The Supreme Court is at risk of invalidating a dozen or so rules enacted over many decades to more fairly tax multinational corporations, financial engineers on Wall Street, and other ultra-wealthy taxpayers. The wrong decision would allow them to resume shielding large parts of their hefty incomes from effective taxation.
If the Court upholds the central claim of the plaintiffs in Moore v. United States as to the definition of income and the scope of the federal government’s authority to tax it, our tax system will become less fair, income inequality will widen, and we’ll lose substantial revenue needed to fund essential public services. The justices should bear in mind these real-world implications when weighing how to decide the case.
The federal government taxes many kinds of “unrealized” income–as well as income realized only at the corporate or other “entity” level–and those affected have arranged their financial affairs accordingly. An adverse decision in the Moore case would cast large parts of the tax code into doubt and disrupt the nation’s financial system.
Following are types of unrealized income or income realized only at the entity level currently taxed that would be thrown into doubt by the wrong decision in Moore.
- Income of rich people renouncing their U.S. citizenship: America’s ultra-wealthy—who can live anywhere—sometimes not only leave the country but renounce their U.S. citizenship to avoid U.S. taxes. In order for the IRS to collect tax on all the investment gains they enjoyed while American citizens, these multi-millionaire expatriates are required to pay a one-time “exit tax”: capital-gains taxes are due on the gains (excluding roughly the first $750,000) on all their appreciated assets as if they had been sold even if they have not been.
- Income from tax avoidance transactions: Beyond buying and selling stocks and bonds, sophisticated investors engage in transactions whose value is derived from the performance of some underlying asset. These “derivatives” include “futures,” which are contracts to buy or sell a commodity or security by a certain date at a fixed price. Savvy investors can manipulate futures to turn a short-term gain (which is taxed at up to 37%) into a long-term gain (taxed at no more than 20%). To prevent that, participants in so-called “regulated futures contracts” are required to treat them as having been sold on the last day of the year even if they weren’t—what’s known as “mark-to-market” taxation. Any gains are taxed (and any losses can be used to reduce taxes) even though the contracts never actually changed hands and the investor raised no cash from a sale.
- Income from certain kinds of bonds: Most bonds pay interest at regular intervals and that interest is taxed each year. Some bonds pay interest in one lump sum when the bond matures: they are originally sold at a discount to their face value and the interest is the difference between the purchase price and the redeemed price. Before the law changed, bondholders only paid tax on bond interest when they collected it—but the bond issuer was allowed to write off a portion of its ultimate interest payment each year. The current rule harmonizes the tax treatment of bond interest: just like bond issuers, bondholders must account for interest annually, paying tax on the imputed amount attributable to each year—even though they have not yet received any cash payments.
- Income from “constructive sales”: It’s possible for sophisticated investors to extract the gain from an investment without actually selling it and triggering capital-gains taxes. These tax avoidance schemes include “selling short against the box” and using derivatives to obtain all the advantages of a sale without actually executing one. Since 1997, tax rules have deemed such techniques “constructive sales” that are as taxable as the real thing.
- Income from passive foreign investment companies (PFICs): American investors in foreign mutual funds and other companies that derive the bulk of their income from passive sources (such as dividends, interest, rent and royalties) can defer paying U.S. tax on that income while running little risk of losing money in the investment. To discourage such tax-avoiding investments in PFICs, the IRS imposes a punishing tax regime on any “excessive” income derived from selling their shares. Taxpayers can avoid that regime by signing up for “mark-to-market” taxation: paying tax each year on the increase in the value of PFIC shares even though they have not been sold and no cash has been raised.
- Income of securities dealers: Dealers in securities like stocks and bonds are distinct from investors because they maintain inventories of such securities for sale to investors like a grocer keeps boxes of cereal on the shelf. Dealers must use the mark-to-market method of taxation, meaning they pay tax on any gains in the value of their inventory even though they haven’t realized the gain through a sale.
- Passive offshore income of American corporations (Subpart F Income): Foreign profits of American corporations are generally not subject to U.S. tax. But for more than 60 years, the U.S. parent company of a foreign affiliate has been taxed on certain kinds of offshore income in the year generated, even if the parent firm doesn’t receive the money. This so-called Subpart F income (named for the part of the tax code that defines it) includes passive forms like interest, dividends, rents and royalties. The reasoning is that this type of income—unlike, say, the profit from a factory—is easy to shift offshore to no- or low-tax havens in order to avoid U.S. taxation and that the U.S. parent corporation is benefiting from the income even if it is not directly receiving it.
- Global Intangible Low-Taxed Income (GILTI): It was the 2017 Trump-GOP tax law that generally excluded foreign profits of American corporations from U.S. tax. (Prior to that, such profits were theoretically taxable here but the tax—except on Subpart F income—could be indefinitely deferred.) To reduce the incentive of corporations to shift profits to offshore tax havens, the 2017 law also instituted the Global Intangible Low-Taxed Income (GILTI) tax system. It assumes that any return on corporate investment in a foreign country that exceeds 10% must be the result of lodging intangible assets like copyrights and patents there. Corporations can use these offshore intangibles to shift profits from the U.S.—in what’s essentially an example of self-dealing—by paying to use them here. A pharmaceutical company, for instance, that’s transferred the patent for a blockbuster drug to a tiny Caribbean nation can shift its sales profits there by paying inflated amounts for use of the patent. The GILTI system taxes some of that offshore income as if it were domestic income (albeit at a reduced rate) even though the cash is not coming into the parent company’s domestic coffers.
- Profits of U.S. Branches of Foreign Corporations: Prior to a big U.S. tax reform in 1986, foreign corporations doing business in America could avoid paying U.S. tax on their profits if they described their American operation as a “branch” of the home office rather than a separate corporation owned by the foreign firm. That’s because separate corporations could only transmit profits back to the home country by paying it out as a dividend, a taxable event. Branches could funnel funds back to the foreign parent without triggering taxes. (An earlier law meant to curb this practice was complicated and hard to enforce.) Since the 1986 reform, the “deemed” repatriation of a branch office’s profits are taxed by the U.S. based on a formula that may not reflect the amount of funds actually traveling back to the home country. The reasoning is that such in-house transfers—unlike dividends, which must be publicly declared—are hard to track, yet without a branch-profits tax, foreign firms would characterize all their operations in the U.S. as branches in order to dodge American taxes.
- Income subject to the Corporate Alternative Minimum Tax (CMAT): Hugely profitable corporations have been able in recent years to pay little or no corporate income tax because firms figure their profits in two ways. They use one set of accounting rules to calculate the “book” income they report to Wall Street—a figure they make as big as possible to attract investors—while employing a different set of rules to calculate “taxable” earnings, a figure they shrink as small as possible to reduce what they owe the IRS. The Inflation Reduction Act enacted last year tries to curb the phenomenon of tax-free corporations by using book income to figure the tax due from a handful of the nation’s largest corporations—those with over $1 billion in annual profits—if they owe less than 15% based on taxable income. The result is that these corporations could be taxed on income that according to the accounting rules for taxable income has not been received.
- Income of partners in a business: Participants in a partnership like a law firm or doctors’ practice are individually taxed on their share of the partnership’s income even if they have not yet received that share. The reason is that the partnership as a separate entity pays no income tax on its earnings, so it’s left to the partners to do so. Accounting rules ensure the partners are not taxed again on the same income when it is finally distributed.
- Income of the shareholders in an S corporation: Shareholders in an S corporation (generally smaller outfits than the more familiar C corporation and with fewer stockholders) are taxed on their share of the corporation’s income even if they have not yet received that share. The reasoning is the same as with partnerships.