In 2017, Congress made several permanent changes to the taxation of foreign earnings with the enactment of the Tax Cuts and Jobs Act (TCJA), P.L. 115-97 . The TCJA imposed a deemed repatriation (Sec. 965). In the Moore v. United States case, the constitutionality of this policy is being challenged.
Listen to Tony Nitti, CPA, Tax Partner — EY, and Damien Martin, CPA, Tax Partner — EY, discuss the pending case live from the 2023 AICPA & CIMA National Tax & Sophisticated Tax Conference, as well as the top tax cases of all time.
What you’ll learn in this episode
Background on the case and case law history involving U.S. taxation (0:44)
Deeper dive into the history of U.S. tax law (11:41)
Hylton v. United States, 3 U.S. (3 Dall.) 171 (1796) (20:38)
Temporary income tax enactment (23:47)
Pollock v. Farmers’ Loan & Trust Company, 157 U.S. 429 (1895) (26:06)
16th Amendment (28:36)
Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955) (34:13)
Lead up to the Moore case (35:20)
Advice for how to explain the Moore case to clients (41:24)
IRS resources
Section 965 Transition Tax — IRS webpage detailing Sec. 965, including an overview, what taxpayers are impacted and what potentially impacted taxpayers need to know.
Other resources
Charles G. Moore, et ux., Petitioners v. United States — Case whether the 16th amendment authorizes Congress to tax unrealized sums without apportionment among the states.
Transcript
April Walker: Hello everyone and welcome to the AICPA's Tax Section, Odyssey podcast, where we offer thought leadership on all things tax facing the profession. I'm April Walker, a Lead Manager from the Tax Section. I'm here today in person at the National Tax Conference with Tony Nitty and Damien Martin, both partners at EY.
They have a session here that's titled, “The Top Tax Cases of All Time.” If that's not a high bar to set, I'll be surprised, but I thought it might be fun to go over some of the highlights of that session on this podcast episode today.
Damien and Tony, I'm going to be here if you need me, but otherwise, I'm going to let you guys talk about the top tax cases of all time. Take it away.
Damien Martin: All right Tony, I don't know how we get better than that saying — the top tax cases of all time. But, I’ll let you set the stage here because we're not just going to geek out like we usually do. We're going to do that.
Tony Nitti: Somebody likes his buddy. I don't know how high up our gratitude needs to go. I don't know if it's April or the AICPA planning committee. I don't know if it's the Supreme Court in the United States. I don't know if it's a power even higher than that, whichever one you believe in, but somebody is looking out for us because, like you said, the description for this class is Tony and Damien are going to talk about the top court cases of all time.
As you alluded too, yeah, we were totally geek out on that. But, I know we were both a little bit worried that it would be more of an academic exercise and there wouldn't be any real practical takeaway.
It's not like everyone's going to go back to their respective offices and be better off because they understand the finer points of Duberstein or North American Oil. We were a little worried. But then we get this gift. We get this gift out of the State of Washington. A little court case involving $14,000 in disputed tax that the district court dismisses in favor of the government. Ninth Circuit does the same. But the Supreme Court of the United States decides, we're going to listen to this case.
Now it changes everything for you and me because when these oral arguments start in a couple of weeks, mid-December, everybody is going to be talking about this Moore case. And when I say everybody, I don't just mean like the people at AICPA National Tax, or people make their living in the tax world. It's gonna lead morning talk shows and it's going to be the front page of papers.
It's because while it's a small case, the implications are potentially huge. If I were to have to convince you, Damien Martin, why you should be paying attention to Moore and why all practitioners going to have to be able to talk about this stuff with their clients? What if I were to tell you that if the Supreme Court rules for Moore gone from the code goes section 965, the mandatory repatriation tax that was born as part of the Tax Cuts and Jobs Act, and potentially along with it, a couple of hundred millions of dollars of, did I say millions, a couple of hundred billions of dollars of federal income tax collected by the government.
Would that be enough to pique your interest?
Martin: You had me at a Supreme Court tax case, but when you're going to add billions to the hundreds of billions at that I'm sold.
Nitti: Okay, you're sold.
I don't make my living much in the international regimes. So, if it were me alone, I don't know if that's enough to pay attention, but what if I were to then say that depending on how a Supreme Court were to rule, also gone for the Internal Revenue Code could be all of the Tax Cuts and Jobs Act.
Everything we've spent the last few years getting our arms around lower individual rates, lower corporate rates, doubled the state tax exemptions, 199A, all of it gone. That would be interesting, right?
So, I'm going to listen to this conversation. Then what if I were to layer on top, buddy, that depending on how the Court would rule, it would open up the possibility soon stripped from the code could be all of pass-through taxation. No more subchapter S, no more subchapter K, no more S corps, no more partnerships. Say goodbye to all the pass-through regimes.
Now, everybody is going to be like, I need to stand up and take notice. How can one case potentially jeopardize all of that?
Martin: That's like a third of the code or something, but I'm a little bit…and you have to help me out here, Tony, because you said $14,000 was like $14,729. A third of the Internal Revenue Code itself. I'm a little bit like those are not the same thing.
You're going to have to bridge that gap for me here as to why something about $14,000 is in front of the Supreme Court.
Nitti: I'll do that. You're not alone with that one-third number. I think that's the same ratio that Paul Ryan, the former Speaker of the House, put on this and said, depending on how Moore goes, we can be kissing goodbye to a third of our tax law.
What makes this cool as we go through this process is in order to understand exactly the answer to the question you just asked, like, how is this possible, you and I need to go through the same cases that we would have been going through if Moore had never come to be only now we get to do it in a context that's meaningful for people here at the conference because they can take this information they're going to learn and then go back to the respective offices and actually use this in the coming weeks.
That's why I say somebody likes us because we get to have the same conversation that we both would have loved anyway, but now feel better about ourselves that we're adding some value to the people who are actually listening.
Moore, like this is not a complicated set of facts. There's nothing about the facts that speak to just how meaningful this case can be. It's a married couple out of the state of Washington. They retired, and in 2006, they have a friend and the friend sees a need in India to get small tools in the hands of farmers.
He conjures up this idea to form a company based in India, and the Moore's are intrigued and so they invest right around $40,000 for a 13% interest in this corporation's stock. It's pretty much the facts right there. Now, time goes on and the corporation does well, I think better than anybody could have hoped it would do. It's making some income year over year, but none of that income was distributed to the Moores.
In the international regime that we operated under at that time, when you have income being accumulated in a controlled foreign corporation, or CFC, generally speaking (and we'll get into one of the exceptions later in Subpart F), but generally speaking, U.S. shareholders don't pay any tax on that CFCs income until it's repatriated to the US in the form of a dividend.
Years are going by and this Indian corporation is making money but it never once repatriated anything in the form of a dividend to the Moores, so the Moores is never once have any taxable income as it relates to this investment in this corporation. Then 2017 rolls around.
Do you remember what happened in 2017, Damien Martin? What changed your life in 2017?
Martin: It's quite interesting. I can remember a lot of late evenings reading a lot of texts and that's different than usual, I guess. I'm not exactly sure but we had the Tax Cuts and Jobs Act.
Nitti: So the Tax Cuts and Jobs Act comes along. As part of that TCJA, and this is a world that you and I don't live in as much as others, but as part of that regime, they are going to switch us from a worldwide system of international taxation to a territorial system.
Really as a way to shortcut that explanation — in this new territorial system, if US shareholders own stock of a controlled foreign corporation, some of that income is going to be subject to the GILTI regime. But when the money is eventually repatriated in the form of a dividend from the CFC to the US shareholder, it won't be subject to tax.
But you can't just flip a switch and move from a worldwide regime to a territorial regime because there were trillions of dollars stashed overseas that had never been taxed in the US. Suddenly we put up a green light and say, you're free to repatriate those dollars and there won't be any dividend income at the US level, that income would never be subject to US tax.
To prevent that windfall, what they did in the TCJA is they added Section 965, mandatory repatriation tax. The mandatory repatriation tax says, look, we get that you haven't gotten these distributions from the CFC but at the end of 2017, we're going to pretend that all 10 percent or more shareholders of a CFC have received their pro rata distribution of the CFC’s income accumulated from 1986 until 2017. You're going to pay tax on that deemed distribution and then now you can move forward in the future knowing that any distribution you get will be tax-free. We're going to pave the way for this move to a territorial regime.
Now for the Moore's, that means my share of this income over the last 2006 to 2017, 11 years or so is about 132,000 bucks, as I recall and so we're going to pay tax on that right around $14,700. They get to thinking and they are like something doesn't sit right with me because I'm paying tax on $132,000 of income. I never touched the income. I never got a penny from this corporation. It doesn't feel right.
And so they immediately challenged, as I said, and the district court dismisses and rules in favor of the government, appealed up to the Ninth Circuit. Ninth Circuit does the same. Now, the Supreme Court is going to hear and they're going to hear it because of why they're disputing it and why everyone has to stand up and take notice because it's not just a run-of-the-mill argument about $14,000.
The Moores are saying, and when we first introduced this concept, it's probably not going to make a lot of sense to a lot of people, but we'll drill into it a little bit. The Moores are saying that Section 965, this mandatory repatriation tax, is unconstitutional. That's a big deal.
They say it's unconstitutional because the 16th Amendment grants Congress the power to levy and collect taxes on income from whatever source derived without apportionment among the states and that's the part that's going to trip people up, but we'll get there.
What they're saying here is, when's 16th Amendment says we can tax, income has to be realized. I have to have been made richer in my individual capacity to have to have something severable from my investment in the CFC that I can go and spend however I want. I never had any of that.
If this 965 tax isn't taxing something that fits under the definition of income, then it is required to be allocated among the states based on relative population. Now, is that surprise you, or is that something where perhaps in your free time you are a constitutional scholar and I'm not privy to that, but I'm guessing for most of our listeners there, I don't know what you're talking about as far as taxes allocated based on population.
Nitti: There's going to be a recurring theme. I think there's a lot of our knowledge about what's happening here comes from popular culture and that's okay. However you get it as long as you get it, that's what matters.
What they're doing as we drill in a little bit more here, is we need to look at two clauses of the Constitution at a high level and then we'll understand how they came to be. But as I said, 16th Amendment says, you can levy and collect taxes on income from whatever source derived without allocating among the states.
Then you have this Article 1, Section 9 Clause 4 of the Constitution that says all direct taxes must be allocated among the states or based on population. It's a very simple argument by the Moores. What they're saying is income has to be realized. You can see it right there in the 16th Amendment where it says is income from whatever source derived. That means it has to be derived from a source. There's this realization requirement, and here under 965, I never got a penny.
You're just forcing me to pay tax on something that I never received and so it can't be a tax on income. What is it then? It's a tax effectively on my ownership of stock in this Indian company, and that is what we believe to be a direct tax on property.
According to Article 1, Section 9 Clause 4, direct taxes have to be allocated among the states based on population. I know how weird that sounds but to understand if the Moores are correct in this argument, we honestly have to go back to the very birth of this nation and get a grip on how these two provisions of the Constitution evolved and then what subsequent court decision said that the Moores are ultimately relying on and so going back to the opening remarks here, that's why this works out so perfectly for us, because we would have been going through most of these cases anyway.
Martin: That's right. It's fascinating because it seems like something like income, the income tax, direct tax, these would be defined things. But maybe as we often see, and this is why you said it's back to are going through the cases and whatnot it actually isn't clear and maybe that's exactly why we're talking about it now.
Nitti: No, I think that's well said. We're going to get into an issue that I think has plagued the United States government for 200 years. This is a very meaningful piece of this country's history and to understand where it started, we truly have to go back to the constitutional convention in the late 1700s. Now, you were a music major, were you?
Damien Martin: I was.
Nitti: I'm guessing the extent of your familiarity with the Constitutional Convention is from your repeated viewings of the Broadway musical Hamilton.
Martin: That definitely again, pop culture is what did you learn to write out. We're going to do a little Hamilton here, is that we're here to sing for us?
Nitti: I will, but I would like to dispel a couple of myths about Hamilton. While undeniably entertaining, there are some historical inaccuracies. First of all, it turns out most of our founding fathers, not actually talented rappers.
Nitti: You wouldn't know that, but that's the truth. But we're talking about that cast of characters here at the Constitutional Convention were talking about Hamilton and James Madison, William Paterson, they're all there and they're figuring out the road map for this new country.
They recognize that they're going to have to generate revenue at some point, pay the bills, but they're particularly sensitive about the whole tax issue because of the whole relationship gone bad with England. They add a section to the Constitution, which the exact citation escapes me at the moment, but basically says, look, we can levy taxes, and then we also are going to look to primarily collected revenue from duties, excises and imports.
The only requirement for things like duties, excises, and imports is that they've got to be assessed uniformly throughout the country. You can't have one rate on federal tax for something in New Jersey and a different rate in New York. Fair enough.
But then there's that first part of that clause where they do have the ability in addition to duties, excises, and imports to collect taxes. What's that going to look like?
They start to kick around what a tax regime may take shape as in this new government of ours, and right away, the southern states start to freak out a little bit. The reason they freak out is because that time in the country's history, what they thought would be the two most likely forms of tax, are one what we call a poll tax or just a tax per head or tax for being alive, being a person, so every person were going to have a tax or whatever, 50 bucks.
Then the second most likely tax would be a tax on land. Just take acres of land and apply a rate per acre, and that's going to be your tax. To understand why both of those taxes scared the hell out of the South, it's probably best to take the second one first. Like this idea of a tax on acreage of land.
The South relative to the North at that time and large swaths of relatively unpopulated land that wasn't highly productive, and so you had fewer landowners with more land and less income that would have to bear the burden of this tax on land if it were simply assessed based on acreage and the people on that acreage.
Then, as far as why they were worried about a poll tax or tax per head, this is where you might say, Tony, and you just got done telling me that the South was more thinly populated than the North, so you would think that a tax per head would hurt the North more than the South, what the South was worried about was, when you're talking about tax per head, how would Congress view slaves?
The South was very concerned that slaves would count in a poll tax. What the South did is they said, any other tax we're going to add here, that you might impose at some point in the future, we want a requirement that those taxes be allocated among the states based on population.
That if Connecticut and Virginia have the same population, they will pay the same share of some national poll tax or national land tax. That seemed reasonable and the North was open to it. But the North said, even still, if we're going to allocate based on population, we would like to count all your slaves for your population for purposes of allocating this tax.
The South said, if you're going to do that, then you got to count all our slaves for purposes of our representation in the House of Representatives, which the North wasn't nearly as keen on. What this led to is one of the darker moments of our country's history, but a compromise. You feel familiar with the 3/5 compromise Damien?
Martin: I am. It came up in elementary school at some point, to your point about going back in history books here.
Nitti: I only learned about it from a recent episode of It's Always Sunny in Philadelphia or Frank Reynolds was reading the Constitution on his phone to settle a dispute at the bar, but it is very much true and it is very much rooted in the tax law.
The 3/5 compromise was when the North and South, looking at the way they did, at slaves and how they would count for purposes of the direct tax said, we're going to split the difference and slaves will count as 3/5 of a person for purposes of allocating these direct taxes.
One of our darkest moments in our country's history is actually rooted in the tax law. Then what we're left with here is this provision. Article 1, Section 9, Clause 4, that says all direct taxes have to be allocated among the states based on population of free men and 3/5 of everyone else. It's all well and good, but here's the thing, buddy. It turns out, our forefathers were not altogether different than the people that you sit with in business meetings and the like.
What I mean by that is you can't tell me it doesn't happen to you all the time. You're sitting in a meeting and people are using buzzwords and you're just going. I assume everyone else knows what these words mean, but I have no idea what they mean, and I'm just going to sit here and pretend that I do and nod my head.
But it turns out that same thing man was happening at the Constitutional Convention, and we actually know this. Because here they are saying this very important term, direct taxes have to be allocated among the states based on population, but no one knew what a direct tax was.
We know it because in James Madison's notes, he notes that Rufus King, the rep from New York, raised his hand and said, what exactly is a direct tax? In his notebook, it says, no one answered. We move forward with this unbelievably important term. Direct taxes have to be allocated among the states based on population and nobody has any clue what direct taxes are.
A rough way to start our new country and its government, but we would not have to wait too long to get our first view of how the Supreme Court interpreted this direct tax law.
Martin: It's actually fortuitous for our tax court conversation or tax case conversation here, because now you can get to a tax case here.
Nitti: I think it's a case we would have gotten to anyway.
The reason we would have gotten to it anyway is because we've already talked about what's at stake, depending on how the Moore case goes for existing law, but it also has implications for proposals into the future.
When people think about things like a wealth tax, or even today I heard they're drafting up more language about a tax on unrealized appreciation for billionaires. That conversation and whether those types of taxes would be constitutional, would all start at this same origin.
What is the direct tax? A couple of years after the Constitutional Convention, Congress decides to levy taxes on the ownership of carriages for the conveyance of persons. Instead, I guess, and then interpret that how you will you own a carriage, you've got one parked in the garage, you're going to pay a tax on it.
There's this guy, Hylton, Daniel Hylton, H-Y-L-T-O-N, and he owned, I think it was 125 carriages, which struck me as being a bit excessive, but whatever reason he had 125 carriages. He's got a buck up on taxes for each of these carriages. Immediately he says, no, this isn't right because I shouldn't be bearing the burden of my carriage tax individually.
This is a direct tax. It needs to be allocated among the states based on population and it lands in the Supreme Court. What's meaningful about that is, who are the dudes on the Supreme Court at this time in the country's history?
The same dudes that we're just at the Constitutional Convention. We should get some pretty meaningful insight as to what they meant by direct taxes, and the court makes really quick work of this case.
They say, look, we've got to look at this logic. It's requirement that direct taxes be allocated among the states based on population. The only things that could possibly be direct taxes are those things that can reasonably be allocated among the states and yield an equitable result.
If we think about carriages. Let's just say for our sake that Connecticut and Georgia had identical population. They're going to pay the same share of this national carriage tax.
But if there are 10 times more carriages in Connecticut than there are in Georgia, then the carriage owners in Connecticut are going to pay the tax at one 10th the rate as the carriage owners in Georgia. Because either way, both states are bucking up the same amount.
If there's a lot more carriages to go around in Connecticut, the per carriage rate in Connecticut is going to be a whole lot less. The court said, no, this doesn't make sense. The only things that can be direct taxes are those that make sense to allocate among the states. Really that's going to be limited to a tax on people and a tax on land.
Which reiterates what we gathered from the Constitutional Convention. It wasn't long decision made pretty quick work of it and for the next hundred years or so, nobody really questioned it and it really didn't come up as an issue again.
But then we end up in the late 1800s and we need a temporary income tax. Congress enacts temporary income tax it doesn't look dissimilar from the one that we have today.
Martin: Before that though, no income tax?
Nitti: There may have been some brief moments, I don't know that they were income tax, I'm trying to remember.
There was like an insurance tax that popped up for a couple of years. It's a bunch of different things, but they need this short-term income tax, so we got graduated rates, we got taxed on service income, doctors and lawyers, we gotten tax on rental income. Doesn't look very different than today.
Of course, they start taxing income and a taxpayer called Farmers Trust says, once again, this is a direct tax, just like that carriage tax, it needs to be allocated among the states based on population. It's unconstitutional, I don't want to pay it. And it goes back to the Supreme Court.
You would have thought, based on the precedent we just discovered in Hylton, that the Supreme Court would have made quick work of this too, because how can an income tax possibly be allocated reasonably among the states based on population?
Go back to my example, Connecticut and Georgia, identical populations is going to pay the same amount of national income tax. Per capita income in Connecticut going to be a lot higher than per capita income in Georgia.
The people in Connecticut are getting away with one because they're in total paying the same amount as people in Georgia, but they've got a lot more income to go around. It doesn't make sense. But in a case that's been, I don't want to use the word panned because it's the Supreme Court, but in a case that's gotten a lot of criticism, they find that this income tax is a direct tax and violates the Constitution because it's not being allocated based on population.
The reason they did it was they said, look, we all agree that tax on the land itself, ownership of land is direct, so how's most income earned in late 1800s America? It's cultivating land, farming land, renting land, whatever it may be.
What they ultimately said was that if we know that a tax on ownership of land is direct tax and it stands to reason that a tax on the income that flows from the ownership of land is also a direct tax. Now, here's where the relationship to the present day becomes very important, because what they could have done, as they could have said, we don't like all of these taxes on income from land. We're going to strip them out and say they're unconstitutional, but the tax is on the doctors and the lawyers, that can all remain behind.
They didn't do that, they said we can't sever the part of this income tax bill that we don't like from the part that we do like, and so we're kicking the whole thing out. That's why we say the entire Tax Cuts and Jobs Act is potentially at stake because it is, depending on how the court would view things.
Nitti: Because we're talking about one thing to your point 965. But if it's all inseverable, then that's how you lose the entirety of it.
Nitti: There's your precedent for how that could happen from the Pollock v. Farmers Trust case where they said, "We don't like parts of this income tax law, so they all have to go."
Now, the more interesting part of that case, if you people are ever inclined to read it, is the dissenting opinions because they go after the majority pretty harshly for the reasons we've talked about, just that it doesn't make much sense to think that an income tax could be allocated among the states. But nevertheless, it's gone and so that's, I don't know, 1895 or so.
Congress is not going to take that lying down, they need their income tax. It takes them a while to get enough states on board, but they did something that would be unthinkable in modern times, they amend the Constitution. We get the 16th Amendment and what they could have done is just amend that previous Article 1, Section 9 Clause 4 about direct taxes and just do away with it or rewrite it in a meaningful way, but they leave that untouched and they create this third class of taxation.
Now we've got rule 1 that you can have duties, imports, and excises as long as they're a uniform rate. We got rule 2, that says direct taxes have to be allocated among the states based on population. Now we get rule 3 which says, "Congress shall have the power to levy and collect taxes on income from whatever source derived without allocation among the states."
We still have that direct tax provision, but in income tax isn't subject to that. That's what the 16th Amendment says and right now at this point you're probably going — The Moore’s argument is built on this concept, income has to be realized. Other than pointing at the language there that says from whatever source derived and saying it has to be derived from a source, which is the same as saying, realize, I don't know where their argument is coming from.
We're going to find in a minute that it's coming from some case law. But now that the 16th Amendment is passed, 1913 rolls around, Congress adds the modern income tax like the one you and I apply our trade in day in and day out now.
Just as we now have Section 61 which defines income, I think back then it was 22. But it did it in the same terms, a very catch-all that was meant to exert the full taxing power of Congress. It said, here's what's income and it lists out a bunch of stuff, interest, dividends, all that kind of thing, and then that catch-all at the end, or gains are profits from whatever source derived.
Same language as the 16th Amendment and so it's meant to be very broad, at least it sounds like it. We've got our modern income tax and again, at this point, hard to argue that there is a realization requirement unless you're really reading into the construction of the 16th Amendment.
But wouldn't take long, about nine years we end up back in the Supreme Court, a case we definitely would have been talking about today even without Moore and where this idea of a realization requirement comes from in Eisner v. Macomber.
Martin: What happened in that case, what's the situation there? What's the setup?
Nitti: Again, couldn't have a more simple set of facts.
Taxpayer owns shares stock in a corporation and they get a stock dividend. Stock dividend, think about, simple, me and you. We each own one share in a corporation where the only shareholders, corporations worth 20 bucks so each of our shares worth $10. Corporation decides tomorrow, "I'm going to get Tony and Damien one more share each."
Nitti: Company is no more or less valuable. We have, you and I more slices of pie, but the slices have gotten smaller. Instead of one share each valued at ten bucks, you and I now have two shares each value to five bucks, but nothing's changed. We just divvied-up the pie differently.
The taxpayer here and Eisner v. Macomber gets a stock dividend, which we wouldn't think based on the logic I just relay there that it would be a taxable event.
But the IRS they were still feeling things out and getting used to the new tax law. They say this is taxable to you. It ends up in the Supreme Court because taxpayers arguing that this stock dividend, how can this be income to me, I didn't really receive anything of value.
So in Eisner v. Macomber they get the decision in the sense that it shouldn't have been taxable income. But in doing so, they did two things that are come under a lot of criticism in the 101 years that have followed.
First, we've been talking about 16th Amendment income Section 22 from whatever source derived very broad definitions of income. Then Eisner v. Macomber comes along and says, income is gain or profit from labor or capital, or both combined. I know just hearing that off the top your head, you don't necessarily get a sense for how narrow and limiting that is.
But when we get to Glenshaw Glass and a couple of minutes, we'll see just how narrow that is relative from whatever source derived concept. Eisner v. Macomber is saying, for something to be income, it's got to be derived from labor or an investment in capital or both combined. That's it. That's all.
There's a lot of things that slipped through the cracks when you go with the definition that's that narrow. Not necessarily germane to this case, but still one of the major criticism of Eisner v. Macomber.
The second thing they did, was they said in this case the reason the stock dividend is not income is because you have this investment in capital in a corporation. But getting the stock dividend, you have not extracted anything of separable value from the corporation itself, something that you can, like I said before putting your pocket and go spend as you want. You have gotten another share of stock and all it's done is reduce your per-share value, but you haven't actually extracted anything meaningful from the corporation. That's why this shouldn't be taxable. That has been what's always been pointed to as the birth of this realization required.
Because in Eisner v. Macomber, they're saying you had investments stock. You didn't separate any value from that corporation in your individual capacity and so we shouldn't be taxing you on the receipt of a stock dividend. This is the big point the Moore's are building their case around that really the initial Supreme Court case after the birth of the modern income tax law interpreted the 16th Amendment is having a realization requirement and nothing that's happened after that should really change.
But what's interesting about Eisner v. Macomber is pretty soon after it was decided, you started to see even lower courts chip away at it, which is unique when you have a Supreme Court defining something as important as income, but lower courts just saying, that definition of income was helpful for a stock dividend, but I don't know that it should apply to everything. It just got more and more distance from that concept. Then it all culminated in another case we absolutely would have been talking about anyway in 1955, Glenshaw Glass.
Martin: Because of the significance.
Nitti: It's the modern definition of income. But I will admit I teach Glenshaw Glass in my master's programs all the time. I do it as extra credit on my exams.
What are the three components of income and Glenshaw Glass. But thinking about Moore has made me rethink what I've been telling people about Glenshaw Glass.
Martin: While at the same time, I'm going to ask you whether or not you're also including Eisner v. Macomber and now we're just more of a Glenshaw Glass.
Nitti: I always teach them Eisner v. Macomber. I was always down on the Eisner v. Macomber.
But Glenshaw Glass, I think I was interpreting it in the way that the Moores do. I don't necessarily know that I think that's the right way to interpret.
Another simple set of facts and Glenshaw Glass, you got a ccompany that's paying another company to manufacture equipment for them that they're going to use in their business. Deal goes bad, they sue, they win. In addition to whatever settlement they get punitive damages.
Punitive damages are not designed to make anyone whole. They are designed to punish the offending party. If you're the receiving party, it's just a windfall. Glenshaw Glass gets a windfall, and I'm sure you or I would have done the same thing at that point in time where knowing the Eisner v. Macomber defined income as gains are profits from labor or capital. None of that stuff is present here.
I've just got a windfall in the form of punitive damages. This shouldn't be taxable income to me. They believe it's not income. It ends up in the Supreme Court. This is where Glenshaw Glass really distanced itself from Eisner v. Macomber and said, Eisner v. Macomber was very helpful for determining if a stock dividend is taxable.
But beyond that, it gave us the modern definition of income and says, hey, this is income here because one, it's session well, it's been two, clearly realized and three, over which the taxpayer has dominion and control.
What's amazing about those three points right there is both the government and the Moores are looking at those three points to support their position about this case. The Moores are saying, look, it's said right there in problem Number 2, this is income clearly realized. Honestly, that's how I've always taught the modern definition of income. It has to be a session in wealth. It's clearly realized and over which you have control.
But what the government is saying, which I think is the right interpretation for whatever that's worth. But what I think is the right interpretation is that saying that in this particular case, we have income because these punitive damages were clearly realized, is not the same thing as saying it had to have been clearly realized to be income.
It's almost like they're just saying, we don't have to worry about realization here in this case because it's clearly been realized. But that's not the same thing as saying if it hadn't been clearly realized, you couldn't possibly be dealing with income here. You see that distinction.
Both sides are pointing to that and supported their position, which is pretty fascinating. From the government's perspective, as you go from Glenshaw Glass and bridge the gap from there to now, what they're just saying is, it's hard to fathom that 965 is unconstitutional because there is this requirement that income be realized when we have half a dozen provisions that we can point to in the existing code where realization does not seem to be required.
We already said, we have Subpart F that's existed since the 1950s. Let's say you own stock in a CFC that are in certain types of income, we're going to tax you on it even though it's not distributed. Yes, that's been pressure tested. All of these have except for 475, 1256 straddles that have an income recognition without realization has been pressured, tested in the courts and approved. Section 475, the mark-to-market regime for securities and dealers that hasn't been tested, but it was only recently enacted. One would think that would have been dealt with on committee level.
Then of course, how do you marry it with flow through taxation. We know with partnerships or S corps doesn't matter if you get a distribution, if the entity generates income, your share of it is picked up on your tax return. What they're saying, and this is pretty fascinating when you think about it. The government is saying, we get that, by and large, we don't tax income until it's realize, but you know why we do that? Not because we are required to buy the 16th Amendment, but because it's a pain to tax income that hasn't been realized yet. It's simply a question of administrative convenience.
If we wanted to tax Damien on his appreciation and is very substantial retirement portfolio every year we could. But it's just not easy.
If we wanted to tax you every time your house value doubles, we could, but we'd rather wait for closed and complete a transaction. Not because we have to, but because it's easier to but if we ever need to divert from that, we can, case in point.
Man, I don't remember the code section. It's up in the 800s I think we're I tried to stay out of, but if you flee the country. If you expatriate, you're treated on your last day as if you sold all of your belongings. You haven't sold them all, but you're treated as if you have on your way out the door, they collect their tax. No realization there.
Now to the Moore's credit, they've tried to do some interesting things with their argument. Number 1, they've crafted in a way that they're not forcing the Supreme Court's hand to throw out, for example, the entire Tax Cuts and Jobs Act.
They've crafted in a way where they really just focused in on 965 and not all of the Tax Cuts and Jobs Act. They're giving the Supreme Court a way out if the Supreme Court wants it to just say, hey, we're only going to focus our attention on 1965.
The other thing that Moore's are doing is they're acknowledging that Subpart F exists and pass-through taxation exists and things like that. But in their brief, they're pointing out reasons why those might be constitutional, but 965 is not.
For example, partnerships don't really exist. They're not a tax paying entity and S Corp, everybody affirmatively elects to be an S Corp. You get what you get what you ask for type of thing. They're saying that those are concept of what they call constructive realization. But with 965, there's none of that.
We're just being forced to pick up income. I don't know that I necessarily agree with the distinction they try to draw between Subpart F in 965, but that's not for me to decide. But that's the big thrust of their argument.
Whereas from a government's perspective, they're just saying that, listen, if you really want to get into the semantics here, we could argue that income has clearly been realized. It's just been realized by your corporation. There is nothing in 100 years of case law that prevents Congress from taxing shareholders on their piece of a corporation's income. You have all these different compelling arguments.
Who knows how this is all going to play out, but what's at stake, we already talked about it. It's a third of the code is you said plus a whole batch of potential future cases.
Martin: That's right. You just wound your way through history. You get Hamilton and I learned something new about the fact that all rapping…I guess at the time that they got the Constitutional Convention.
But again, I always had a mentor that told me this really honest say, subscribe to the Wall Street Journal because whenever a tax story hits the Wall Street Journal, that's the day that you're going to get a bunch of calls from your clients.
Now I'm sitting at my desk, Joe Client’s calling because of whatever article they've read winding through all of that, what do I tell him? Tony? How do I distill hundreds of years of everything you've just walked us through?
Nitti: The big takeaways are just the fact that the Moores are suggesting that if you have income that has not been realized, it's not really income at all that's being taxed, it's property ownership and that falls under a different purview of the constitution.
What really matters here is not whether 965 is going to go the way of the dodo, but what it would open up in terms of the potential for the rest of the code. Because as we said, you're talking about hundreds of billions of dollars at stake and 965 tax. Then people are going to want to know what does this mean that the next time I get a K1 from my S Corp and don't have a distribution that goes along with it? Can I sue that? It's unconstitutional.
If I'm required to market my securities to market the end of every year in the 475, can I go in and sue and say that's unconstitutional? Does this mean, because I could tell you this, if Moore is decided in favor of the taxpayer, they can forget these proposals.
They're kicking around for a wealth tax or like this billionaires tax on unrealized appreciation in assets under President Biden's proposal. They would fail this realization requirement, so it's a little case with huge implications. If you want to understand why we got to hop in the old way back machine and go back to the Constitutional Convention, and I'll take you through the evolution.
But it's really interesting stuff and obviously the timing is perfect because all arguments start in just three weeks I think. I think you're right, I think everyone is going to be talking about it and I think to the extent that people who are listening to this podcast can feel like they understand what's at stake? Why the argument is what it is? Maybe have a few thoughts of their own on how the Supreme Court may look at this thing.
The whole point is exactly what your mentor told you, which you don't want to have happen is somebody saying, we know about this Moore case and you look in with a blank stare and go. I'm too busy cranking out returns I don't know what you're talking about.
It's very rare that tax law rises to the forefront of the public consciousness and when it does, we've got to be able to speak intelligently about whatever's being bandied about and that is about to happen next month I had no doubt about that.
Martin: You want to be able to tell them more essentially is what you're saying. Yeah. I waited all this time but I guess that's ultimately why you say greatest tax cases of all time. How much bigger can you get in this concept of realization income? It's at the heart of what we do every day you and I.
Nitti: Even just take a more simplistic view than that, there's a chance that if we were doing this same session next year more depending on how it's decided might be on a list of the most important tax cases of all time.
We get a chance to deal with something in real time that I don’t think a lot of people are paying attention to now, but it could be all anybody's talking about in three or four months because no one knows how this is going to go.
The Supreme Court has been, how should we say, unpredictable maybe a bit? Who knows what direction this goes? But we were not being overly dramatic at the intro about what is at stake here. Like you said it, Paul Ryan said it, maybe a third of the code potentially either be thrown out with the decision which I think is unlikely based on the way it's crafted, but absolutely opened up for attack. If it's true that the 16th Amendment requires realization, then yeah, there's a lot of, Subpart F, I don't get how that's any different.
Nitti: When it opens up, although maybe it won't be the greatest case but there'll be like the greatest case that led to a lot of other cases, because you're talking about litigation that you're going to see if that happens. It's an interesting time and thinking about how all these pieces fit together. Even maybe the fact that I don't know if the thing that sticks with me, maybe as living in the individual, the human world.
The fact that actually absent that they would've paid more taxes as an individual at the individual rate. It would have been paid like 49,000 instead of the 14,000, it's fascinating aspects to this to the international side. It touches basically everything so it truly is fascinating.
Nitti: I know Annette Nellen said in her presentation today talked about how enjoyable it can be to actually read all these different briefs that have been filed and she's not lying.
The arguments each one has their own interesting point and counterpoint. I know some people are arguing that the problem with the mentor repatriation tax is that it tax you on your share of the CFCs income 1986-2017, even if you only acquired the stock in 2016.
I said, how can I be taxed on earnings that were accumulated before I became a shareholder? Allow me to introduce you to sub-chapter C because that's been happening for C corporations. If you and I buy stock in GE today and next month it makes a distribution out of income that was earned in 1914 doesn't change anything for us we have dividends income. That to me, that's again, something that's been pressured test it, so it's hard for me to understand that argument. It's going to be must-watch TV.
Martin: It's a Super Bowl for us tax geeks I think in a lot of ways.
Nitti: Like I said, this will extend beyond our little tax geek kingdom and go into the mainstream.
Martin: Next year April, maybe we come back and we really evaluate was more what it was kept up to date. But thank you April for hanging with us here.
Walker: I kept thinking that if Moore turns out a certain way then and the S Corp it goes away, then I don't know if Tony be employed next year. That's what I was thinking.
Anyway, thanks Tony for the history lesson, thanks Damien for walking us through this was so fun for me to hear it. Hamilton's one of my favorites and the only thing missing a little bit of rapping. Maybe that'll happen next.
Thanks again, you guys it was great. Again this is April Walker from the AICPA Tax Section. This community is your go to source for technical guidance and resources designed especially for CPA tax practitioners like you in mind. This is a podcast from AICPA and CIMA together as the Association of International Certified Professional Accountants. You can find us wherever you listen to your podcasts and please follow us so you don't miss an episode. You can also find us at aicpa-cima.com/tax and find other Odyssey episodes. I think Tony sneaks in there on a couple of those, so you can go back and listen to some of those and get access to the resources mentioned during the episode. I guess once this airs we might have more information on the case, so we'll have to see how to follow along. Thanks everybody for listening and have a great day.
Keep your finger on the pulse of the dynamic and evolving tax landscape with insights from tax thought leaders in the AICPA Tax Section. The Tax Section Odyssey podcast includes a digest of tax developments, trending issues and practice management tips that you need to be aware of to elevate your professional development and your firm practices.
This resource is part of the robust tax resource library available from the AICPA Tax Section. The Tax Section is your go-to home base for staying up to date on the latest tax developments and providing the edge you need for upskilling your professional development. If you’re not already a member, consider joining this prestigious community of your tax peers. You’ll get free CPE, access to rich technical content such as our Annual Tax Compliance Kit, a weekly member newsletter and a digital subscription to The Tax Adviser.