Analyzing Moore: The ruling that upheld the Sec. 965 transition tax

Tony Nitti, CPA, discusses a recent U.S. Supreme Court decision that some observers viewed as having the potential for wide-ranging changes in tax law. In the end, the decision was a narrow one, but the details of what was addressed and what wasn’t make for an interesting conversation on this collaborative podcast episode.

Nitti, partner–National Tax at EY, joins April Walker, CPA, CGMA, lead manager–Tax Practice & Ethics at AICPA & CIMA, for this episode, jointly produced by the JofA and the Tax Section Odyssey podcast.

On June 20, the Supreme Court upheld the constitutionality of the Sec. 965 transition tax in a narrow opinion that applies only to passthrough entities (Moore, No. 22-800 (U.S. 6/20/24)). The Court found it was not required to address whether it is a constitutional requirement that income must be realized before it can be taxed.

Nitti and Walker discussed the ruling in a late June recording.

Resources:

• The unabridged version of the Walker and Nitti conversation on the Tax Section Odyssey page.
• Journal of Accountancy news coverage of the June 20 Supreme Court ruling.
• A November 2023 conversation about the Moore case.

What you’ll learn from this episode:

• Details of the Supreme Court vote and the facts of the Moore case.
• Why Nitti said that an expected “showdown” didn’t happen.
• What Nitti observed about the case from its oral arguments in late 2023.
• How the case could open up further discussion on the taxation of unrealized gains and the constitutionality of a wealth tax.
• The value, in Nitti’s eyes, of reading the dissenting opinions.

Play the episode below or read the edited transcript:

— To comment on this episode or to suggest an idea for another episode, contact Neil Amato at Neil.Amato@aicpa-cima.com.

Transcript

Neil Amato: Welcome back to the Journal of Accountancy podcast. This is Neil Amato with the JofA. This episode is a special collaboration between the JofA podcast and the Tax Section Odyssey podcast. In it, my colleague April Walker, lead manager on the Tax Practice and Ethics team, and EY tax partner Tony Nitti are talking about the Supreme Court’s recent Moore ruling and what it means for tax practitioners. That’s coming up after this word from our sponsor.

The case that Walker and Nitti are discussing, covered by the Journal of Accountancy after the Supreme Court decision on June 20, examined the constitutionality of the mandatory repatriation tax under Sec. 965 of the law known as the Tax Cuts and Jobs Act. In a narrow ruling, the court upheld the tax by a vote of 7–2. We will post pertinent links in the episode show notes. Again, here are April Walker and Tony Nitti talking about the news in a late June recording.

April Walker: Hello, everyone, and welcome to the Tax Section Odyssey podcast, where we offer thought leadership on all things tax facing the profession. Today we have a really quick-turnaround podcast that I’m really excited about with Tony Nitti. He is a partner at EY national tax. He is a frequent guest on the show. Tony, I’d love for you to give us a quick background to set the stage for us on the Moore case.

Tony Nitti: Sure. I don’t want to bury the lead, so let’s talk about the ruling before we even get into the facts, but the Supreme Court did rule by a 7–2 majority in favor of the government. So, effectively saying that Sec. 965 of the Code that was added as part of the Tax Cuts and Jobs Act and what we call the mandatory repatriation tax, that it is in fact constitutional. Yes, this was a victory for the government.

But let’s back up now. Let’s go through the facts and then talk about, why was everybody hanging on the Supreme Court’s decision here? Why was this such an eagerly anticipated opinion in the tax community?

So the facts in Moore — very basic. We’ve got a retired couple up in the state of Washington. In 2006 they invested some money in an Indian corporation. They took back more than 10% of the stock, and the corporation was owned more than 50% by U.S. shareholders, thereby making it a controlled foreign corporation, or CFC. Then from 2006 all the way to the end of 2017, this CFC made money, but it never actually repatriated any amounts back to the Moores in the form of a dividend.

So, under the laws in place at that time, the Moores had no income to recognize at the individual level because they hadn’t received any dividends from their CFC. Now we know that since 1962, Part F has imposed a deemed dividend on shareholders of a CFC when that CFC is earning certain types of passive income. But that’s not what we’re talking about here. The corporation, the CFC in India, it was earning regular operating income, so there was nothing to attribute back to the Moores in the form of a deemed dividend — until Dec. 22, 2017, because that’s when Congress passed the Tax Cuts and Jobs Act.

As part of that tax bill, one of the things we did was shift from what we call a worldwide system of international taxation to a territorial system of international taxation. With that shift, what was going to happen and what did happen is that income held in a CFC post-2017, when it was repatriated to the U.S. in the form of a dividend, would not be subject to tax at the individual level. But you can’t just flip a switch and make that move, April, because if that income has been stashed in a CFC prior to 2017 and has never been subject to U.S. tax, if you suddenly opened the floodgates and allow what was rumored to be anywhere from $1.5 trillion to $2 trillion that had been stashed in CFCs, never subject to U.S. tax — if you allow that to come back post-2017, tax-free, that’s a windfall. That money would have never been subject to U.S. taxation.

To prevent that windfall, Congress enacted Sec. 965, this mandatory repatriation tax. What it did is it said, look, certain shareholders of a CFC, as of Dec. 22, 2017, you have to pretend that you received a dividend equal to your pro rata share of the CFC’s income from whatever came later, 1986 or when you actually acquired the stock, all the way through to the end of 2017. By doing that, by picking up this deemed pretend dividend and paying tax on it, now we can pave the way for this switch to a territorial regime where in the future that same money can actually be repatriated back to the U.S. and not have to be subject to U.S. tax. The Moores, dutiful taxpayers that they were, paid the 965 tax. I believe it was $14,729. Then they got around to thinking, what did I just pay tax on? I never received anything. I put money into a CFC, and I sat on my hands, and I enjoyed the fact that the company was doing well, but I never took a penny out. Why on earth am I cutting a check to the Internal Revenue Service? They sued in district court, and the district court dismissed in favor of the government. They appealed up to the Ninth Circuit. The Ninth Circuit did the same.

Then over the summer last year, the Supreme Court decides that they will listen to this case. It certainly surprised a lot of people. Why would the nation’s highest court agreed to hear an argument over $14,000 in tax? But the root of it was the fact that they were arguing, the Moores were, that Sec. 965 was unconstitutional. That’s a big deal, right? When you’re saying something’s unconstitutional. But that goes beyond just your run-of-the-mill argument that you tend to see in Tax Court.

The reason they were saying it was unconstitutional, tit was something that was certainly going to pique the interest of the Supreme Court, and certainly in this day and age: What they said was the Sixteenth Amendment to the Constitution grants Congress the power to lay and collect taxes on income — from whatever source derived without having to apportion that tax among the states based on population. But when the Sixteenth Amendment says it can tax income, by definition in the Sixteenth Amendment, [the income] has to be realized. There has to be what we call this realization requirement, and we’ll examine that further.

But just for our purposes right now, it just means that I need to have something in my hands that makes me richer from an economic sense, that I can do what I will with. Now we know that tax law has expanded upon the concept of realization where you can have concepts of constructive realization, but we’ll get into all that. But the idea is something had to happen to leave me richer in an economic sense. They said, here in 965, I’m being taxed on amounts that clearly I never received, there has been no realization. If there’s been no realization, then whatever they’re taxing me on cannot be income.

The only thing they could be taxing me on is my ownership of stock in a CFC as of a specific date and time, December 22, 2017. That type of tax, a tax on ownership of property, is a direct tax under the meaning of Article 1, Section 9, clause 4 of the Constitution, what we call the direct tax clause, and is required by that clause to be apportioned among the states based on population. Since 965, last time I checked, was directly assessed and not apportioned among the states based on population, the tax violated the Constitution.

So, a really fascinating argument, April, because what it looked like it was doing was setting us up for a showdown for the ages. Because in their written briefs, the Moores, the taxpayers, more or less said to the Supreme Court, we need you to rule once and for all that, yes, the Sixteenth Amendment contains a requirement that income be realized before it can be taxed as income. You can only imagine, and this is what we discussed in our first podcast and at [the AICPA & CIMA National Tax Conference], what the implications of that type of ruling would be.

If the Supreme Court last Thursday had handed down a ruling that said income has to be realized, it’s not just 965 that would face expulsion from the Code. How does partnership law, S corporations, how do they survive if there is now this constitutional realization requirement. When you think about passthrough taxation, we know that the owners are taxed on their share of the passthrough entity’s income, whether they get a penny or not in the form of distributions. If you’ve suddenly got this realization requirement, how do you make peace with Subchapters K and S? Or what about Subpart F that we just talked about, right, that since 1962 has allowed Congress to say to shareholders of a CFC, we know you didn’t get anything out of the CFC, but the CFC is earning passive income, and to prevent abuses, we’re going to pretend that you got your share of that passive income and subject it to tax.

How can Subpart F continue to exist if there’s this new constitutional realization requirement as established by the Supreme Court? The reason we got together in November, and the reason we had a whole session devoted to it National Tax, was because smart people like former House Speaker Paul Ryan, were saying look, a victory for the taxpayers in Moore could invalidate up to a third of the current tax law. That’s a big deal.

Then for the government’s part, they appeared to be saying to the Supreme Court, it’s time for you to rule the opposite, that there is no realization requirement inherent in the Sixteenth Amendment. Imagine what those consequences would be if we’re saying income does not have to be realized. It’s not just about preserving Subpart F and Subchapters K and S. It’s about the future of tax law. If income doesn’t have to be realized, then Congress, if it needs to, could attempt to tax taxpayers’ unrealized appreciation in their assets.

And lest anybody think that’s far-fetched, remember that a couple of weeks after we got together in November, April, Sen. Ron Wyden formally released his proposal for what he calls the billionaires tax, which is a minimum tax that would reach, in part, certain individuals’ unrealized appreciation in their assets. It’s a very real proposal that’s floating out there right now. If the Supreme Court last Thursday were to have come down and said, there is no realization requirement, Congress can tax whatever it wants, then it would obviously leave the door open for something like that tax on unrealized appreciation or maybe, and I think this is a slightly different argument that we can get into, or maybe even a wealth tax, which, obviously, Elizabeth Warren and other candidates in the 2022 election from the Democratic side were proponents of.

And so we, in November — just like every major newspaper, just like every morning talk show — were discussing Moore because of the implications. We thought we were headed for a landmark decision, an absolute showdown where the Supreme Court, backs to the wall, had to say once and for all, is there a realization requirement in the Sixteenth Amendment?

Walker: Very nice. Let’s talk now about what that really meant: The showdown and what did we learn from this, and what significance does it hold for our taxpayers now?

Nitti: Well, in short, when you ask how did the showdown came out, it didn’t. That’s disappointing to many. It’s anticlimactic to many. But it also shouldn’t be a surprise that, ultimately, the court was able to decide without even addressing the realization requirement.

First week of December is when the oral arguments were held in Moore. It became very clear in the oral arguments that both sides, taxpayers and the government, had perhaps become aware of the gravity of what they had asked the Supreme Court to rule on, because they both took steps to give the court an avenue to a more narrow, less impactful ruling so that the taxpayers, the Moores, they came in and said, whoa — and again, I’m inferring some things here — but they came in and said, hey, we’re reading the same articles everyone else is that we could try to throw out one-third of the Code here. You don’t have to do that, Supreme Court, in order to rule in our favor. Because what we’re going to do here in these oral arguments is we’re to concede for you that these other provisions that people are looking towards, they’re constitutional for their own reasons.

Partnerships? Partnerships work because partnerships have always been treated as being a mere aggregate of [their] partners, like they don’t have a separate tax existence, and so that is why income of a partnership can be taxed at the partner level, whether or not it’s been distributed. S corporations — every shareholder who’s around at the time the S election is made has to affirmatively consent to that election. You know what you’re getting into. What you’re getting into is being taxed on income that perhaps you haven’t realized yet, but as long as you sign up for it, then you’re stuck with it. They say that’s what makes S corporations different, the fact that you have to consent to it.

Then Subpart F — this was a little bit of a reach, I think. But they said, look, Subpart F is designed to attack specific abuses where people are putting passive income in a CFC when they could just as easily hold it in their individual capacity, so we think that one is OK as well. I think that last piece, in particular, hurt the taxpayers a bit because, if you read Justice [Amy Coney Barrett’s] and [Samuel Alito’s] concurring in judgment opinion, they’re not quite so sure it appears to me that Subpart F would even be necessarily constitutional, and we can get into why that would be in just a few moments.

They were trying to make it easier in the Supreme Court saying, you don’t have to worry about throwing out this other stuff. But 965, it’s a different animal. It’s not a partnership, it’s not an S corp., It’s not Subpart F. It is a situation where we invested money in the CFC, got nothing in return for 12 years, and now you’re taxing me on income that I’ve never received — that’s got to go. That’s unconstitutional.

The government, they came in and they said, hey, Supreme Court, guess what? You can rule in our favor without even addressing this realization requirement. Because if you look hard enough, you’ll realize here that income has clearly absolutely been realized. It’s just that it was realized at the corporate level, at the CFC level. If we look back at the judicial precedent of this very court, we can see, in the mid-1920s to the late 1930s, a series of cases that allow Congress to attribute the income that’s been realized by an entity, specifically when that entity is taxed as a passthrough for U.S. tax purposes — and that’s a partnership, that’s an S corp., and in a lot of settings, it’s also a CFC — but Congress can attribute the income earned by a passthrough to its owners even if it has not been distributed.

They said, Supreme Court, we’re giving you an out here. You can rule in our favor without even talking about realization. Instead, just focus on attribution. Acknowledge that the income has been realized at the CFC level, and there’s nothing preventing Congress from saying we’re going to attribute that income at the CFC level to its shareholders, including the Moores and make them pay tax on it even though it is yet to be distributed.

After the oral arguments, I think most people who were watching closely saw the writing on the wall. Because the Supreme Court is in the habit of issuing the most narrow opinion that they can in order to rule on a specific set of facts, and so with the government having given the Supreme Court a pretty clear avenue to a more narrow ruling that didn’t have to address the realization requirement, I think a lot of people anticipated that we were going to get a decision that was largely based on attribution rather than realization.

That’s what ultimately came down last Thursday. That’s why I say it feels anticlimactic to some because we only had to get, April, to the second footnote in the entire case where the majority opinion drafted by Justice [Brett] Kavanaugh said, look, we’re not here today to talk about what would happen if Congress were to try to tax unrealized appreciation or even wealth. Then even in the body of the opinion, Kavanaugh comes out at some point and says, look, the Moores wanted us to say there’s a realization requirement. The government wanted us to say that there is not. We don’t need to address that today in order to opine on this set of facts.

So the realization debate has just been deferred, because instead what they did is the majority kept it very simple, and just like the government proposed to them, they looked at cases stretching from 1925 — there were four of them from 1925 to the late 1930s. They’re slightly different facts in each case, but by and large, you had these four cases that showed that Congress has flexibility.

When you have an entity taxed as a passthrough, and you have flexibility if you’re Congress of either taxing at the entity level or taxing at the owner level. Now, the court did put some guardrails around that flexibility. Kavanaugh talked about the fact that this should be limited, this concept of attribution, should generally be limited to, as I mentioned before, entities that are taxed as passthrough for U.S. tax purposes, which would be your partnerships, your S corps., things like grantor trust and then CFCs.

But then also, Justice Kavanaugh was saying that we’re not saying that they can tax the same income at both levels under the same character. But yes, you can have income at the corporate level, dividend and shareholder level, but they were putting some guardrails around it. But generally speaking, they kept it very simple, and the majority did two things. One, as I said, they looked at that judicial precedent that says, we’ve got a history here, for example, in Heiner v. Mellon, being able to tax partners on income that, even under state law, they were not permitted to receive in the form of distribution.

Then we have the Brubaker case, where Congress was able to tax partnership income at the entity level because it was effectively acting as if it were a corporation. They looked at these four pieces of precedent and said, yes, the concept of attribution is alive and well. We can take this income earned at the CFC level and attribute it to the Moores. Then they just took some steps to take apart the Moores’ argument that 965 is somehow vastly different from Subchapters K and S and Subpart F.

Because they said, look, this argument that partnerships are never respected as separate taxpaying entities, we know that’s not the case, and we have case law here that says, at various moments in time, we’ve been able to levy taxes at the partnership level. We know that for a variety of reasons, for federal tax purposes, partnerships are respected as their own entity, maybe not necessarily taxpaying entity, but their own entity, and aren’t mere aggregates of its partners.

From an S corporation perspective, you say that every shareholder has to consent to the election, and they do, but think about if the shareholder makes changes and now you have shareholders owning 49% of the stock and they want to revoke that S election — you need more than 50% consent to revoke an S election. You can have 49% of shareholders who do not consent to that election, but they’re powerless to do anything about it, and so they said the mere requirement that you consent is not enough here to differentiate [Subchapter] S from 965.

And then Subpart F, the argument for the Moores was largely based on the degree of control that a shareholder had to have in the CFC. But it’s the same 10% control for 965 purposes as it is for Subpart F purposes. So the court just basically said, your arguments, Moore, aren’t convincing to us. We’re going to keep this simple. We’re going to attribute the income of the CFC to you here and say that is perfectly constitutional. The decision was a little anticlimactic but should not have been surprising.

Walker: Little bit of a dud on the decision, attribution versus realization. But Tony, is there anything we can glean or learn from this decision?

Nitti: I certainly think there is. We’ve got a 33-page dissenting opinion from Justices [Clarence] Thomas and [Neil] Gorsuch that could best be described as strongly worded, maybe scathing, whatever you want to call it. But it was very clear that these two justices, in dissenting to the majority’s opinion, really felt like the Supreme Court had a missed opportunity here to address this ambiguity in the law and figure out once and for all whether or not there was a realization requirement.

Because they accused the majority — and this is a direct quote — of “changing the subject” in addressing attribution over realization. But then went on to say, pretty definitively — no “pretty” about it, they went on to say definitively — we believe there’s clearly a realization requirement inherent in the Sixteenth Amendment, and so we don’t agree with this ruling.

Listen, it’s a dissenting opinion, so to some degree the angry argument set forth is the legal equivalent of Grandpa Simpson shaking his fist at a cloud. But we should still pay attention to it because I believe that it was a well-crafted argument by Justices Thomas and Gorsuch, as it goes through the evolution of the Constitution that I think could absolutely serve as a foundation for future defenses against, for example, a tax on unrealized appreciation.

So I think there’s a lot to be learned from this dissenting opinion, where Thomas and Gorsuch build out their argument as far as why there’s a realization requirement in the Sixteenth Amendment. Because yeah, like I said, I do think it’s well thought out.

Walker: Well, this is about as breaking news as this podcast gets. Any final thoughts you want to share with us, Tony, as we’re reflecting on this long-awaited decision?

Nitti: Anytime the Supreme Court talks tax, we have to pay attention. We have to listen. I would just encourage people to read all of it. Read the majority opinion, read the two concurring opinions, and certainly read the dissenting opinion just to see how this may all shake out at some point in the future.

But, obviously, it’s all at the mercy of when it eventually comes in front of the court. But to me, it’s just a fascinating history lesson on the evolution of taxes. Really, I’ve always said there’s no better way to learn the tax law than reading case law. I think the 80 pages or so here of Moore, even though it may not be what everyone hoped it would be, certainly offers a lot of insight and a lot of educational value.

Walker: Perfect. Yes, I like to leave people with some homework, and that’s some good homework to do. Go read the decision. Thanks again, Tony. This has been delightful. I appreciate your time and energy on this.

Again, this is April Walker from the AICPA Tax Section. You can find us wherever you listen to your podcasts, and please follow us so you don’t miss an episode. You can also find us at aicpa-cima.com/tax. Check out our other episodes and also get access to the resources.

Amato: Thanks to Tony Nitti and also host April Walker. On the Tax Section Odyssey episode page, which we will link to in the show notes on the JofA page, you’ll be able to find a link to hear a lot more about the constitutional background of this issue, going back through many years of Supreme Court cases, the creation of the Sixteenth Amendment, and more.

Also we’ll link to a discussion that Nitti, Walker, and Damien Martin, another EY tax partner, had in Novembe, 2023 about the case in a Tax Section Odyssey episode. Again, this episode is a collaboration with the Tax Section Odyssey show and the Journal of Accountancy. Thanks for listening.