United States: Supreme Court upholds the constitutionality of the Section 965 Transition Tax

In brief

On 20 June 2024, the US Supreme Court ruled, in a 7-to-2 decision in favor of the government, to uphold the constitutionality of the section 965 transition tax in Moore v. United States. This case has been closely watched because it informs a potential future dispute concerning the legality of a wealth tax and significant longstanding portions of the US tax regime. The original question presented was whether, under the Sixteenth Amendment, income must be realized before it can be taxed. The Court concluded that if a controlled foreign corporation realized income, then Congress could attribute that income to the corporation’s US shareholder and tax the shareholder accordingly. By applying this principle of attribution, the Court avoided the question of whether the Sixteenth Amendment includes a realization requirement, leaving that issue open for future litigation.

Key Takeaways

Moore preserves the status quo and underscores the conclusion that large parts of the Code, including Subpart F and passthrough regimes, are proper exercises of Congress’s taxing power under the Constitution.

In more detail

The majority opinion (delivered by Justice Kavanaugh and joined by Chief Justice Roberts and Justices Sotomayor, Kagan, and Jackson) held that the transition tax falls squarely within Congress’ constitutional authority to tax. The majority sidestepped the question of whether the Sixteenth Amendment creates a constitutional realization requirement to instead address a more narrow question: “whether Congress may attribute an entity’s realized and undistributed income to the entity’s shareholders or partners, and then tax the shareholders or partners on their [pro-rata] portions of that income.” The majority relied on the Court’s longstanding precedent (particularly from 1925 to 1938) that established “a clear rule” that a business entity’s income could be attributed to its owner. The Court highlighted analogous statutory regimes  (including the current partnership tax, S corporation tax, and subpart F regimes) to conclude that, when dealing with an entity’s undistributed income, Congress may tax either (i) the entity or (ii) its shareholders or partners under the attribution doctrine.

In reaching this conclusion, the majority dismissed the Moores’ reliance on Eisner v. Macomber as “misplaced.” They narrowly interpreted Macomber as addressing the question of whether a corporation’s stock dividend, which generated additional stock without changing the value of the shareholders’ total stock holdings, conferred taxable income to the shareholders. The Court declined to treat the “dicta” from Macomber as dispositive on the issue of attributing an entity’s undistributed income and further noted that any ambiguity regarding the scope of the Macomber holding was resolved by the Court’s holdings in Burk-Waggoner Oil Assn. v. Hopkins, Heiner v. Mellon, and Helvering v. National Grocery Co., which established the principle that Congress has the power to attribute a business entity’s undistributed income to its owners and then tax the owners on their pro rata share of that undistributed income. The majority also rejected as unavailing the Moores’ attempts to distinguish the transition tax from the partnership tax, S corporation tax, and subpart F regimes. Finding that the transition tax was not distinguishable, the Court further emphasized that the elimination of these other tax provisions would lead to a “fiscal calamity” by depriving the US of trillions in lost tax revenue necessary for critical national programs.

The majority went to some lengths to emphasize that their holding is narrow and limited to the (i) taxation of the shareholders of an entity, (ii) on the undistributed income realized by the entity, (iii) which has been attributed to the shareholders, (iv) when the entity itself has not been taxed on that income, and the holding is further cabined by the Due Process Clause that prohibits “arbitrary” attribution. The Court carefully avoided a broader reading that would implicate a potential future dispute concerning the constitutionality of a wealth tax.

In her concurrence, Justice Jackson argued that realization was not constitutionally required under the Sixteenth Amendment and that Macomber’s realization requirement, as clarified by Helvering, narrowly addressed the stock dividends at issue in that case. She further noted that for the Moores to have prevailed, they would have also needed to establish that the transition tax was a direct tax requiring apportionment. She signalled that the transition tax may have been alternatively upheld as an excise tax, which would be excluded from the direct tax category.

Justice Barret also wrote a concurring opinion that Justice Alito joined. The concurrence argued that realization was constitutionally required, based in part on the text of the Sixteenth Amendment (which refers to income that is “derived”) and a long line of the Court’s precedent that instructs that a mere asset appreciation or economic gain does not constitute taxable income. The concurrence ultimately agreed that the transition tax was constitutional, concluding that although the Moores did not realize income, KisanKraft did, and Court precedent allowed Congress to disregard the corporate form to determine whether the shareholder received income in substance, if not in form.

The dissent (authored by Justice Thomas and joined by Justice Gorsuch) similarly argued that the Sixteenth Amendment constitutionally require realization of income. The dissent described the origins of the US federal taxing power and how this history informed the constitutional constraints on a direct tax relative to an indirect tax. They then turned to the history of how the Sixteenth Amendment was ratified and narrowly framed it as a means to abolish Pollock’s rule that an income tax is classified as direct or indirect based on the classification of the underlying income source. The dissent urged that the Sixteenth Amendment did not otherwise disturb the pre-Pollock constitutional limitations and instead created a constitutional distinction between income and its source that necessarily includes a realization requirement for the former. The dissent characterized the majority’s attribution doctrine as a “new invention” and narrowly conceded that Congress may attribute income to the entity or to the individual who actually controlled it when necessary to mitigate tax-avoidance purposes. The dissent also argued that the transition tax is distinguishable from other forms of pass-through taxation. The dissent highlighted that subpart F, unlike the transition tax, is scoped to tax US shareholders on the earnings of the foreign corporation realized during the same year as the shareholder’s control.

In short, the majority’s narrow holding reflects a balance between preventing a large-scale upheaval of the US tax regime and communicating that there are limits to Congress’ taxing power. And Justice Barrett’s concurrence and Justice Thomas’s dissent show that at least four members of the Court are ready to apply a realization requirement to a potential future wealth tax.