A&M Tax Advisor Weekly
Congress’ ability to pass meaningful tax legislation before 2025 remains uncertain. In the meantime, the U.S. Supreme Court has jumped into the fray, thanks to a Washington state couple who have challenged the constitutionality of imposing a tax on their share of a corporation’s undistributed income in Moore v. United States, No. 22-800. The provision in question — the transition tax on untaxed foreign earnings enacted by the Tax Cuts and Jobs Act (TCJA) — if invalidated, could trigger opportunities for significant refunds of the tax, while potentially bringing into question other tax regimes. This alert delves into the potential implications of what could be a monumental Supreme Court decision and the actions taxpayers may want to consider.
Under section 965, the one-time transition tax applies to post-1986 accumulated earnings and profits of certain U.S.-owned foreign corporations (specified foreign corporations, or SFCs), to the extent those earnings had not been taxed under pre-TCJA rules. U.S. shareholders that directly or indirectly owned at least 10% of the voting power of an SFC, were taxed on their share of the SFC’s undistributed income at reduced rates. Taxpayers had to report the effect of the transition tax on their 2017 or 2018 tax returns, depending on when the SFC’s taxable year ended.
Taxpayers could elect to pay their transition tax liability over eight years — 8% in each of the first five installments and 15%, 20%, and 25% in the sixth, seventh, and final installments, respectively. Taxpayers had to make the installment plan election by the due date of their 2017 (or 2018) tax return (considering extensions) and pay the annual installments by the due date (without extensions) for filing their return for the relevant year (April 15th for calendar year taxpayers).
In the Moore case, a couple invested in a business organized in India in 2005 and stated they owned about 13% of the controlled foreign corporation (CFC), and therefore were subject to and paid the transition tax on their share of the corporation’s undistributed retained earnings. The Moores sued for a refund of the tax of about $15,000, which the IRS and lower courts denied. On June 26, 2023, the U.S. Supreme Court agreed to review the constitutionality of the transition tax raised by the Moores in their refund suit.
Before the 16th Amendment to the Constitution, the federal government under Article 1 was prohibited from imposing a “direct tax” unless it was apportioned among the states based on population. The Supreme Court had determined that a tax on income is a direct tax, and therefore subject to the apportionment requirement. The 16th Amendment, however, limited the scope of the Article 1 provisions by granting Congress the “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.”
The Moores argue that since Eisner v. Macomber, 252 U.S. 189 (1920), the Court’s decisions have held that the 16th Amendment’s exemption from apportionment is limited to taxes on “realized” income and that a shareholder’s interest in corporate profits is not “realized” until distributed, and therefore the transition tax as applied to them violates the Constitution’s Apportionment Clause.
The Ninth Circuit, in dismissing the Moores’ arguments, observed that courts have previously held taxes similar to the transition tax to be constitutional, such as the subpart F regime which attributes CFC income to U.S. shareholders who have not received a distribution. The circuit court further stated that “realization of income is not a constitutional requirement” for taxation. How the Supreme Court rules on that principle, one way or another, could reshape Congress’ taxing authority.
Some commenters have argued that a ruling in favor of the government that realization is not a prerequisite for any income tax will make it constitutionally permissible for Congress to impose federal taxes on property and wealth. However, to fall within the scope of the 16th Amendment and avoid the apportionment rule, the tax must be imposed on income (not on property or wealth). With the transition tax, income has been realized by the foreign corporation. The Court could narrowly determine that in certain situations, it is constitutionally permissible for income realized at the corporate level to be attributed to certain controlling shareholders based on theories applied in cases that have upheld subpart F against constitutional challenges.
Some have argued that a broad ruling by the Court in favor of the taxpayers could spawn similar constitutional challenges to tax regimes beyond the transition tax, including the subpart F rules and rules for partnerships and other passthrough entities. While a decision that could require a complete revamp of the tax system seems unlikely, nothing is completely off the table as the Supreme Court justices debate the issues. However, it seems possible for the Court to decide in favor of the taxpayers without rendering subpart F unconstitutional in its entirety by distinguishing the transition tax (at least as it applies to the Moores’ fact pattern) from the rest of subpart F (including the global intangible low-taxed income rules) as not involving a tax abuse that justifies the attribution of realized income from the corporation to the U.S. shareholders (i.e., constructive dividend treatment). The Court could also distinguish the Moores’ circumstances from the universe of taxpayers that were appropriately taxed under section 965.
Regarding the questions raised about whether a taxpayer-favorable decision would make the U.S. tax regime for partnerships and other passthrough entities unconstitutional, the Court could distinguish the law of partnerships and partners from the law of corporations (including CFCs) and shareholders. Partners may be viewed as having a more direct ownership interest in partnership property and income, as compared to the ownership interest (or lack thereof) that shareholders are deemed to have in their corporation’s property and income. The same direct ownership perspective would be applicable under laws regarding trusts and beneficiaries. Further, taxpayers who effectively choose to be subject to tax (such as shareholders of an S corporation who have elected to treat the corporation as a passthrough entity) could have limited standing to challenge a tax on constitutional grounds.
Current tax provisions that could be affected by the Court’s decision extend beyond those discussed above, such as: (1) mark-to-market rules for security dealers and regulated futures contracts; (2) accrual-based income rules such as those for original issue discount; (3) and the passive foreign investment company rules.
Because the Supreme Court’s decision in the Moores’ case is not likely to be announced until mid-2024 at the earliest, taxpayers may want to consider filing a protective refund claim for open years before the statute of limitations expires. Under section 6511, an income tax refund claim generally must be filed within three years of the date the return was filed or two years from when the tax was paid, whichever is later. Taxpayers who elected to pay the transition tax in installments should consider filing refund claims for any taxes paid in the prior two years.
Example: A calendar year taxpayer with a $1 million transition tax liability paid the initial installment of $80,000 (8% of $1 million) on April 15, 2018; filed its 2017 tax return October 15, 2018; and paid installments on April 15th of each subsequent year. This taxpayer should consider making refund claims for the installments that were paid on April 15th in 2022 and 2023.
The refund implications for shareholders of S corporations differ because they may elect to defer their transition tax liability until a triggering event occurs (the corporation ceases to be an S corporation; the S corporation ceases to exist; or the taxpayer transfers shares of stock in the corporation). After the triggering event, the S corporation shareholder may elect to pay the liability in eight installments. Therefore, the statute of limitations on a refund claim for some S corporation shareholders may not have started to run, negating the need for a protective claim.
The U.S. Supreme Court might do what Congress probably won’t be able to do, at least before 2025: reform the tax code. While some may find it difficult to imagine that the Court would dramatically reshape the tax landscape by invalidating the transition tax on constitutional grounds, whatever the Court decides will likely have great significance. Therefore, businesses and individuals affected by the transition tax may want to consider protecting their rights to claim refunds until the Moore case is decided. Similarly, taxpayers may want to evaluate the potential effects of a broad ruling by the Court, which could affect additional tax regimes. If you would like assistance evaluating the implications of the Moore case or filing a protective refund claim, please feel free to contact Kevin M. Jacobs of our National Tax Office.