Professor Hank Adler of Chapman University discusses the income realization requirement dispute in the transition tax case Moore v. United States before the Supreme Court, and its implications on the U.S. tax system.
This transcript has been edited for length and clarity.
David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: tell me more, tell me more.
The U.S. Supreme Court recently decided to hear a constitutional challenge to the validity of the transition tax passed as part of the Tax Cuts and Jobs Act. This case, Moore vs. the United States, has the potential to make vast changes to established parts of the tax system.
So here to explain what this case is about and what implications it might have is Tax Notes senior legal reporter Andrew Velarde.
Andrew, welcome back to the podcast.
Andrew Velarde: Hi Dave. It’s good to be here again.
David D. Stewart: Why don’t we start off with giving listeners an overview of what this case is about?
Andrew Velarde: Sure. At the center of the case is the issue of whether the 16th Amendment has a realization requirement for income and what weight is to be given to a century-old Supreme Court precedent that many law school students might remember from their introduction to taxation class.
The Moores, who are minority holders in a controlled foreign corporation, have challenged the section 965 transition tax imposed on a taxpayer’s accumulated foreign earnings, arguing that it is not a tax on income and therefore is unconstitutional because it is not apportioned among the states. The 16th Amendment allows for unapportioned taxes on income. The Moores argue that the transition tax is a tax on unrealized gains, and income taxes have a realization requirement.
So in June 2022, the Ninth Circuit affirmed a district court’s decision to reject their challenge. In its decision, the Ninth Circuit said courts have consistently held that other taxes, like the transition tax, are constitutional and that whether income is realized is not determinative.
David D. Stewart: Now I understand you recently talked with someone about this. Could you tell us about your guest?
Andrew Velarde: Yes, I talked with Professor Hank Adler. Hank is the Burra Executive Professor of Accounting at Chapman University, having previously worked as a tax partner at Deloitte & Touche. Hank submitted an amicus brief in Moore in support of the taxpayers before cert was granted by the Supreme Court in June.
David D. Stewart: And what sort of issues did you get into?
Andrew Velarde: We talked not only about the realization requirement but several Supreme Court cases that were being closely examined here. That would be Eisner v. Macomber, Commissioner v. Glenshaw Glass, U.S. v. Carlton. We also examined the potential implications of a taxpayer-favorable decision here, including its potential reach to subpart F or maybe even passthrough regimes.
David D. Stewart: All right, let’s go to that interview.
Andrew Velarde: Hank, welcome to the podcast.
Hank Adler: Thank you. I’m pleased to be here, Andrew.
Andrew Velarde: Terrific. So Hank, I want to start off by asking, numerous groups have filed amicus briefs with the Court asking it to grant cert. In addition to yourself, we had the Chamber of Commerce, the Cato Institute, and Americans for Tax Reform, just to name a few. Why is this case so important, and what’s at stake here?
Hank Adler: Let me jump in and reframe just a touch at the beginning here about the facts. Because I think we don’t know exactly who’s going to listen to this podcast.
So the facts in Moore, which you did perfectly from a technical sense, is the Moores invest in an Indian farm tool business — Indian being in India — and they buy 11 percent. And [there are] probably some altruistic goals here: They’re going to sell small tools to farmers. They put up a certain amount of money, and then nothing happens. They never receive a dividend, they never sell their stock, and they wake up one morning in 2018, and they owe a tax.
So I think when we talk about realized income, we have to start from just the understanding that the Moores bought a piece of paper, essentially. There’s an 89 percent owner. They have no rights to anything, and now they’re being subjected to the tax, and the tax goes back to when they purchased the stock, but if they had owned it for longer, it would go back to 1986.
So I think that just frames the issue to the sense of the shock, and I think that’s the right word for the Moores when they realize this tax. And I make the argument in a lot of different articles that this would be no different than you or I waking up tomorrow morning and having bought a share of General Motors, Congress saying, “Well, sorry, Andrew and Hank, you now own a tax on the undistributed income since 1913.”
I think an interesting way to frame the question you’ve asked: What’s at stake here? My colleague and I, Lacy Willis, started writing on this in 2018, which is before, of course, anybody ever heard of the Moores except the Moores themselves. And we entitled the piece that this portion of the [Tax Cuts and Jobs Act] was the worst statutory precedent over a hundred years. We believe that to this day.
As to your precise question, there are billions of dollars, hundreds of billions of dollars involved. If I remember the last time I read about this, they said the amount of income that was going to come into the country was somewhere between $775 and $800 billion, which would equate [to], we’ll call it $350 billion worth of tax.
Taxpayers were allowed to pay the tax over eight years without interest. So most of the taxpayers paid it over that period of time. Probably the first year is gone, statute-of-limitations-wise, unless there was some kind of statute deal. So they’ll probably pick a number $50 or $75 billion that could be refunded tomorrow, and another couple hundred billion dollars that are going to be paid over the ensuing five or six years.
So that’s the monetary piece of this. And then should the Supreme Court agree with the Moore case, there are lots of new taxes that could come out of Congress because technicians would believe, and I think they would be correct, that if Moore is incorrect in fighting the case that we could have a tax on appreciation and maybe even a tax on wealth. And then, we’ll probably talk about this later, there are a handful of laws out there that could be challenged under the Supreme Court telling us 113 years later what a direct tax is.
So it’s the biggest case in a hundred years.
Andrew Velarde: We’ll get to the potential reach to other taxes in a minute. But I’m glad you alluded there to Eisner v. Macomber. The Moores have argued that the Ninth Circuit improperly departed from that Supreme Court precedent sat there in Eisner v. Macomber in denying that there was a realization requirement to income.
That case held that a pro rata stock dividend wasn’t income under the 16th Amendment and that the tax on it was therefore an unconstitutional direct tax. The government has argued, and the Ninth Circuit also held, that Macomber should be applied narrowly; there’s no set definition of income, and realization is not determinative.
On a denial for a rehearing, there were four Ninth Circuit judges that dissented, arguing that a limiting principle on an unapportioned direct tax on unrealized income should be considered. So my question to you is who is right here, and what is the role of realization in determining what income is?
Hank Adler: Well I think, and I’m going to read a little bit to you if I might, from the original Macomber case, which, at least to the best of my thinking and writing, has never been overturned and still holds its precedent. But I think it was clear under Macomber now almost 100 years ago, maybe it is 100 years, that there needed to be realization.
And if you look at the summary, and I’ll just read you a couple quotes from that, they said, “Income may [be] defined as the gain derived from capital, [from] labor, or [from] both combined, including profit gained through sale or conversion.” They then say, “Mere growth or increment of value in a capital [investment] is not income; income is essentially gain or profit in it itself of exchangeable value, proceeding from capital, severed from it, and derived or received from the taxpayer.”
And I think the second, probably the quote that I think is most meaningful in Macomber, [let me] get my notes, is they say, “Short of liquidation, or until dividend declared, taxpayer has no right to withdraw any part of either capital or profits from the common enterprise; on the contrary, its interest pertains to any part, divisible or indivisible, but to entire assets, business, and the affairs of the company. Nor is it in the interest of the owner in the assets themselves,” for anything but the whole.
So I think Moore, clear as a bell, and later we’ll talk about another case, tells me that I need realization; I need an event to take place, a taxable event where the taxpayer has access to funds, for lack of a better term.
Andrew Velarde: All right. Well, the government has argued that since Macomber, the Supreme Court has consistently interpreted the term “gross income” to apply broadly to any accession to wealth. To quote from Commissioner v. Glenshaw Glass, which is another Supreme Court case from 1955 involving money received for punitive damages, it says, the government argues, limited the reach of Macomber. Why do you disagree with that contention?
Hank Adler: Well I disagree, and when I teach, I teach more Glenshaw Glass than I do Macomber. I’ve never figured out how Macomber got to the Supreme Court. I mean, essentially, it was a stock dividend case; nobody got any economics. And then, within that case, they made some really important statements. You and I might’ve been able to do Macomber in a paragraph.
When I teach Glenshaw Glass, and I’m looking for the right quote here, they say, “Here, we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” And I think when we refer specifically to just accessions to wealth, we don’t get to what the Court was trying to say. I see a lot of that in the research that comes to my desk.
We tend in 2023, I’m sure I do the same thing, we tend to quote only the pieces that make us feel good. But I think Glenshaw Glass is just spot on.
Andrew Velarde: All right, well, you have argued, I’ve seen it written in our pages, I believe, that the 16th Amendment scope has to be based on [the] original public meaning of the text. This is a court that seems to be amenable to exploring original textualism. So in that vein, what is the original meaning, and where do you look to exclude unrealized gains from the definition of income?
Hank Adler: Well, you mentioned a minute ago the dissenters in the Ninth Circuit. And they do just a wonderful job, far better than Hank Adler could do, where they go into the definitions from 1916 from Black’s Law Dictionary. And there they say, and I’m going to quote here again, “The 1910 edition of Black’s Law Dictionary defined ‘income’ to include ‘that which comes or is received from any business investment in capital.'” And they go on to essentially say it takes a realization event.
And I think you could go, and this wasn’t your question, I think you could go back 100 years prior. And it’s unimaginable to me walking into that constitutional convention and saying, “And by the way fellas, we’re going to take part of your net worth.” It’s inconceivable.
But Bumatay and his group, I think that’s how he pronounces it. They do a great job of lining out Black’s Law Dictionary. I can bore you to death by reading the quotes. I think they pretty much get there. Income was that which we think is realized.
Andrew Velarde: So even if realization is a requirement for income, the government has several fallback arguments. I’d like to examine one of those now. It asserts that, “Fine, even if we lose on that point, the transition tax applies to gains realized by corporations and there is no constitutional ban on Congress disregarding a corporation and taxing shareholder income.” How would you respond to that?
Hank Adler: Well, I respond a couple ways. And this wouldn’t be going to the Supreme Court if there wasn’t some question here. And if there’s vulnerability, this is probably where it is. I think that it’s pretty clear that Congress can do just about anything they want with [a] corporation itself.
There’s a lot of cases where they start talking excise tax, etc. But I don’t think we have anything that says they can tax the shareholders directly on the income from the corporation. I don’t think we have that case.
[In the] solicitor general’s response, she quoted National Grocery, which is an accumulated earnings tax case, and a couple of other cases. In some words, I think it’s in National Grocery, they say no constitutional ban disregarding corporation and taxing shareholder income. I think that’s in her statements. But there’s also nothing that says they can do it.
So if you go back to the concept of unrealized income, I can’t find anything in the Constitution or in the 16th Amendment that gets me to that answer. But I think the justices will probably spend [a] considerable amount of time on that.
Andrew Velarde: So a taxpayer-favorable ruling could potentially sweep very broadly, though it’s also conceivable the Court could rule for the Moores and craft a narrower holding, singling out the transition tax. Though as you mentioned earlier, that could have larger ramifications as well, just based on the amount of income it’s predicted to bring in.
But as the government points out, the transition tax was built upon subpart F rules, which have been [in] existence for decades. And there are also some similarities to GILTI as well. Subpart F has been held constitutional by multiple circuit courts.
Some experts have fretted that a taxpayer-favorable decision could implicate rules surrounding mark-to-market taxes and even subchapter K and S rules since Congress taxes passthroughs, even if profits aren’t distributed. There are some who also argue that the Court’s holding may apply to still unenacted wealth taxes. Though this could potentially be viewed as an advisory opinion.
What do you think about the potential reach to other taxes if there is a realization requirement for income?
Hank Adler: Well, I think some of the arguments, with all due respect, are frivolous. I really do. I mean the partnership, to say that because we have partnership, I’ve chosen to be partnership and I have [a] statute going back forever that says it’s a flowthrough, as to how a decision here would say no longer can I have flowthroughs, I can’t get there.
Subchapter S, which I think in two ways is the one where we say Congress kind of made this decision years ago, subchapter S is elective. So what we’ve said in subchapter S, going back [to] 1958, if I remember the statute, in 1958 they said, “You are entitled,” given in those days less than I believe 12 taxpayers. It might’ve been 10; it’s now 100. “You are entitled to waive the line between corporations and have it be treated as a flowthrough,” with 1,000 rules on what to do with accumulated E&P [earnings and profits]. Very different than the “let’s tax it all at one time” that we have here.
So I don’t get there on those two. They mentioned 1256. 1256 is a Ninth Circuit case. Interestingly enough, this is a Ninth Circuit case. And the court took the position, Ninth Circuit took the position that essentially in the currency option trading world that they had access to the funds. Could they jump on that? Yeah, I think they could.
GILTI. I told you we’re getting ready for this. I’m not a subchapter F expert, and I’ve read GILTI, and I am surely not an expert in that. But there’s probably some risk from the subpart F that I’ve looked at, basically it’s all about other words for a deemed distribution, a deemed dividend. We don’t have the income in the corp, pick up the income regardless, the active income was left alone.
GILTI I’ll leave to your next interview because I would just do a terrible job on that. But it certainly could lead, and I have kind of an argument with one of my co-authors on some of this stuff over the last couple of years. It clearly could, I think, just absolutely knock any tax of appreciation out of the box on the federal purposes. I mean, there’s no realization there. Whether this case would trend toward a wealth tax or not, it’s almost a different issue to me.
And something you can think about, I haven’t written about this, [not] sure how to write about it. But if you think about it, we go back to 1986 and we say we’re going to tax all the income since 1986. That has absolutely no relationship to wealth at all. It has no relationship to the value of that corporation. I mean, we don’t know the facts, but they say Moore is successful. What if Moore is just about to go bankrupt because of some liquidity issue? I mean, there’s just a complete mismatch there. And I think that’s one of the baselines of why we like to have realization.
So that’s a long-winded answer. And one of the things I keep fiddling with in my mind is how can the Supreme Court run away from this? How can they narrow their decision so that they don’t deal with all these 100-year issues and have to define direct taxes?
And I haven’t solved it. And to be honest, it makes me happy. I spent my whole career dealing with this issue of “what’s direct taxes?” Well, for God’s sake, we should know. It’s just incredible that this would go on for 100 years. Two hundred years in some ways.
Andrew Velarde: You mentioned 1986; I’m glad you brought that up. That the transition tax reaches back that far to the accumulated earnings since 1986. I have seen you have previously argued that the transition tax violated due process as it is improperly retroactive going back that far.
Is this a distinguishing feature the Court could rely on to limit any holding to just this tax? And if it is distinguishing, how do you differentiate it from the Supreme Court’s decision in United States v. Carlton, a 1994 case on the state tax deduction change, which held that retroactive changes do not violate due process?
Hank Adler: It’s such a good question. Let’s talk about Carlton for a second and what it said. And Carlton’s a local guy here. I met him, I don’t know him very well.
Carlton was a case where Jerry Carlton, the well-respected lawyer in Orange County, found a huge loophole in the tax law. And he was doing an estate tax return. He just drove a truck right through it. And what happened was Congress figured out there was a loophole, and they undid that loophole back, I think, less than 12 months, but let’s say 16 months. I can’t remember exactly. And so government, Treasury argues that we should be able to retroactively fix a bad law.
So now we have the Carlton case, and Jerry loses it at every level. And so it goes to the Supreme Court, and the Supreme Court says, “We have to have…” My words. “We have to have the right to fix things that are a mistake.”
And now we get two concurrent opinions, not dissenting opinions, but concurring decisions. One from Sandra Day O’Connor, [in] which she specifically says, “Look, we’re only going back a year. We’re not looking at more than a year.” And then we have Scalia, which was joined by Judge Thomas, and I think he’s got to be so excited about this opportunity. They say, “We read Carlton, which you guys wrote, and we agree with the ultimate decision. We read that to say just if you want to raise money, you should be able to go back as far as you want for retroactivity.” So I think, and there’s a big problem with this I’ll get to in a second. I think this is an opportunity for the Court to rein in Carlton.
Now what’s the problem with that is that wasn’t briefed by anybody. When Andrew Grossman, who’s done an incredibly good job on this, Baker Hofstetler, when he was making his decision on how to go for cert, he decided to isolate on a single issue. It’s hard to fault him because here we are at the Supreme Court and the world, everybody that I talked to as we were waiting for [if] we were going to get certiorari or not said, basically, “We have no chance.” So I wouldn’t fault Andrew for a second. He’s brilliant. He’s a good guy. But it hasn’t been briefed.
So now you have to look, maybe it’s Sebelius where Judge Roberts brought all of, not all of it, but a very important issue up at the last minute that the healthcare thing was really a tax. That was never briefed, either. So Court has that opportunity if they choose to. I’m writing another brief and my brief will say something to the effect of, “If for some reason the Court gets to unrealized income is OK, now it must deal with Carlton.”
Will the Court care what Hank Adler thinks? I have no idea. I doubt it, but I’m going to write it. I’m going to spend a lot of time writing it up because I think it’s another issue that the Court really should deal with.
Andrew Velarde: That’s interesting. Is there anything else that sets the transition tax apart from other taxes being discussed that could possibly be swept up in this controversy?
Hank Adler: Yeah, there’s one other issue, and I’m just going to call it Adler’s notion. Because nobody’s read it, including Adler. But the tax rate is just unique. As you know, we have two tax rates. We have an 8 percent rate to the extent that essentially the taxpayer had liquid assets. And then, if there’s more unrecognized income than the amount of liquid assets, everything else is taxed at 15.5 percent.
So at least that I can find, and I’m still looking, there has never been a tax in the United States, federal rate tax, where there was anything but a rate scale, a rate chart, or something like that. So here we have a situation where the tax is based upon liquidity of a foreign entity.
So you think about it, let’s assume that Andrew and Hank both have CFC interest in identical companies. And it’s the end of 2017, and Andrew makes a huge profitable sale, and before the end of the year, he puts that money into machinery equipment. Adler, exact same circumstances, I hold onto the cash. Do you know I pay a 15.5 percent tax? You pay an 8 percent tax. We have exactly the same amount of income.
So I keep fiddling with that notion that that shouldn’t be. And I don’t think for a second the Court will take it up, but I may write a few paragraphs.
Andrew Velarde: Well, that’s interesting. Hank, I want to thank you for taking the time and chatting with me today. This has been a terrific conversation.
Hank Adler: Oh, I’ve enjoyed it. This is super.
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