Supreme Court Deliberation on Income Definition

In December 2023, the Supreme Court considered the fundamental question: “How is income defined?” Moore v. United States centered on the question of taxation of unrealized income. Unrealized income is defined as a gain that exists only on paper. For instance, if you purchase a share for $20 and its value increases to $25, there is a $5 unrealized gain if you retain the share without selling it for cash. The Court must ascertain whether “unrealized income” falls within the definition of “income,” potentially infringing upon the Sixteenth Amendment, which grants Congress the power to levy taxes on income.

The Sixteenth Amendment states:

“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.”

Ironically, the Amendment was passed to reverse a Supreme Court decision which essentially prohibited a federal income tax.

The Case of Charles and Kathleen Moore

In 2017, Charles and Kathleen Moore, the Plaintiffs, received a $15,000 tax bill in Washington State. The Moores contend that this tax bill was for gains they never realized. The Moores are controlling owners of a multinational corporation. The tax liability in question resulted from the 2017 Tax Cuts and Jobs Act enacted under President Trump’s administration. The Moores assert that since they never received income distributions from the company, the gains cannot be classified as income, rendering the tax on the $15,000 unconstitutional. The purpose of this one time tax liability was to cover the transfer from one international tax rule to another. Previously, if you earned foreign income overseas in a foreign corporation that you owned, you wouldn’t have to pay taxes on those earnings until you brought the profits back to the United States. The U.S. Congress determined that was an incentive to keep profits offshore, estimating as much as $3 trillion in shielded offshore profits.

Potential Impact on Tax Code and Litigation

The court’s findings could lead future courts to strike down other parts of the U.S. tax code. The Moore case could set the stage for future litigation with stakes affecting ordinary taxpayers. Historically, Congress has defined income under statutes and generally only taxes realized income. However, whether there is a realization requirement under the Constitution may not be decided by the court. And, if the court doesn’t make a definitive finding, the question becomes whether the realization requirement operates as a legal standard that is unclear and difficult to apply.

Debates Over Taxation of Unrealized Income

In the past, debates over federal “Billionaire Tax” have raised the issue of taxation of unrealized income.  Nonetheless, Paul Ryan, former House Speaker who participated in drafting the 2017 legislation, clarified that the goal was to “finance a conversion from one system to another, and it wasn’t to justify a wealth tax.”

Potential Ramifications and Future Trends

If the Court decides that the tax levy is unconstitutional, the decision will likely affect the future taxation of pass-through entities including Limited Liability Companies, S Corporations and Partnerships. If the Moores win, the federal government might be forced to pay back billions of dollars in corporate tax collections. This tax is expected to yield $340 billion by 2027, predominantly by large international corporations. Most of these taxes have already been collected.

Anticipated Legal Landscape

Both liberal and conservative tax experts anticipate the courts to be inundated with tax litigation over the coming years or even decades if the court strikes down the tax provisions. The Supreme Court is expected to decide on this case in the upcoming spring or summer. The decision could force Congress and the Treasury Department to defend related rules going forward and may shape the income tax law for all taxpayers.