Keeping a Tax Clash from Going Out of Bounds

For the past few years, many progressives have made it a high priority to impose on the superrich an annual wealth tax that takes hold even on those whose wealth declines in a given year—or, failing that, to impose a tax on unrealized income (i.e., simple accretions of wealth by people who have not sold or otherwise disposed of their property). These proposals looked to be off the table until the decision of the Supreme Court to hear Moore v. United States (2023) put the matter into high relief.

Moore started out as a technical tax dispute when the government sought to collect $14,729 in taxes from Charles and Kathleen Moore under the mandatory repatriation tax (MRT) part of the Tax Cuts and Jobs Act (TCJA) of 2017 on income trapped in a corporation by the MRT’s regulations. But the case quickly attracted greater attention because the Moores claimed that the MRT tax was unconstitutional because gain had not been realized—that is, distributed from the corporation to the Moores. They stated that the case presented this question:

Whether the Sixteenth Amendment authorizes Congress to tax unrealized sums without apportionment among the states.

The Sixteenth Amendment (1913) reads:

The Congress shall have the 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.

The government then raised the stakes in its papers opposed to certiorari, insisting that the “realization” requirement had no constitutional significance under the Sixteenth Amendment. So it appeared that the issue had been joined because the government flatly rejected the famous decision in Eisner v. Macomber (1920), in which Justice Mahlon Pitney held that in the case of a common stock-on-stock dividend, no income was realized because the new shares that came did not result from the sale or other disposition of real wealth, and hence were not taxable. His opinion generated a sharp response in 1921 from one of the academic tax gurus of the day, Robert Murray Haig, (his views were later adopted by Henry Simons in 1938), who said realization of income by sale or other disposition was utterly irrelevant to the economic definition of income, which simply spoke about “the money value of the net accretion to one’s economic power between two points at time,” which the government took as the correct baseline.

When the government challenged the Moores’ argument, it became imperative to defend the traditional system. As John Yoo and I explained in our brief in support of the Moores’ position, any increase or decrease in the value of an asset is ignored until there is a sale, when two conditions are typically satisfied. First, the valuation question is solved by looking at the value of the cash or other asset received, from which the sold asset’s original cost, properly adjusted, can be deducted to determine gain. Second, the receipt of the new cash or asset indicates that the taxpayer does not have to face any liquidity crunch.

But not quite. As is often the case, the realization requirement is only the first step on the path to a workable system of taxation. Thus, there is clear over-taxation if the amount realized from the transaction comes in the form of private-company stock or other illiquid asset that is both difficult to value and not a source of ready cash. So, there are many complex corporate transactions upon which the Internal Revenue Service correctly imposes a nonrecognition rule, not only for stock dividends, but for contribution of property to corporations, reorganizations, and spinoffs, where explicit statutory provisions keep that received income out of the tax base until the asset is converted to either cash or marketable securities. At that point, the tax can be collected on the gain deferred at the earlier time. The number of taxable transactions is substantially reduced with this simplification, thereby increasing the underlying growth in the economy.

It is instructive to see that Haig’s definition offers no constructive guidance on how to deal with such transactions. First, that formula does not require a tax on the recapitalization in Macomber because it was an instantaneous transaction that neither increased nor decreased corporate or individual income. What a consistent application of the Haig-Simons definition of income would require is an annual accounting of gains and losses for each taxable year, as market values ebb and flow. That task becomes far more formidable for shares of closed corporations, trusts, artwork, and much more. Thus, in the well-known case of Glenshaw Glass (1955), the Supreme Court taxed a cash punitive-damages award in an antitrust case by holding that this “windfall” was “derived” from capital or labor—but this decision did not apply the Haig-Simons definition. There, the correct approach would have required the taxpayer to make an annual evaluation of the fair market value of the underlying antitrust claim for each of the seven years of litigation, which no one can do well.

In other cases, such as Lucas v. Earl (1930) and Helvering v. Horst (1940), fixed amounts of cash were taxed to the salaried employee when respectively the cash payments were made directly to his wife, or the interest payments were made directly to the taxpayer’s son instead of to the bondholder himself. None of these cases sought to tax unrealized gain under Haig-Simons. Both were intended to thwart income-splitting that undermines progressive taxes.

Yet sometimes a realization requirement is too lax: certain financial assets like options and derivates should be taxed without regard to realization, to guard against massive tax evasion. As pointed out in two briefs, one by the American Tax Policy Institute and a second by Professors Reuven Avi-Yonah, Clinton Wallace, and Bret Wells, many liquid financial assets like derivatives and puts and calls have precise market values. Most investors hold large portfolios of these financial assets, and if the realization requirement were in place, they could close out the losing transactions but not the winning ones. The potential for abuse is grave, and the cure simple. An imputed realization does not impose any serious constraints on valuation or liquidity, for these assets are easy to value and sell. Getting rid of the realization requirement in such cases thus marks a major improvement over a world with a uniform realization requirement. This functional analysis preserves the status quo in taxation without the verbal sparring over the meaning of the term “realization,” a term that was less than clear when the Sixteenth Amendment was adopted. Careful incremental adjustments, which both expand and contract the tax base, yield simpler and more sensible results.

Against this background, we must put the controversy in Moore in context. One constant argument, made here in two briefs, one by Akhil and Vikram Amar and the other by Bruce Ackerman, Joseph Fishkin, and William Forbath, for broad reading of income is that the Sixteenth Amendment overrules in Pollock vs. Farmers’ Loan (1895), which to the great dismay of progressives, both then and now, held that the income derived from real estate was treated as a direct tax on wealth and thus had to be apportioned among the several states by their population (such that states with wealthier residents paid lower taxes per resident). But their historical exercise is largely beside the point, because the income from real estate in Pollock was in cash, so the Sixteenth Amendment unambiguously includes it in the tax base. Since that result touched only liquidated sums, the issue of the taxation of unrealized income under Haig-Simons was never part of that debate at all.

Several other briefs, most notably one by my NYU tax colleagues, point out that the current structure of taxation would be upended by the universal application of the realization requirement, which would pick up not only cases dealing with financial assets but also various taxes, including modern partnership taxation and the Civil War Revenue Act of 1862, which allow the imputation of liquidated sums at the partnership or corporate level to be taxed to the partner or shareholder who did not receive it.

In light of this history, it is best to read the question presented narrowly so that it refers only to specific sums collected at the entity level that did not go down to the shareholder or partner level. Thus Heiner v. Mellon (1938) applied this approach to tax at the individual level sums realized at the partnership level, but not distributed to partners—an easy case because there were no prohibitions on these distributions. A similar rule applies to partnerships where disputes between partners prevent any distribution of partnership assets needed to pay the tax, but even here a settlement of the private dispute could release the assets. No such option is available in Moore, so the only relevant question is whether that impediment on distribution prevents a disputed tax on a sum that could be calculated to the penny. This toss-up question is far removed from any larger debates over the big constitutional question, which was in fact only mentioned but not resolved in the brief prepared by tax professors Donald Tobin and Ellen Aprill.

John Yoo and I took the position that the timing under the MRT could not have been worse because the immediate tax was on sums that might never be distributed, which would result ironically in over-taxation because those dollars were not worth their face value to the Moores. Best therefore to defer the tax until the distribution is made. The court should decide Moore on narrow grounds to forestall an unneeded revolution of our current tax system.

© 2023 by the Board of Trustees of Leland Stanford Junior University.