The sweeping tax reform enacted in 2017 (the Tax Cuts & Jobs Act) significantly reworked the ways in which individuals, corporations, and pass-through entities are taxed. However, one important but often overlooked change was the shift from a worldwide tax system to a hybrid tax system that’s a cross between the territorial system and the worldwide system. Previously, an individual or corporation paid tax on their foreign earnings, but only upon repatriation. But post-2017, there was a deemed repatriation (Internal Revenue Code Section965) in the form of a one-time mandatory “transition tax” on accumulated untaxed earnings of foreign corporations.
The Mandatory Repatriation Tax (MRT) was imposed on domestic taxpayers at the rate of 15.5% for foreign earnings held in cash and at 8% for other earnings held in illiquid assets. Six years later, the U.S. Supreme Court will finally hear the case of Charles and Kathleen Moore vs. the United States, which challenges the legality of MRT. Moore has significant implications for affluent individuals and multinationals because the very definition of income, the 16th amendment and the future of taxation in America will be argued. You and your clients will want to pay close attention to the outcome of Moore as it unfolds in December.
Case Facts
The Moores are a 60-something couple from Redmond, Wash. who invested $40,000 in an Indian company, KisanKraft Machine Tools. To date, they’ve received no dividends or distributions from that investment. MRT applies to American-owned companies that conduct business in foreign countries. MRT imposes a one-time tax on investors’ shares of profits that haven’t been passed along to them. That’s to comply with the transition to the new hybrid tax system. Thus, at prevailing rates, the Moores faced a $14,729 tax bill on their $40,000 investment—even though that investment has generated no realized income to date. But that’s only a small part of the real story.
“Jerry, all these big companies, they write off everything” – Cosmo Kramer (Seinfeld)
Cosmo Kramer’s ignorance of tax law is funny because it reflects a reality for most Americans. If I asked you to think of one word most often associated with taxes, I doubt you’d say “revenue.” But revenue is the Internal Revenue Service’s middle name. And because the last four fiscal years have accounted for the largest deficits in U.S. history (unadjusted for inflation and excluding 2009), the agency has been on an aggressive revenue hunt. Suddenly the Moores’ obscure $14,729 tax bill has implications above its weight class.
Since partners in a partnership are taxed even when cash isn’t distributed, could the same rules soon apply to corporate shareholders? While shareholders haven’t “realized” any cash distributions income that can be taxed under the 16th Amendment, the government will argue that there’s no “realization” requirement in the Constitution—only evidence of economic gain or profit. So, the government will likely argue that a shareholder’s economic gain is a share of the company’s income, even if it’s not yet distributed.
A Wealth Tax
The wealth tax was a fringe ideology when Elizabeth Warren talked about it frequently on the 2020 presidential campaign trail. But now it’s become mainstream. So much so, that it’s been included in every Greenbook presented by the Biden administration. While no specific guidance exists, the general concept calls for an annual tax (separate from and in addition to income tax) to be applied at a set rate on a taxpayer’s net worth in excess of a threshold. So, the wealth tax would tax unrealized capital gains – every single year.
Think of the wealth tax as an estate tax in which everyone is deemed to have died each year. That sounds absurd, but Warren’s plan has gained support for its highly progressive (in a tax sense) nature and the wealthy’s perceived exploitation of the existing tax code. It should be noted that beyond the legal barriers, there’s no established framework to address such a tax from the taxpayer or IRS sides.
Right to Collect Taxes
The 16th amendment to the U.S. constitution, passed by Congress in 1909 and ratified in 1913, gave itself the right to collect taxes. Here’s an important excerpt:
“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.”
The idea that the federal government had difficulty raising money is hard to imagine today. The second half of the amendment regarding apportionment among states was the focus in the early 20th century as a response to an 1895 Supreme Court case, Pollock v. Farmers' Loan & Trust Co. However, the word “incomes” is at the heart of Moore.
In 1920, we get a critical interpretation of the 16th amendment from the Supreme Court in Eisner v. Macomber. The Court ruled that stock dividends weren’t income. “Mere growth or increment of value in a capital investment is not income; income is essentially a gain or profit, in itself, of exchangeable value, proceeding from capital, severed from it.” Further, another landmark 1955 case upheld the requirement for realization in Commissioner v. Glenshaw Glass.
In contrast, we have plenty of examples of “unrealized” income being taxed such as pass-through entities, constructive sales under IRC Section 1259, and even some reorganizations (see the 1938 Supreme Court case of National Grocery Co. v. Commissioner). There’s evidence for potential outcomes in either direction. Regardless of the inflection point at which we stand today, there are many good opportunities for planning.
Planning Opportunities
While the wealth tax and MRT may seem like uncharted territory, we can rely on fundamental principles and techniques to address this novel situation. When it comes to the MRT, you can really help clients plan for their liquidity, including potential exit opportunities and any related capital gains or losses. More broadly, you can help them plan for a potential wealth tax using similar tactics to address gift and estate taxes. As I wrote recently, focus on gifting illiquid business interests with high potential for appreciation out of clients’ estates. Consider a family limited partnership to manage succession and tax planning, and engage experienced and credentialed professionals for any legal, tax or valuation issues.
Substantial Impact
Moore could have a substantial impact on U.S. tax policy and revenue collection. It could invalidate some current U.S. tax policies and a broad ruling could stretch far beyond the provision contested by the plaintiffs. It could also proscribe potential future tax policies that Congress may wish to adopt when it comes to changing international tax norms. The size of the impact hinges on the scope of the Court’s ruling.
Anthony Venette, CPA/ABV is a Senior Manager, Business Valuation & Advisory, DeJoy & Co., CPAs & Advisors in Rochester, N.Y. He provides business valuation and advisory services to corporate and individual clients of DeJoy.