Reference to “Can Congress Tax the “Wealth” of Charles and Kathleen Moore by Deeming it Income? A challenge to a 2017 law could shut the door to Elizabeth Warren’s far more ambitious levy.”
The impetus for this commentary is a Rivkin & Grossman opinion piece that appeared in the Wall Street Journal (WSJ) on Thursday, September 2, 2021, and a proposed federal tax that may be applied to unrealized appreciation in assets.
The short answer to the question is yes but we will have to officially wait to hear from the judiciary.
Moore is challenging in federal court a 2017 federal tax law change that subjected deferred foreign source income of a foreign corporation, to which they were shareholders, to immediate income taxation. Rivkin & Grossman, who are accomplished lawyers, argue in support of Moore that such a form of taxation violates the US Constitution (including the 16th Amendment). Moore argues that until the accumulation has been distributed by the corporation, they have no income and thus the tax is being applied on wealth, not income. They cite US Supreme Court precedence which defined income as, “the undeniable accession to wealth, clearly realized, and over which the taxpayers have complete dominion.”
Here is the rebuttal.
US shareholders of controlled foreign corporations since the 1960’s have been subject to current income taxation on items that are defined as Subpart F income whether distributed or not to them. Further, US pass through entities such as partnerships, S Corporations, and grantor type trusts have long produced taxable income includible in the income of their owners or beneficiaries whether distributed or not. However, in the context of a domestic C Corporation this isn’t the case – only actual distributions are taxed as income.
The federal courts have also upheld even more egregious reaches of federal tax law – the “kiddie tax”. Under the “kiddie tax” the unearned income (i.e., interest, dividends, and capital gains) of children (even those 18-24 years old) can be subjected to income tax at the parent’s marginal tax rates! Children may be in a lower tax bracket than their parents. That is the case without regard from whom the children received the assets that produce the unearned income. With the invention of the “kiddie tax” Congress was attempting to void a perceived abuse of wealth transfers designed to minimize income taxation of a family. But what if the wealth was inherited from a grandparent as opposed to as a gift during an ancestor’s lifetime? It doesn’t matter according to federal courts and therefore the “kiddie tax” is a valid form of taxation.
This notion of “deeming” something under our tax laws is unwarranted. Yet it frequently happens and most recently during the COVID-19 pandemic when many states and cities argued they could “deem” a person now working from home as still working where they once did for taxation purposes. Imagine that?
On the legislative front Congress is considering a bill that in our view is also going to be subject to Constitutional challenge if ever enacted – a tax on unrealized appreciation in assets. Unrealized in the sense that an asset hasn’t been re-sold. Appreciation in the sense of the value today in excess of the value when it was purchased. The policy behind such legislation is that wealthy persons often accumulate wealth during their lifetime and pass that on to heirs without the incidence of income taxation. That is, under current law the heirs inherit property that they can sell and neither the deceased nor the heirs pay income tax on that appreciation determined as of the date of death of the decedent. The challenge is whether a tax on unrealized (as opposed to realized, i.e., as a result of sale) appreciation is income for purposes of the US tax law and the 16th Amendment to the US Constitution.