Supreme Court appears wary of repercussions of major case that could upend tax code

Washington — The Supreme Court appeared inclined to leave in place an obscure tax provision enacted during the Trump administration during oral arguments on Tuesday, with several of the justices expressing concerns with the repercussions of a broad decision in the closely watched case.

The dispute before the justices, known as Moore v. U.S., involves the "mandatory repatriation tax," a one-time tax targeting U.S. taxpayers who held shares of certain foreign corporations. Charles and Kathleen Moore, who invested in a company based in India more than 15 years ago, brought the case, arguing that the tax is impermissible under the 16th Amendment because it taxes unrealized gains.

During more than two hours of arguments, the justices peppered lawyers for both sides with questions about the implications of their positions and appeared aware of how a sweeping ruling would reverberate across the U.S. tax system and put existing tax laws at risk. 

Solicitor General Elizabeth Prelogar, who represents the U.S before the high court, warned the justices that invalidating the mandatory repatriation tax would "cause a sea change in the operation of the tax code and cost several trillion dollars in lost tax revenue." But Andrew Grossman, who argued on behalf of the Moores, told the court that allowing a tax on income that a taxpayer has not yet received "sweeps away what the framers regarded as the essential check on Congress' power to tax property."

Addressing the ramifications of a decision striking down the mandatory repatriation tax on the tax system, Justice Sonia Sotomayor noted that the provision is similar to the tax treatment of partnerships, S-corporations and foreign corporations controlled by U.S. taxpayers.

"These are longstanding taxing mechanisms by the government," she said. "Your theory would undermine those as well, wouldn't it?"

She later pointed out that the drafters of the 16th Amendment, which clarified the federal government's authority to tax income, could have specified that only realized income could be taxed, but they didn't.

"The concept of realization was very well-established at the time the 16th Amendment was adopted, but the amendment does not reference realization," she said. "All that the drafters had to do was add the word 'realized' after income … but they never used the word 'realized.'"

Justice Elena Kagan said there is a "long, century-old history of these kinds of taxes on gains from your holdings in a foreign corporation" and questioned why the mandatory repatriation tax was different.

"Congress, the U.S. government can't tax those foreign corporations directly, and they wanted to make sure that Americans didn't stash their money in the foreign corporations, watch their money grow and never pay taxes on them," she said.

Moore v. U.S.

The legal battle over the mandatory repatriation tax dates back to 2006, when Charles and Kathleen Moore invested $40,000 in India-based KisanKraft Machine Tools in exchange for 13% of the company shares.

KisanKraft's revenues have grown each year since it was founded, and the company has reinvested its earnings to expand the business instead of distributing dividends to shareholders.

The Moores did not receive any distributions, dividends or other payments from KisanKraft, according to filings with the Supreme Court. But in 2018, the couple learned they had to pay taxes on their share of KisanKraft's reinvested lifetime earnings under the mandatory repatriation tax, which was enacted through the Tax Cuts and Jobs Act, signed into law by President Donald Trump the year before. The tax was projected to generate roughly $340 billion in revenue over 10 years.

The tax required U.S. taxpayers who owned at least 10% of a foreign company to pay a one-time tax on their proportionate share of the company's earnings. As a result of the new requirement, the Moores were assessed to have an additional $132,512 in taxable income and had to pay $14,729 more in taxes.

The couple paid the tax but filed a lawsuit against the government seeking a refund and challenging the mandatory repatriation tax as unconstitutional.

A federal district court sided with the U.S. government and dismissed the case, concluding that the mandatory repatriation tax is a tax on income permissible under the 16th Amendment, which granted Congress the authority to tax "incomes, from whatever source derived."

The U.S. Court of Appeals for the 9th Circuit affirmed the lower court's decision, finding that "there is no constitutional prohibition against Congress attributing a corporation's income pro-rata to its shareholders."

The Moores asked the Supreme Court to review the 9th Circuit's decision, arguing that the mandatory repatriation tax operates as a tax on property, not income. Grossman warned the justices that if it sides with the Biden administration, it would "open the door to taxation of practically everything." 

In court filings, lawyers for the Moores noted that legislation has been introduced in Congress to establish a so-called wealth tax, while the White House has proposed what it calls a billionaire minimum income tax.

"All property that we have is made up of flows of income that have been invested," Grossman said. "If all that was necessary was some level of income, then Congress could simply point at anything and say at some point this was income, at some person at some level, and therefore it can be subject to taxation."

But the Justice Department disagreed, and Prelogar told the court that the mandatory repatriation tax is "firmly grounded in the 16th Amendment's text and history." The provision, she said, taxes income that was realized by the foreign corporation and attributed to U.S. shareholders, which is similar to other pass-through mechanisms.

"The constitutional question is actually quite easy and it doesn't require the court to consider some of the foundational questions about the meaning of the 16th Amendment in other contexts," Prelogar told the court. "Here, we have paradigmatic realized income at the entity-level and this functions just like the pass-through taxes on partnerships."

Warnings of disruptions to the tax system

The potential impact of a decision by the Supreme Court addressing Congress' power to tax certain types of unrealized gains, and, conversely, the consequences a ruling invalidating the mandatory repatriation tax would have on the broader tax system, sparked questions from many of the justices.

Justice Brett Kavanaugh suggested that the court could rule narrowly and avoid the question of whether income must be realized in order to be permissibly taxed under the 16th Amendment.

"Even assuming or leaving open whether realization is a constitutional requirement, there was realized income here to the entity and then it's attributed to the shareholders in a manner consistent with how Congress has done that and this court has allowed," he said.

But Justice Neil Gorsuch repeatedly pressed Prelogar to lay out the limits of Congress' taxing power, suggesting that siding with the government could prompt lawmakers to levy new taxes, such as on Americans' retirement accounts or gains in the value of property.

"Would you agree that when the court opens a door, Congress tends to walk through it?" he asked.

Justice Samuel Alito said it's a "fair argument" that if the Supreme Court rules for the Moores, "large, important pieces of the tax code will also logically fall," citing concerns raised by Prelogar in filings. But he said he wanted to understand the limits of the government's position.

"How far may Congress go in attributing income to someone who has not realized that income, in the standard understanding of that term?" he asked.

The effects of a decision striking down the mandatory repatriation tax was raised in several briefs filed with the court in the run-up to arguments.

The American Tax Policy Institute warned that a decision invalidating the mandatory repatriation tax could have a broad reach throughout the U.S. tax system and "create doubts about the constitutional status of many provisions, generating a wave of tax refund claims and litigation in the coming years." 

Former House Speaker Paul Ryan, who led the chamber when it passed Republicans' tax reform plan in 2017, called the Moores' lawsuit a "misguided challenge," and warned that if the justices rule for the couple, "a lot of the tax code would be unconstitutional."

"I'm not for a wealth tax, but I think if you use this as the argument to spike a wealth tax, you're going to basically get rid of, I don't know, a third of the tax code," Ryan said during a September event at the Brookings Institution.

Recusal questions

While the case attracted input from a slew of nonprofit organizations and states, it was also ensnared in the ongoing scrutiny over the ethics practices at the Supreme Court after Alito participated in interviews with David Rivkin, a lawyer who is representing the Moores, and James Taranto, an editor at the Wall Street Journal.

In the article published in the Wall Street Journal in July, Alito criticized Congress for its efforts to impose a binding code of conduct on the Supreme Court and said it does not have the authority to regulate the high court. The Supreme Court adopted its own code of conduct, the first in its history, last month, though it lacks an enforcement mechanism.

In response to Alito's interviews, Democrats on the Senate Judiciary Committee urged Chief Justice John Roberts to ensure Alito recused himself from future cases concerning legislation that regulates the Supreme Court and the tax dispute brought by the Moores. The Senate Democrats warned that Rivkin's access to the justice could create an appearance of impropriety.

But Alito refused to step aside from the case, saying in a statement in September there was "no valid reason" for his recusal. Alito argued Rivkin was participating in the interviews as a "journalist, not an advocate," and said the case pending before the high court was never mentioned.

A decision from the Supreme Court is expected this summer.