Is the Section 965 Tax Even Legal?

By Stanley Rose December 18, 2023

Introduction

In 2017 as part of the Tax Cuts and Jobs Act legislation (“TCJA”), Congress created a provision that imposed a tax on certain foreign holdings of U.S. taxpayers. It dramatically changed the timing and method of taxation to which those taxpayers were accustomed. This tax, housed in Section 965 of the Internal Revenue Code, is known by a number of names, including the “repatriation” tax or “transition” tax. Two impacted taxpayers (a husband and wife team) questioned the legality of the tax, primarily because it imposes tax on individual owners, based on corporate earnings that have not yet been distributed to those owners. The case is now before the U.S. Supreme Court. Many believe that the outcome of this case will have widespread ramifications that will go well beyond Section 965 because there are several other federal taxes that are assessed prior to receipt of earnings, and a decision that invalidates this tax might also invalidate those. Others fear that a decision in favor of this tax will be seen as a rubber stamp for a step further by allowing progressives in Congress to continue pursuit of a so-called wealth tax.

Section 965 background

As part of 2017’s TCJA, Congress rolled out a rather unusual provision via Section 965 of the Internal Revenue Code. Greatly oversimplifying, it created a tax on accumulated – and significantly, undistributed – earnings of foreign corporations and imposed it on U.S. owners of those corporations. Prior to this tax, most owners would be taxed only after receiving cash distributions (dividends) from those earnings. In fact, the vast majority of U.S. income taxes are imposed only after a taxpayer receives money that, theoretically and logically, funds the related taxes and creates the ability to pay them. With the new 965 rules, owners incurred a tax in the absence of any distributions, based on accumulated corporate earnings as of 12/31/17. As a concession acknowledging that taxpayers would have to fund the taxes on this “phantom income” out of pocket, the resulting tax could be paid over an eight-year period beginning in April 2018.

Charles and Kathleen Moore are U.S. taxpayers affected by the 965 tax based on their minority ownership of a company in India. The Moore’s argument can be understood only with a basic understanding of the extent and limits of the U.S. government to impose any taxes. An abridged tutorial follows:

The Constitution itself (before the 16^th amendment) allowed for “direct” federal taxes, but only if they were apportioned among the states. In other words, the percentage of nationwide revenues that the federal government derives from taxpayers in a particular state must match that state’s population relative to the national total. That limitation is nearly unworkable, although that didn’t stop Congress from ignoring it a number of times by imposing a national income tax to cover the cost of the Civil War and for other purposes in the decades following the war. These efforts consistently were questioned and found by the Supreme Court to be unconstitutional or were reversed by Congress prior to having its hand slapped again by the court.  Just before World War I, however, the 16^th Amendment to the Constitution was created, authorizing the federal government to impose a direct income tax – based on “income.”

Fast-forwarding a century, the Moores argue that 2017’s Section 965 tax is not really based on their income; it instead imposes a tax based on uncollected holdings of another party – and is therefore unconstitutional. A court of appeals disagreed, and the Moores appealed to the U.S. Supreme Court.

The issue

Theoretically, Sec. 965 primarily accelerates taxes rather than creates them – assuming the owners of the foreign entities would at some point withdraw those funds rather than redeploy them overseas. But that acceleration has been estimated to generate revenues in the hundreds of billions of dollars, and many taxpayers have paid 6 of the 8 annual payments, with the last installment due 16 months from now, based on the initial year the tax applied. That alone represents a lot at stake for the government.

However, there is concern that if this tax is found to be unconstitutional, some other more common taxes could fall as well. As noted above, most U.S. income taxes are imposed only when the party being taxed collects funds related to the income being taxed. (The tax is, of course, easier to pay when the funds are actually in hand.) But what about the incremental tax imposed on owners of domestic pass-through entities, like partnerships, LLCs, and S corporations? Those owners have long been taxed on their shares of annual entity earnings, whether or not any part of those earnings are remitted to those owners. (In exchange, the entities themselves generally are not taxed.) There also are so-called “mark to market” rules that can cause certain investors to report taxable income based on increases in value of certain holdings. (But mark to market rules apply only if the taxpayer elects to use that regime.) Arguably, in those cases, as with Sec. 965, tax is being imposed on a party that has not yet enjoyed the income on which the tax is based. If the Supreme Court determines that Sec. 965’s tax is illegal, will all of these other taxes see the same fate? That would most certainly create a mess of epic proportions. And make no mistake, Congress would quickly come up with another method to overcome the hit to its coffers.

On the other hand, some are concerned that if Sec. 965 is simply upheld, it will open the door to new taxes imposed on mere holdings and unrealized income, such as the various “wealth taxes” proposed by some progressive members of Congress.

Hearings in the Moore case began this month, and a decision from the court is expected in the summer of 2024. There is a lot of back-and-forth in U.S. Supreme Court hearings and analysists often can predict the outcome based on the justices’ lines of questions. Interestingly, analysists who are closely following this case are drawing more conclusions about the guardrails rather than the binary outcome. In other words, it isn’t clear whether the Moores will win or not. The justices have full discretion over which cases they agree to hear, and they are well aware of what may hang in the balance. Their comments and questions so far suggest that whatever their decision regarding Sec. 965 itself, the case may be decided so narrowly that it prevents disruption of the current method of taxation of partnership, LLC, and S-corporation owners while simultaneously preventing Congress from cooking up wealth taxes that some argue stretch the bounds of the 16^th amendment’s definition of “income.”

Where does it leave us?

Your author has no better crystal ball than his readers, but sees far more in common between 965 and current taxation of pass-through entities than between 965 and recently-proposed wealth taxes. 965 and passthrough taxes are based on income that is truly earned: An entity sold something or provided some services, thereby exchanging its product or service for cash, or at least an account receivable. The proceeds simply have not yet been distributed to the party being taxed. By contrast, some recently-proposed wealth taxes are based on mere increases in value of investments or products that have not yet been converted to cash or receivables by anyone. No transaction has taken place.

My guess? And it is only a guess: When the court renders its decision in June, we’ll see that Section 965 survives. It will be impractical for nearly 8 years of toothpaste (the annual installments) to be put back in the tube, and the justices are well aware of this. By next summer, most of our clients who have encountered the tax will have paid all but the final (8^th) installment of the tax. And once paid, actual collection of the related earnings via distribution to the entity’s owners is tax-free. (This makes sense – the tax was already paid.) Will the justices render a decision requiring many thousands of amended returns? And what about years for which the statute of limitations is closed? The statute typically is 3 years . . . can taxpayers only claw back what they coughed up in the most recent 3 years, and the rest is lost? Many, if not most, of the taxpayers subject to Sec. 965 encountered it in its first year of applicability; it represented a 12/31/17 tax that could be paid over 8 years. So is the statute truly open for the most recent 3 payments, or does the fact that the tax was imposed 6 years ago (outside the 3-year statute of limitations) mean that none of it remains “open?” This is only part of the barrage of questions that would follow the unwinding of that tax if determined to be unconstitutional. It would be large, messy, and undoubtedly followed by a flurry of new lawsuits. I can’t imagine the Supreme Court cares to set that madness in motion if it has any legitimate path to avoid it.

For those reasons, I think the Sec. 965 tax will survive. But I’d guess the decision will be accompanied by rationale provided by the justices that will prevent floodgates from opening to other types of truly unrealized income. Time will tell.

For more information, please contact Stanley Rose or your BNN tax advisor at 800.244.7444