The Supreme Court granted certiorari on June 26 with respect to the Ninth Circuit’s decision in Moore v. United States. The question presented is whether the section 965 transition tax is a “direct tax” that violates the Apportionment Clause of the US Constitution.

The Supreme Court has not invalidated a federal tax on constitutional grounds since Eisner v. Macomber, over a century ago. The last time the Supreme Court addressed the direct tax clause, in the Affordable Care Act case NFIB v. Sebelius, it required only a few paragraphs to hold that a tax on the condition of not having health insurance was not a direct tax.¹ The opinion in NFIB was written by Chief Justice Roberts and joined by four other members of the court, two of whom (Justices Sotomayor and Kagan) are still on the bench.²

1.         The Moore Case.

The case involves the constitutionality of the section 965 transition tax, which was enacted in the Tax Cuts and Jobs Act of 2017. Section 965 deems the accumulated post-1986 deferred foreign income of certain foreign corporations, including controlled foreign corporations (CFCs), to be Subpart F income for 2017 (or 2018, depending on the foreign corporation’s taxable year end). Thus, section 965 may impose a tax on income that was earned by the foreign corporation decades ago which has been retained at the foreign corporation level and has not been distributed to the US shareholder.

The taxpayers were 11% owners of KisanKraft, a CFC that supplied modern tools to small farmers in India. KisanKraft had retained earnings of $508,000 as of the relevant date in 2017, meaning that the taxpayers’ tax liability was increased by roughly $15,000 under section 965. As described below, the taxpayers challenged the tax claiming that it is a “direct tax” that violates the US Constitution’s Apportionment Clause and does not qualify as an “income tax” under the Sixteenth Amendment, or alternatively, that it violates the Due Process Clause under the Fifth Amendment.

The US District Court for the Western District of Washington granted the government’s motion to dismiss the taxpayers’ complaint.³ The Ninth Circuit affirmed the district court,⁴ and the taxpayers’ motion for rehearing and rehearing en banc was denied.⁵

The Ninth Circuit’s decision relied on authorities upholding the constitutionality of Subpart F⁶ and on the constitutionality of taxing undistributed partnership income⁷ to hold that realization of income is not a constitutional requirement and that what constitutes a taxable gain for purposes of the US Constitution’s Sixteenth Amendment should be broadly construed .⁸ Although the Ninth Circuit’s panel opinion was unanimous, three of the Ninth Circuit judges joined Judge Bumatay’s dissent from the petition for rehearing en banc.⁹ Attorneys from the Competitive Enterprise Institute, a conservative advocacy organization, served as co-counsel for the taxpayers in the lower courts as well as in the successful petition for certiorari.

2.         The Taxpayers’ Arguments.

The taxpayers, relying on Eisner v. Macomber¹⁰ and Commissioner v. Glenshaw Glass Co.,¹¹ challenged the constitutionality of section 965. In determining whether a tax is constitutional, the US Supreme Court has generally analyzed taxes as either “direct” or “indirect.” Indirect taxes include duties and excise taxes, which are not subject to the Apportionment Clause of the US Constitution. Direct taxes must meet the requirements of the Apportionment Clause, and include taxes on income. The Sixteenth Amendment was adopted to overturn the result in the 1895 Supreme Court decision, Pollock v. Farmers’ Loan & Trust Co.,¹² which held that a tax on income from personal property was a direct tax subject to the Apportionment Clause, and thus the tax was required to be imposed in proportion to population, a requirement that is obviously difficult to meet. The Sixteenth Amendment specifically authorizes a federal tax on income (and therefore excludes an income tax from the Apportionment Clause requirements).¹³

The taxpayers argued that the section 965 transition tax is an unapportioned direct tax that is not an income tax, thus violating the Apportionment Clause.¹⁴ The taxpayers' position is that because the CFC’s income had not been distributed to them, it had not been “realized,” and that unrealized income was not included in the common understanding of “income” at the time of the adoption of the Sixteenth Amendment. At the certiorari stage, the taxpayers and numerous amici repeatedly raised the specter of the Biden Administration’s Green Book proposal for a tax on unrealized capital gains, which they deemed a federal wealth tax, as a reason to nip the section 965 transition tax in the bud.¹⁵

3.         The Government’s Arguments.

The government, relying on Helvering v. Horst¹⁶ argued that whether the taxpayer has realized income does not determine whether a tax is constitutional, what constitutes a taxable gain under the Sixteenth Amendment’s authorization of an “income tax” should be broadly construed, and there is no blanket constitutional ban on Congress’s disregarding corporate form to facilitate taxation of shareholders’ income.¹⁷ The government noted that partners are taxed on their undistributed shares of partnership income, even where there is a prohibition on such distributions.¹⁸ The government also noted that US citizens who expatriate are treated as if they had sold all their assets the day before expatriation, even though they did not have any realized gain.¹⁹ Even assuming there is a realization requirement, the government noted that KisanKraft had actually realized income, and there was no prohibition on disregarding the corporate form to facilitate taxation. The government also argued that the taxpayers’ reliance on Eisner v. Macomber was misplaced, because later decisions, including Glenshaw Glass, had limited its reach to the pure statutory issue of when realization occurs, if realization is a requirement for the particular tax at issue.

4.         The Slippery Slope (Or What About Subpart F and GILTI . . . and Mark-to-Market and OID and PFICs and Partnerships and S Corporations and Expatriates?).

As the government’s opposition to certiorari noted, there are numerous provisions in the Code which apply to unrealized amounts, which have either been upheld on constitutional grounds or have never been challenged. The list is potentially much longer than the one articulated by the government, extending to numerous provisions which, at least as of now, have not been questioned. In the Ninth Circuit, the taxpayers distinguished Subchapter S as elective and the expatriate tax as potentially postponed to actual realization, but did not address many of the other provisions that could be affected by a broad decision tying constitutionality to realization. It is unclear where on the slippery slope the Court will find a stopping place and whether the potential invalidation of large swaths of the Code favors a taxpayer victory in Moore. And as the taxpayer and the numerous amici strenuously urge, the Court’s ruling could also impact proposals to tax unrealized gains in the future.

5.         Filing a Claim for Refund Based on Moore.

Taxpayers contemplating refund claims based on Moore face a potential statute of limitations issue. The section 965 transition tax was required to be reported on the 2017 tax return (2018 for certain taxpayers), and the three-year statute of limitations for filing a claim for refund for 2017 would have expired for most taxpayers in 2021 (or in 2022 for those taxpayers reporting transition tax on a 2018 return). Taxpayers that have agreed to extend the statute of limitations for assessment may claim a refund under section 6511(c), up to six months after the expiration of the statute of limitations for assessment.²⁰ In addition, section 6511(a) provides that claims for refund are timely if filed within two years of a payment. Taxpayers that elected to pay the section 965 transition tax liability in installments may claim a refund under section 6511(a) with respect to amounts paid within the last two years prior to filing the claim, i.e., the second half of 2021, 2022 and 2023.

Taxpayers with open statutes of limitations for refund claims may wish to file a federal (and state) protective refund claim for 2017 (or 2018 as applicable) citing the pending Moore decision.²¹ In addition, as discussed above, if the section 965 transition tax were to be invalidated, depending on the Supreme Court’s rationale, a decision could have implications for other Code provisions such as Subpart F and GILTI. These potential implications should also be considered in filing protective refund claims for open years. Similar refunds may be available for state taxes.

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