Supreme Court Wary of Remaking Income Tax

WASHINGTON—The Supreme Court looked unlikely to impose strict new limits on Congress’s power to tax income, with some conservative and liberal justices alike signaling wariness about upending long-settled principles of the federal tax code.

Tuesday’s arguments involved a relatively small payment required by a one-time charge under the 2017 tax overhaul. Challengers are seeking a ruling limiting income that can be taxed to money “realized” by taxpayers—that is, cash they receive or in some fashion control, as opposed to a mere increase in the value of their holdings.

Conservative groups behind the case see it as an opportunity for the court to narrow the definition of income taxable under the 16th Amendment, heading off progressive initiatives such as taxes proposed by Democrats on wealthy people’s unrealized capital gains.

But several justices seemed less concerned with hypothetical future taxes than with possible effects on statutes long familiar to investors, tax advisers and businesses. Those include the Internal Revenue Code provision known as Subpart F, which since 1962 has required many American shareholders in foreign corporations to pay taxes on their pro rata portions of those companies’ undistributed passive income. It prevents Americans from placing assets inside foreign corporations as a way of deferring U.S. taxes.

Justice Amy Coney Barrett asked how Subpart F differed from the tax imposed on the plaintiffs, Charles and Kathleen Moore of Redmond, Wash. They are seeking a $14,729 refund of the tax payment required by their investment in an India-based company which they say hadn’t paid them any money.

Andrew Grossman, representing the Moores, said Congress had enacted Subpart F to target tax-avoidance schemes, which wasn’t an explicit purpose of the 2017 provision.

“So there’s some kind of fraud overlay to this, is this really functioning as a tax shelter?” Barrett said. “That’s a constitutional requirement?”

Grossman said lawmakers “could not ordinarily attribute corporate income to shareholders, but could do so only in the instance where there was some sort of fraudulent abuse of a corporation to avoid income.”

Solicitor General Elizabeth Prelogar, defending the Trump-era tax law, told the court that the 16th Amendment imposed no realization requirement on taxing income, but even if it did, the Moores’ investment would fall under it.

Justice Neil Gorsuch found that argument troubling, saying the government’s argument opened the door to taxing “millions of Americans who hold small amounts of stock in their retirement investment accounts.”

Prelogar said while Congress had that power, it has never sought to impose such taxes and such far-fetched hypotheticals were a distraction from the narrow question before the court.

Justice Brett Kavanaugh agreed. “Members of Congress want to get re-elected,” he said. “That’s why they are far-fetched.”

Prelogar conceded that a federal tax on property, in contrast to state or local property taxes, would be an unconstitutional “direct tax” unless each state paid in proportion to its population.

That pointed to an obstacle for measures such as an annual wealth tax proposed by Sen. Elizabeth Warren (D., Mass.). But Prelogar urged the court to avoid ruling on other ways that Democrats have considered raising taxes on the super-rich. President Biden and Senate Finance Committee Chairman Ron Wyden (D., Ore.), for instance, have proposed taxes on the unrealized gains of very wealthy people.

Under those plans, increases in the value of stocks and other assets could be considered income and taxed annually. Prelogar acknowledged that such taxes would be novel and asked the court not to opine on them while they remained speculative.

The fundamental question before the court—whether income must be realized, or received, to be taxed under the 16th Amendment—could also apply to tax code sections affecting bond investors, partnerships and multinational corporations. If the court issued a broad ruling that income must be realized to be taxed, it could prompt a wave of lawsuits challenging other tax provisions, lawyers say.

The 2017 tax law, written by Republicans and signed by then-President Donald Trump, included a one-time charge on profits that U.S. companies held in their overseas subsidiaries. It was part of the transition to a new international tax system. The one-off tax also applied to some individuals, such as the Moores, who owned more than 10% of foreign companies.

The government argues that Congress has the power to tax shareholders on their portion of undistributed earnings. The 16th Amendment, ratified in 1913, gave Congress the power to tax “incomes, from whatever source derived” without having to collect money from each state in proportion to its population, as a constitutional provision from 1789 required in some instances.

The 1789 provision placed that limit on “direct” taxes, but as with income, that’s a term the court never has squarely defined.

At Tuesday’s arguments, Justice Ketanji Brown Jackson said that apart from whether the 2017 provision was specifically allowed by the 16th Amendment as an income tax, to prevail the Moores would also have to show that it was a direct tax.

The definition of such a tax under the Constitution, she said, was narrow, based on a founding-era compromise between free states in the North and the slaveholding states of the South.

Jackson cited a 1796 opinion by Justice William Paterson, who in Hylton v. U.S. wrote that without the apportionment provision for direct taxes, Congress “might tax slaves at discretion or arbitrarily.” Such considerations, she suggested, should not limit federal taxation of income today.

The Hylton case upheld a federal tax on carriages as a permissible excise tax.

Grossman noted that Paterson wrote only for himself and said his opinion “certainly didn’t stand for the position of the court.”

A decision in the case, Moore v. U.S., is expected before July.

Write to Jess Bravin at [email protected] and Richard Rubin at [email protected]