decision supports the continuation and possible expansion of taxation of corporate retained earnings, which can play a decisive role in fiscal policy. Moreover, the decision provides a constitutional framework that can be used to justify such legislation, making it a focal point of political campaigns and policy discussions.
The dissenting opinions and concurrences in Moore suggest that future attempts to impose an estate tax in the United States would need careful statutory structuring to withstand scrutiny. The challenge is to clearly and consistently define what constitutes income versus wealth and to ensure that any new tax regime complies with established constitutional principles.
Indirect Tax vs. Direct Tax
The decision reinforces the notion that income taxes are indirect taxes. If a wealth tax were structured similarly to MRT, which attributes to taxpayers increases in the value of assets (similar to profits or income) and then taxes them, it could be argued that the tax it is indirect, so it does not require division. This interpretation may provide a path to implementing an estate tax without violating the constitutional requirement of segregation.
The requirement of realization
A critical aspect of the Moore decision is the discussion of realized income. The court pointed out that MRT taxes realized income – income earned by the corporation and attributable to shareholders. This precedent can affect the structure of an estate tax, affecting many of your clients. If a wealth tax involves attributing increases in the value of assets to taxpayers, whether these increases must be realized to be taxable (ie, through a sale or other conversion to cash) remains an open question. Future cases will have to address whether realization is a constitutional requirement for income taxation and how this principle can be applied to wealth taxes.
How counselors can adapt
The introduction of a wealth tax would present new challenges and opportunities for advisers to help their clients. A wealth tax can be broadly similar to a wealth tax. Proactive estate planning strategies can also help mitigate an estate tax. Additionally, the lack of a comprehensive framework of service providers to address wealth tax compliance and planning presents a significant challenge.
Advisors must adapt and potentially expand their service offerings to meet these new demands. They must develop expertise in new areas of tax law to navigate the complexities of wealth tax, including the challenges of taxing unrealized gains. They will need to collaborate with technology providers to create effective compliance tools. An integrated approach involving legal, financial and technological experts is essential for providing comprehensive solutions. This collaboration will help address regulatory scrutiny and administrative burdens while optimizing tax outcomes for clients.
Questions remain
The decision underscores the complexity of the US tax system and the constitutional challenges associated with imposing new forms of taxation, such as the estate tax. While the decision upholds the RTM as a legitimate income tax, it leaves open important questions about the future of wealth taxation. HNW individuals and their advisors must navigate these uncertainties, realizing that any future estate tax proposal will likely face rigorous legal and constitutional scrutiny. This decision drives a need for careful planning and adaptation to ensure compliance and optimize tax outcomes for clients.
Anthony Venette, CPA/ABV is a Senior Manager, Valuation and Business Advisory, DeJoy & Co., CPAs and Advisors in Rochester, New York. He provides business valuation and advisory services to DeJoy's corporate and individual clients.