On December 5, oral arguments will begin in the Supreme Court case Moore v. United States. In short, this tax case is poised to upend a century of tax law, addressing the ability of the federal government to tax unrealized gains as income. Most significantly, unrealized income would no longer be taxable. If you’re a business, specifically a U.S. shareholder owning greater than 10% stock in a foreign corporation, this case has major implications for you.
Moore v. United States and the 16th Amendment
If you can recall middle school history class lessons about The Constitution, the 16th Amendment addresses taxes: “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.”
Broadly speaking, this Amendment allows Congress to tax all income, no matter how or where it’s made. But what about unrealized income, i.e., accrued partnership gains that the taxpayer has not yet received in the form of a cash distribution from a partnership or foreign entity earnings not yet distributed to U.S. shareholders?
Moore v. United States and Tax Code Section 965
While Moore v. United States does address the Constitution itself, petitioners – Charles and Kathleen Moore – were really seeking to challenge a tax provision created under the Tax Cuts and Jobs Act of 2017 (TCJA) – Section 965. Known as the transition tax, Section 965 requires shareholders to pay on the “untaxed foreign earnings of certain specified foreign corporations as if those earnings had been repatriated to the United States,” i.e., otherwise unrealized income.
The Moores are part owners of an India-based farming equipment company. Like many U.S. shareholders with foreign interests before the passing of TCJA, they were able to defer taxes on their profits indefinitely unless or until this income was brought back to the U.S. According to IRS documentation, more than $2 trillion of unrealized income has been harbored and untaxed by large corporations like Apple, Microsoft and Google at foreign affiliates.
Once a corporation brings this income into the U.S., it would be taxed at the corporate income tax rate of up to 35%. The TCJA lowered that rate to 21%. Additionally, “Section 965 allows U.S. shareholders to reduce the amount of the income inclusion based on deficits in earnings and profits with respect to other specified foreign corporations. The effective tax rates applicable to income inclusions are adjusted by way of a participation deduction set out in section 965(c). A reduced foreign tax credit applies to the inclusion under section 965(g). Taxpayers may elect to pay the transition tax in installments over an eight-year period.”
In short, the Moores and corporations with foreign entities stood to greatly benefit from TCJA provisions by being able to bring their foreign income back to the U.S. at a greatly reduced tax rate. Obviously, the IRS stood to benefit as well in the short term with an influx of revenue, and potentially in the long term with the incentive to stop offshoring. But the Moores are challenging the repatriation of their foreign earnings and, in essence, the constitutionality of Section 965.
Moore v. United States and implications for partnerships, future tax law
More specifically, the Moores are challenging the U.S. government’s taxing of unrealized income. Citing a 1920 tax case, they argue that the transition tax is unlike other income attribution provisions because “it doesn’t rely on constructive realization of income by those being taxed and instead relates back to the ownership of a specified asset at a specified time,” i.e., income requires realization. 
Like deemed repatriated income under Section 965, partnership tax is structured similarly, as a partnership does not pay tax on its income but “passes through” any profits or losses to its partners. Even when partners do not realize income in the form of cash distributions, partners are nonetheless taxed on the undistributed income. In effect, partnership taxation functionally taxes unrealized income and the implications of Moore stand to challenge the constitutional underpinning of partnership tax. Imagine the Moore constitutional challenge to unrealized income as the one Jenga piece that may topple the tower. Now, imagine the tower as multiple key Tax Code provisions, including Section 965 and partnership taxation, that may crumble if the tower topples. Will the Supreme Court remove the one Jenga piece and topple the tower or choose a different Jenga piece and the tower stands?
Should the Supreme Court rule against Moore, agree that the TCJA and Section 965 are constitutional, expect tax law to remain relatively status quo and businesses to reduce offshoring potentially.
Should the Supreme Court rule in favor of Moore and deem the TCJA and Section 965 unconstitutional, this could potentially be a one-time win for U.S. shareholders with foreign interests. However, it could also lead to other future challenges, including:
- Section 965 Repatriated Foreign Earnings – will businesses move more business and investments to foreign countries to defer paying taxes, as was typical practice prior to TCJA?
- Partnerships – will partnerships go untaxed since unrealized income may no longer be taxable? Will more businesses choose to form partnerships to seek these tax benefits?
- IRS and government funding – will there be a struggle to collect taxes and essentially fund America and taxpayer-funded programs with which we’re familiar?
The Moore v. United States case should be argued and decided in a few months, with a ruling likely in late spring or early summer.
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