Can Congress Tax Unrealized Income? SBE Council Weighs in on SCOTUS Case

By at 17 October, 2023, 11:54 am


By Barbara Weltman –

Can Congress tax unrealized income?

That’s the big question before the U.S. Supreme Court in Moore v. U.S.  The Court will consider the question during its 2023-2024 term, which started October 1, 2023. There’s no telling when a decision will be announced; it could be as late as June 30, 2024. But understanding the issue and what’s at stake for the U.S. tax system is important for everyone.

What Moore is All About

To understand what the case is about, consider the tax changes that gave rise to it.

Before the Tax Cuts and Jobs Act of 2017 (TCJA), there was a worldwide tax system which allowed corporations to exclude foreign earnings until they were brought back on shore, effectively deferring the tax. Many corporations didn’t repatriate these earnings, deferring taxes indefinitely.

The TCJA changed the tax system to a territorial system, which was more in line with other countries, including Canada, United Kingdom, and France. To make the transition, the TCJA created a one-time rule – referred to as a transition tax or a mandatory repatriation tax – to tax accumulated unrepatriated earnings at a rate of 12.5% for earnings held in cash and 8% for earnings held in other assets. It applies to shareholders owning at least 10% of a controlled foreign corporation (CFC).

A foreign controlled corporation is one that is 50% or more owned by U.S. shareholders. An election could be made to spread the tax over eight years, beginning in 2017.

The case involves a couple who are part owners of CFC located in India. Their corporation has retained earnings of $508,000, triggering a tax liability to them of about $15,000. They challenged the constitutionality of the tax on the grounds that the 16th Amendment to the U.S. Constitution, allowing Congress to impose an income tax, doesn’t apply to unrealized income (the basis of the transition tax).

What a Decision in the Case Could Do

It’s hard to predict what the Court will do. It could find the transition tax to be perfectly constitutional. It could agree with the constitutional arguments of the Moores and rule narrowly, focusing only on the transition tax. Or it could rule broadly and find that other provisions of the TCJA must fall.

The Tax Foundation estimates that an expansive decision would result in nearly $5.7 trillion in “lost” revenue for the federal government over the next 10 years.

Even if the Moores are successful, taxpayers who paid the transition tax may or may not be able to get a refund. Those who paid it in a lump sum in 2017 or 2018 are out of luck because of the statute of limitations. Those who opted for the 8-year spread may recoup some of the taxes paid if they file refund claims (the government won’t automatically issue them).

SBE Council Weighs In

The Small Business & Entrepreneurship Council (SBE Council) has filed an amicus brief with the U.S. Supreme Court, arguing that if the Court finds the transition tax to be unconstitutional, it should sever the provision from other foreign tax rules created by TCJA. While other parties have filed amicus briefs for or against the constitutionality of the tax, SBE Council is the only one addressing the issue of severability.

SBE Council strongly supported the TCJA, such as the domestic provisions that lowered corporate and individual income-tax rates, the deduction for qualified business income, and the 100 percent bonus depreciation rules, among others. It also supported the international-tax provisions of the TCJA, which created the Repatriation Tax. In its amicus brief, SBE Council asserts that if the Court were to hold the Repatriation Tax unconstitutional “without addressing the effect of that holding on other provisions of the Internal Revenue Code of 1986,” such “uncertainty would be highly detrimental to small businesses and entrepreneurs.”

According to SBE Council’s brief:

“If the Court sustains petitioners’ challenge, it should avoid the deleterious effects of uncertainty by clarifying the scope of its ruling. Specifically, the Court should make clear that, if petitioners cannot constitutionally be compelled to pay the Repatriation Tax, the requirement to pay that Tax is severable from the remainder of the Internal Revenue Code, which continues to function whether or not the Repatriation Tax is paid.”

The brief goes on to explain its position and the precedent of severability.

According to SBE Council president & CEO Karen Kerrigan, the TCJA “was the most significant overhaul of the federal tax system since 1986, which included key changes that foster a more competitive environment for businesses of all sizes, including small businesses and entrepreneurs. It created a more level cross-border playing field for U.S. businesses of all sizes. If the transition tax is deemed unconstitutional, the Court should go further and apply severability to save other aspects of the TCJA, which would promote certainty.”

Final Thought

If the Court decides to side with the government’s position enunciated in the holding of the federal appellate court in the Ninth Circuit, Congress could begin taxing all kinds of unrealized income. That means, for example, a wealth tax that’s already been suggested could gain traction. If it holds in favor of the taxpayer and the federal government loses significant revenue, small businesses could face additional taxes, while the TCJA’s other positive provisions remain intact.

So, the Court’s decision could produce several negative outcomes for entrepreneurs and small businesses. Congress would likely be forced to act more quickly if the Repatriation Tax is ruled unconstitutional, but making it severable, as SBE Council argues, could at least provide some level of certainty in an environment where Congress may be scrambling for tax dollars.

Barbara Weltman is a member of SBE Council’s advisory board, and has been a leading consultant for small businesses of every kind for over twenty years. She’s the founder of Big Ideas for Small Business® and has written numerous books on small business operations, including J.K. Lasser’s Small Business Taxes, Complete Idiot’s Guide to Starting a Home-Based Business, and The Rational Guide to Building Small Business Credit. Follow Barbara on Twitter @BigIdeas4SB.

News and Media Releases