This past week, the Supreme Court in Moore v. United States upheld the power of the US government to impose a mandatory repatriation tax (MRT) on income in an American-controlled foreign corporation that has been returned to the United States after it went untaxed while kept abroad. The MRT imposed a tax of $14,729 on Charles and Kathleen Moore, even though they could not lawfully take that money out of the Indian farm-equipment company, known as KisanKraft, in which they had invested. That situation is not unusual under US tax law, which imposes a tax at the partner level on income that has been earned and retained because it cannot be distributed because of, for example, a dispute among the partners as to its proper allocation.
The rule followed in Moore, if extended widely, could easily create a liquidity crunch, which is why it was easy enough for Congress to postpone the tax until the money was received by the individual shareholder or partner. Timing questions like these run through the Internal Revenue Code. Justice Brett Kavanaugh’s majority opinion noted that cases like Heiner v. Mellon (1938) had long imposed that tax, so the odds of the Moores winning on that point were always slim, given the broad power of Congress to fine-tune the tax system under the Sixteenth Amendment, which reads:
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.
All forms of income are touched, and the references to apportionment and the census were intended to remove any doubt that income from property was taxable, overruling the decision in Pollock v. Farmers’ Loan and Trust Co. (1895), which struck down such a tax as an unapportioned direct tax. The plaintiff insisted that a tax on unrealized income is a tax on property to which the old apportionment rules applied. But no, it is not a poll tax or a tax on real estate, so that argument too cratered.
At first blush, therefore, it is hard to see why an arcane case like Moore should generate much interest. The explanation is that the plaintiffs used this as a vehicle to insist that the realization requirement first stated in Eisner v. Macomber (1920) should become a hard and fast constitutional norm that would do two things: first, prevent the imposition of a tax on unrealized appreciation in all sorts of assets, including the shares of public and private corporations; and, second, serve as a barrier against a tax on wealth over a certain amount, sometimes set at $50 million per annum and upward, even if total wealth declined during the period.
To back up, Macomber involved a recapitalization of the Standard Oil Company by a 50 percent common-on-common stock dividend, in which the gain in value from the new shares was exactly offset by the reduction in value of the remaining shares. This is why, even today, this recapitalization is a poor candidate for taxation. The academic offensive against Macomber went into high gear shortly after the case went down. The key weapon was a dual offensive first by Robert Haig in 1921 and then by Henry Simons in 1938, both of whom defined income as the accretion of net wealth between any two points in time (plus consumption), which has no realization requirement at all.
In my view, it was a mistake for the plaintiffs to push the realization requirement outside of Moore’s narrow context. Indeed, John Yoo and I wrote an amicus brief for the plaintiffs that spent most of its time explaining why it was utterly imprudent to seek to impose, against one hundred years of uniform practice, a general tax on unrealized appreciation of shares of public or closely held companies, or indeed any land, art, litigation, insurance claim, or other asset. Under current law, these items are not typically taxed until they are sold or exchanged. A tax on unrealized income would expose wealth in these forms to immediate taxation, which would generate two enormous problems: first, some assets would have to be sold or mortgaged to pay the taxes, which would create an end-of-the-year stampede of assets that would destabilize financial markets, as major fluctuations could happen within minutes. Second, the estimation of the fair market value of these multitudinous assets—not an issue in Moore—could easily take years to estimate for a large portfolio with literally thousands of assets held in complex vehicles. Those pyrotechnics cannot be executed in income taxation that works on the calendar year.
The ultimate motive for this lawsuit was to insist that no wealth could be taxed until it was realized, which would solve both of these problems. Justice Kavanaugh’s majority opinion wisely refused to rule on this issue. A concurrence by Justice Amy Barrett, joined by Justice Samuel Alito, delved into the dangers of taxing unrealized income, as did a dissent by Justice Clarence Thomas, joined by Justice Neil Gorsuch. But on the other side of the ledger, in her concurrence Justice Ketanji Brown Jackson said the door to the tax on unrealized appreciation was still left open. The Wall Street Journal worried that a “Supreme mistake” on wealth taxes had been committed. The New York Times applauded because, in its view, a wealth tax was still on the table. Its position was enthusiastically endorsed by both Senators Elizabeth Warren and Ron Wyden, who noted that “billionaires should have to pay a fair share of taxes like everybody else.”
Fortunately, it appears that the wealth tax is unconstitutional no matter what the proper role of realization is because wealth is a static quantity (not so the accretion of wealth, which is a minimum condition of any income tax under Haig-Simons). But that same categorical argument cannot be made against a tax on unrealized income. Unfortunately for the plaintiff, the realization requirement under a mature tax system is both too permissive and too restrictive at the same time.
Where the realization requirement works best is with the receipt of cash and marketable securities that can easily be converted into cash, so that their immediate taxation lies at the heart of any sound taxation system. Indeed, in order to prevent tax gaming under a progressive system of taxation, it has long been correctly held that income must be taxed to the professional who earned it and not to the spouse to whom it was directly paid by the employer.
Yet, there is a second class of assets for which receipt is not an appropriate taxable event and the initial nonrecognition of gain is the proper response. I am still haunted by the question that the late Boris Bittker asked a class of budding lawyers in 1966: are you taxed on the full value of your new partnership interest as of the date of its acquisition? The answer, by acclamation, is no: no to the prospect of paying taxes on millions in taxable income long before the cash is actually received. And that is, to this day, why a recapitalization is a tax-free reorganization under the Internal Revenue Code. Forcing the sale could create both liquidity and valuation problems, so that the proper tax treatment, for rich and poor alike, is to postpone the tax until those shares are disposed of in a way that realizes either cash or marketable securities.
The existence of a third class of assets, however, is what dooms any effort to impose a universal realization precondition for all transactions. There is a large set of pure financial assets like stock options, puts and calls, that are not tied directly to productive assets, but which trade to secure liquidity and provide hedging functions necessary for the stability of domestic and international financial markets. But these assets present no valuation problem, and their sale in no way requires the liquidation of shares or other interests in productive assets. To require realization as a precondition for gain allows an easy road to tax evasion. Buy a put (the right to sell shares at a certain price), and then buy a call (the right to buy shares at a certain price), knowing that one will go up and the other down. Sell for the loss and postpone the gain. There is no reason to allow this kind of behavior, which is why the realization rules are wholly out of place in this environment. This is why Justice Kavanaugh noted that making realization a universal prerequisite would cut huge holes through the Internal Revenue Code.
To my mind, it was unwise for the plaintiff to push for the universal realization requirement in light of the sensible uniform practice that confines it to limited circumstances. So, does this mean that there are no obstacles to the tax on unrealized appreciation of most assets? That would mark a massive and unwise departure from sound practice. At this point, I would point to this wise observation of Justice Kavanaugh when he wrote in Moore that “long settled and established practice can carry great weight in resolving constitutional questions.” This appeal to tradition calls for keeping the realization requirement where it has long done its most important work—blocking taxation on unrealized appreciation of virtually all capital assets.
