The U.S. Supreme Court on Thursday upheld the constitutionality of the Sec. 965 transition tax in a narrow opinion that applies only to passthrough entities. 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 (Moore, No. 22-800 (U.S. 6/20/24)).

Charles and Katherine Moore sued over the Sec. 965 transition tax, which the Supreme Court referred to as the mandatory repatriation tax in its opinion, because they said it increased their tax liability for 2017 by about $15,000. The Moores argued the tax, established in 2017 by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, is unconstitutional, saying income must be realized before it can be taxed.

Background

In 2005, the Moores invested $40,000 in exchange for 11% of the common shares of KisanKraft, a company that a friend owned in India. KisanKraft is a controlled foreign corporation (CFC), which means U.S. persons own 50% of its ownership or voting rights. CFCs are treated as passthrough entities under Subpart F.

At the time the Moores made their investment, U.S. taxpayers did not generally pay U.S. taxes on foreign earnings until those earnings were distributed to them.

But Sec. 965, as amended by the TCJA, imposed a one-time transition tax on untaxed foreign earnings — either at 8% or 15.5%. The tax applies whether or not the foreign earnings are distributed — they are deemed repatriated. The tax is imposed on U.S. persons owning at least 10% of a CFC. Undistributed earnings from after 1986 and prior to 2018 were deemed distributed and taxable in tax year 2017.

The Moores challenged the constitutionality of the transition tax, arguing that it is an unapportioned direct tax and not a tax on income because income must be realized before it can be taxable. Under Article 1, Section 9, of the U.S. Constitution, any “direct tax” must be apportioned so that each state pays the tax in proportion to its population; however, the Sixteenth Amendment exempts from this apportionment requirement “incomes, from whatever source derived.”

Taxing undistributed income

The Supreme Court determined that the question before it was whether Congress could attribute an entity’s realized and undistributed income to the entity’s shareholders or partners and then tax the shareholders or partners on the income attributed to them. The Court stated that its “longstanding precedents, reflected in and reinforced by Congress’s longstanding practice, establish that the answer is yes” (slip op. at 8).

According to the Supreme Court, the transition tax operates in the same basic way as the taxation of partnerships, S corporations, and Subpart F income, under which an entity’s undistributed income is attributed and taxed to the shareholders or partners. The Court said that the transition tax was consistent with the principles that it had articulated in upholding those kinds of taxes in cases such as Burk-Waggoner Oil Ass’n v. Hopkins, 269 U.S. 110 (1925), Heiner v. Mellon, 304 U.S. 271 (1938), and Helvering v. National Grocery Co., 304 U.S. 282 (1938). Thus, the Court concluded, the transition tax “falls squarely within Congress’s constitutional authority to tax” (slip op. at 22).

The Supreme Court noted, however, that the Due Process Clause does not allow “arbitrary attribution. And nothing in this opinion should be read to authorize any hypothetical congressional effort to tax both an entity and its shareholders or partners on the same undistributed income realized by the entity” (slip op. at 23 (citation omitted)).

Income realization requirement

While the Moores argued that realization is a constitutional requirement of an income tax and the IRS argued it was not, the Supreme Court found it was not required to answer that question to decide Moore’s case because the income was realized by KisanKraft and then attributed to the Moores. Thus, the Court did not “address or resolve” the issue of whether realization is a constitutional requirement in its 7–2 opinion.