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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.
Published in Law
It is hard not to get to the idea that all Taxation is Theft.
We need to have taxes.
And
The government always wants too much.
The sentence in bold is where the government runs amok.
A nonrecognition rule should not exist in any way for anyone or any organization of any kind. Unrealized income–money the person has never had in an account or in his or her hand–should not be subject to any taxes, state or federal.
Sometimes the government has to realize it can’t have what it wants. For everyone’s protection, that’s just the way it is. The Constitution is like a good parent–sometimes it says no.
Postscript: And the rules don’t work both ways. I am a small independent contractor. If a job ends up taking twice the amount of time the company and I originally agreed to and I am not paid for the extra time, I can’t deduct the loss from my income for tax purposes.
I fear an attack on private retirement accounts, if “not realized” income is allowed to be taxed.
Private accounts have billons of dollars in them, not currently subject to taxation under current law. Taxing the private accounts could result in lower funding of retirement accounts, just as the Social Security trust fund is being drawn down. There be nothing but trouble and mischief if “not realized” income is subject to taxition.
If the value of our investments goes down, can we deduct the unrealized losses?
Of course not.
Without a market price or a sale, no “valuation” is truly valid. And the opportunity for fraud is endless.
The compliance costs for regular valuation of, say, shares in a private pre-revenue company, would be crippling. Nobody in their right mind would insure the valuation experts against the risk of a counter-finding by the IRS with penalties, unless the insurance was so expensive that nobody would ever want to own such an asset. Forcing a valuation on private assets would disincentivize all startup companies.
So now we know that the definition of a Libertarian is someone who wants to keep an unrestrained progressive tax system in place, just don’t let it totally destroy a quasi free market economy.
With libertarians like this, who needs Progressives. Just because Richard is more or less a shade to the right of Chuck Shumet and Elizabeth Warren shouldn’t give him the right to call himself a Libertarian. If Richard were a libertarian he would have spent his career calling for the REPEAL of the 16th Amendment, not trying to dazzle us with his recondite knowledge of the idiotic views of influential judges and legal tax ‘experts’ from the 1930s. The 16th Amendment is THE UBER Progressive policy ever in the history of the country and is the source of funding for the Progressive totalitarian state. Without it Leviathan becomes a fish out of water and would quickly expire.
Come on, Richard. Forswear your Progressive priors and proclivities and start championing a repeal of that sordid vitiating of the Constitution.
I know, I know. You have too much of a vested interest professionally in bamboozling us deplorables with your astonishing legal insights into how to slow our decline into Venezuelan economic status and utter serfdom, to which progressive policies lead, to ever lend a hand to pursuing actual freedom from the tyranny of the US tax code in its entirety. Thanks for very little, if anything.
It’s a win-win for the left.
What do you mean, “unrestrained progressive tax system”? I’m in favor of a progressive tax system, though I’m opposed to many aspects of the way our system is currently set up. But how can you accuse anyone of being in favor of an unrestrained progressive tax system. I’m not even sure what that means, which is why I ask.
If there were such a repeal, I’m pretty sure one person opposed to the consequences would be you. I’m not positive about that, but I’d place a bet on it.
But what if it were repealed and replaced with other progressive tax systems? Would you be happy about that?
I agree with every word you’ve typed.
Of course the uber rich do not have to even worry about any of this.
For example, last year, Elon Musk went to the owners of Twitter and tried to have them accept as the collateral for his purchase of Twitter 40 billion plus in Tesla stock.
They refused the deal.
So then he went off to secure the pledge from a group of oil business individuals, asking that they would offer up the same amount to purchase twitter in Elon’s name, using the same amount of Tesla stock as collateral. (This deal that occurred has turned out to be a very good thing for the Arabs who did this – as Tesla stock has been on the rise.)
But no where along the line did Musk or the Arabs have to think about the IRS or Uncle Sam. Because as long as the stock is not converted into cash…
It is just the average guy that has the IRS worries.
####
Our current federal income tax is a progressive tax system. It is ubconstrained inasnuch as anything that passes Congress regarding direct taxation is allowed. See Roberts’ opinion on the Obamacare tax/penalty.
The original U S Constitution forbade direct taxation of individual citizens. The federal government would have to get revenues from states on an enumerated (based on population) basis. The 16th Amendment allowed the federal government to tax citizens directly, which destroyed federalism and fundamentally transformed America, essentially allowing and funding the rise of a totalitarian (deep) state. If you are unaware that we are living in such a state, you are not paying attention. I oppose all progressive tax systems. And you would lose your bet.
The federal government should have to extract revenues from the States, not from individuals. That was the original social compact under the Constitution and I for one would like to return to that.
States can establish tax systems to meet their share of federal revenues and I am sure there would be many different tax regimes in the different States. I would move to whatever state was furthest from a progressive tax system. At least one that had no state income tax, unless it’s other forms of taxation were too onerous.
In my book, you also fit the definition of a flaming progressive.
Nanocelt, you make good and strong arguments. I agree with you!
But
is not helpful. Name calling is beneath you. And it distracts from the argument itself.
The fact that it is a progressive system is separate from the fact that it allows the national government to do direct taxes. And both are independent, as far as I can tell, from Roberts’ opinion. The Obamacare tax is regressive rather than progressive, is it not? But it is direct.
I think you are conflating two different uses of the term progressive. Progressive taxes are taxes that take a higher percentage of of higher incomes than lower incomes. That’s separate from the progressive movement, which was about putting government into the hands of experts more than elected officials. That is a separate issue from whether we have direct taxes or not. Modern progressives happen to prefer all three, except when they don’t, such as when they allow the wealthy to shelter income from taxes when they invest it in making government larger. .
So would I, but I am glad for any support of decentralization and I am not going to berate someone who is working in that direction just because he isn’t going whole hog in favor of tearing everything down and starting over from scratch.
We should also remember how some people say true communism has never been tried. The same is true of libertarianism. As a pure ism, none of them will work.
Whether a state has a progressive tax is a separate issue from whether it taxes all or none of a) income, b) wealth, c) property, or d) money transactions. All of those can be either progressive or regressive. (Though nobody has figured out how to keep a sales tax from being regressive.)
I am not surprised at what’s in your book.
I am not conflating meanings of progressive. You are inappropriately trying to parse the word for what I see as malign purposes. Any “progressive” tax is perforce an act of using the tax system for social ends rather than revenue ends, eg, using government coercion to harm one citizen more than another, to forcibly reduce to a degree income inequality. And to increase government revenue from the same number of people thus allowing government more social and economic power than it would otherwise have. So anyone who favors such a progressive tax system is a progressive in the sense of empowering and enlarging government. You can’t favor progressive taxation and not be a progressive. Ergo in my book, again, and you cannot imagine what is in my book, you are a progressive. Taft, the President who got the 16th Amendment going, was a progressive (which he demonstrated conclusively when he shepherded through the SC the odious Buck v. Bell decision and signed off on forced sterilization of the “unfit “) in all senses of the word.
The problem as I see it is that the Democrat party is all progressives and the Republican Party is mostly progressives. So our government becomes progressively progressive perforce. Eric Vogelin consider progressivism as a modern Gnosticism and included in that category along with socialism, communism, and fascism, paving the road to serfdom. I would say paving the road to perdition and oblivion.
But then, no one that I know agrees with me. So go gently into that horrendous night, never mind raging at the dying of the light of human freedom. The system that Epstein understands so well, to me is the system of prison bars that confine us all, that consigns us to being subjects rather than citizens. I for one object.
This is where we are headed. Politicians have the same orientation as Willie Sutton.
You are being silly. Progressive taxation has a specific, historical, commonly-used meaning. You could look it up if you don’t believe me. Your private definition is making a mush out of whatever ingredients you throw into the blender.
His definition isn’t wrong. If you makes more, you pays more, meaning it’s not an equal burden. We all pay the same sales tax rate. Why is that?
Half the country pays no net income taxes, not just due to the progressive tax structure, but due to transfers, direct and indirect.
This gives both the gov’t more power, and the people who have no skin in the game (to use a Ricochet phrase) to direct the activities and outcomes of others.
If we’re looking for equal treatment under the law (and maybe we aren’t), a progressive tax isn’t it. I’m OK with a progressive tax, an extremely simple one, and a cleansing of the 4,000 pages of the tax code. But it’s not Christmas yet, and I don’t think I’ll get this present.
No, I am pointing out that anyone who favors a progressive income tax disagrees with the original US Constitution, and that disagreement is synonymous with progressive political views. That 16th Amendment was the pinnacle of success of the progressive movement of the progressive era and everyone from William Jennings Bryan to William Howard Taft, was a progressive. The 16th Amendment fundamentally transformed America. Remember that a “steeply progressive income tax” was the 10th point of the Communist Manifesto.
You, my friend, are being intentionally obtuse. But the more you write the more clear it becomes that you are a progressive and no friend of limited government and human freedom.
You are conflating perhaps three issues, not just the two meanings of the term progressive..
If you got the 16th amendment revoked it would take an extraordinary effort, because it would decentralize some of what the modern progressives want to have centralized. But suppose it could be done. The states would then enact progressive state taxes in order to raise their apportioned share of money, each total of which is based on their population. The same people who were willing to decentralize would not likely be willing to have the new state taxes become more regressive than the old national taxes were. In any case it would be a separate issue, because there are two separate issues: the progressivity of taxes and the modern trend towards centralization.
Then there is the issue of regulation. The old as well as the modern progressives preferred to put more power into the hands of the experts. Whether that’s done at the state level or the local level, it’s a separate issue from a) federalism, and b) the progressivity of taxes.
You are not going to make progress on any of those three issues if you treat people as political enemies if they don’t sign on to your entire three-part program and if you are unwilling to discern the separate issues within it.
Right now, this moment, officials in all fifty states are complicit in their willingness to benefit from a “Child Protection Service” allotment from the Fed government to all the individual states. The nearly entire mission of existence for this program is about ripping children from parents.
What charges are tossed at the “abusive parents”??
Homeschooling is one such category.
Having a child with an undiagnosed illness is another.
One statistic: Four families a day in Idaho have their children taken.
Are you aware that for every individual or couple receiving an allotment for having a foster child under their roof, the state they are in receives 5 times that amount!
Children’s names are “lost” inside this system – and if lucky enough, the child is found before their entire life is abt being sex trafficked.
Some state officials have confessed that without their state receiving such monies and without their ramping up the programs of ripping a child from parents, their states would not have a balanced budget.
And where are these funds coming from?
Wait for it —
The Social Security Fund!
The practical issues associated with annual valuations of assets are enormous. The legal system already has a very hard time keeping up with disputes about the valuation of the relatively small number of assets that have to be valued in probate for estate tax purposes.
So because it’s hard it shouldn’t be attempted? We give up on freedom? We simply let ourselves continue to become a progressively progressive hellhole? We continue on our road to serfdom? You seem content with that. And no one is my enemy as I am immaterial to anything. But progressives are certainly enemies of freedom, and that disturbs me.
Some states may tax progressively but some states will not. Some states will even realize that all taxes should be low broad simple to understand, as little disruptive of economic incentives as possible, as minimally costly to collect as possible, flat and designed to simply produce needed revenues and not be used for purposes of social engineering. With a federal direct tax that is not possible at all.
encouragingly, more states are eliminating state income taxes (though others are becoming ever more onerous in their progressive taxation). A progressive tax disincentivizes economic improvement. A regressive tax incentivized economic improvement. (So there is that built in social engineering aspect even to a low broad tax such as a sales or transaction tax; and governments could be very well funded on a 2 or 3 percent transaction tax alone, if a government entity were to be financially prudent with appropriately limited objectives; a welfare state begats an ever greater need for welfare, until the whole society is a basket case)
Regulation is another steep hill to climb. Many federal agencies need to be eliminated, like the EPA, and many many more. The federal administrative law system needs to be dismantled. Even the FBI, the CIA, the FDA, The NIH, the CDC, whole departments like the interior department, the commerce department, the energy department, not to mention the federal reserve, the SEC, the Department of homeland security, the education department, HHS, Medicare, Medicaid,etc.
But we have two political parties, one of which is rabidly progressive and the other of which is less rabidly progressive. So you, your children, your children’s children, and so on, until the 7 th or 8th generation, or beyond, can continue to kiss freedom and prosperity goodbye.
unfortunately my generation (baby boomers) has contributed mightily to the current sorry state of affairs and for that I am deeply sorry.
Am I Delusional? Yes. Are the things I have suggested, and more, Necessary to preserve freedom and prosperity? Also, yes.
Here’s hoping the scales will fall from the eyes of enough people to advance my delusions.
You obviously didn’t read what I wrote.
Sorry. But if I can be officially labeled a terrorist and a deplorable because I was a tea partier and voted for Trump (only because I saw him as a lesser evil than Hillary or Joe), why should I be precluded from characterizing anyone favoring a progressive income tax as a flaming progressive.That, unfortunately is exactly my view of anyone who favors such a tax. And since I am considered an enemy of the state already, why should I worry about making more enemies? I’ve got nothing to lose.
I’m not in favor of tearing everything down and starting from scratch. The Founders gave us a sound structure. I would like that sound structure and the freedom it provides. Just the Tax code.
The Obamacare tax was progressive. It increased with income up to a max of $695 or 2.5% of income, whichever was greater. And it was a tax on nothing. A tax imposed if you did nothing, eg did not purchase a product defined by the federal government. The Robert’s decision affirmed that the Congress can tax you for…nothing! So Richard is very correct to worry that Americans might be taxed on unrealized gains. That would create economic chaos. For progressives that is the best feature of such a tax regime.
You are right that the 16th Amendment does not require a progressive income tax, just an income tax. Per that Amendment, the income tax could be a flat tax. Same rate on all income for everyone. So why won’t Congress do that? Because Congress is comprised of Progressives that WANT a progressive tax for social engineering purposes and to enhance their own power, and raise campaign funds by placating lobbyists. The whole thing is an abomination. And causes massive economic harm. The 16th Amendment was sold on class envy and the public was lied to. They were told the tax would be applied only to a few millionaires. It was quickly applied to large segments of the population and the top rate went to about 90%
For the record, I am not a Libertarian. For example, I strongly support DeSanti’s actions against Disney, which Libertarians do not. Also his efforts at the New School.
Progressives could not erect a Progressive state without both a direct and a progressive federal tax system. Progressives, a direct Progressive tax, and Obamacare (a progressive project) are inseparably related. Anyone who espouses any Progressive idea is one.