The Supreme Court Agrees that Section 965 Tax is Legal

By Stanley Rose June 26, 2024

Introduction

In a December 2023 article, we explained the significance of the Moore v. U.S. case, involving the so-called “repatriation” or “transition” tax prescribed by Internal Revenue Code’s Section 965. As many, including your author, predicted, the tax survived the Supreme Court’s scrutiny, but in a way that many see as putting Congress on notice that it is at the edge of its leash.

Background

Sec. 965 imposes a tax on undistributed earnings of a traditional foreign corporation. The tax is assessed on the owners of the corporation, although the income has not yet been paid (or even committed to being paid) to those owners. It therefore has close parallels with how “regular” income tax is imposed on owners of “passthrough” entities, such as partnerships, LLCs, and S corporations. Congress’ action sprung from its belief that too much cash from untaxed foreign income was being stockpiled and retained overseas indefinitely, rather than repatriated and taxed in the U.S. The 965 tax was kickstarted by taxing undistributed, cumulative income of such entities as of 12/31/17, with the resulting tax being payable over an eight-year period.

The Moore case involved a husband and wife who were taxed on undistributed income of a company in India of which they owned a minority share. They questioned the constitutionality of being taxed on income that had not been distributed to them.

Significance

The Moore’s tax was relatively small (around $15,000) compared to that of many large companies, but observers of this case were greatly interested for reasons that had very little to do with the Sec. 965 tax itself and even the billions of dollars collected that potentially would have to be returned if it were struck down. Those concerns were:

1. If the tax was deemed to be unconstitutional, what about the somewhat similar tax imposed on passthrough owners, long in existence, on undistributed income of partnerships, LLCs, and S corporations? Would that entire regime be thrown out the window?
2. If instead the tax was upheld, would it open the door to other taxes on undistributed income, including unrealized income based on increases in value – like the so-called “wealth taxes” favored by some U.S. congressional progressives?

If either of those outcomes materialized, it would represent a fundamental change in the way the U.S. imposes income taxes, and only a very narrow decision from the U.S. Supreme Court could prevent it. “Narrow” in this context does not refer to a close decision that almost went the other way (5-4, for instance). It means that the decision would need to turn on a very narrow and highly specific set of facts – facts that if slightly different could produce an entirely different outcome.

The court seemingly threaded that needle, with a 7-2 decision upholding the tax where concurring and dissenting judges dropped a number of hints that a pure wealth tax might see a very different outcome.

Outcome/discussion

The court drew strong parallels between passthrough taxation and the Sec. 965 tax, basically noting that the income of both has been earned; the income merely has not yet been distributed. A transaction of some sort has occurred – it just happens to be at the entity level. Once it has occurred, a tax can be imposed on the entity that generated the transaction or on its owners.

This is distinguished from a tax imposed on someone’s net worth, which would assess a charge on increases in value of assets that have not yet been sold (there is no transaction incurred by the owners or by the entity).

Justice Barrett, in a concurring decision joined by Justice Alito, noted that the government seems to think it can take a snapshot of an asset’s value at two points in time, and tax as income all “economic gains” measured between those arbitrary points in time, and warned that market fluctuations could even wipe out those gains after the point of assessment but before receipt of the income. She also noted that the Moores being taxed on the accretion to wealth enjoyed by their company is not much different than an F-250 owner being taxed on possession of the truck because the steel used in its manufacturing had its roots in income previously earned by Ford Motor Company. She also warned that although Congress can attribute and tax income of a closely held foreign corporation to its owners, lower courts should not assume Congress has the power to “attribute the income of a publicly traded domestic corporation to anyone holding a few shares in (a) retirement account.”

Justice Kavanaugh, in writing for the majority, noted that Sec. 965 operates just like passthrough taxes, and mused that if one were struck down, they all would fall, and “fiscal calamity” would result. But he also warned that the court’s opinion was “narrow,” and that a hypothetical tax on appreciation turns on many other factors.

Justices Thomas and Gorsuch dissented, because the Moores never actually received any of their investment gains, and unrealized gains are not taxable as income.

Conclusion

In summary, a majority of the justices see Sec. 965 as a valid tax. But they reach that conclusion by categorizing it as simply another variant of passthrough taxes rather than a portal to a world of new, unbridled wealth taxes. There is no shortage of veiled warnings in their explanations that many or most justices would view taxes on truly unrealized income (realized by neither the owner nor his/her company) as a very different animal.

On the 965 front, the court gave Congress a big green light. But as they look past that intersection to the next light (and depending on the lens they used when reading the court’s decision), members of Congress, at best, might see yellow.

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