Redefining the 16th Amendment: The Impact of the Mandatory Repatriation Tax on Ultra High Net Worth Clients

How has a relatively minor tax bill — $14,729 to be exact — turned into one of the most important tax cases for the United States? The matter at hand is whether the United States federal government can tax unrealized gains as income in Moore v. United States (Docket 22–800). 

What is the Mandatory Repatriation Tax?

In 2017, the Tax Cuts and Jobs Act (TCJA) was signed into law, introducing  the mandatory repatriation tax (MRT), or transition tax, on pre-2018 profits that companies and some U.S. shareholders kept in sheltered accounts abroad. Prior to the Act, U.S. corporations were generally taxed on worldwide income, but foreign income could be deferred indefinitely by retaining earnings through a foreign subsidiary. Through Tax Code Section 95, MRT taxes profits regardless if shareholders receive the income.

Will SCOTUS Reinterpret the 16th Amendment?

The Sixteenth Amendment of the United States declares:

“The Congress shall have 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 Amendment was ratified in 1913 and granted Congress the authority to institute a graduated income tax on the earnings of American workers and  paved the way for the modern income tax system as it is known today. Prior to ratification, the United States collected the majority of revenue from tariff and excise taxes. The 16th Amendment is credited to Senator Norris Brown of Nebraska, who first proposed the idea of a nationwide income tax.

There have been several Supreme Court cases regarding the Amendment, including a 1915 case where the Court declared income tax constitutional.

Taxing Unrealized Gains: Moore v United States

Will Moore v. United States become one of the most important cases in tax history? The case dates back to 2005 when Charles G. and Kathleen F. Moore invested $40,000 in a friend’s firm, KisanKraft, in return for 11% of common shares. KisanKraft, which supplied modern tools to small farmers in India, is more than 50% owned by U.S. persons and is considered a controlled foreign corporation (CFC).

Like many CFCs, KisanKraft has never distributed earnings to shareholders, instead reinvesting all earnings as additional shareholder investments and keeping the funds offshore. Prior to 2017, U.S. citizens would only pay taxes on CFC earnings that were distributed due to the provision in the U.S. tax code called “Subpart F” (26 U.S.C. § 951), which allowed for the taxation of certain types of a U.S. person’s CFC earnings when that U.S. person owned at least 10% of a CFC’s voting stock. U.S. shareholders meeting this ownership threshold could be taxed on their share of specific categories of undistributed CFC earnings, such as dividends, interest, and earnings invested in certain U.S. property. 

However, Subpart F did not permit the U.S. government to tax U.S. shareholders on the CFC’s active business income held offshore. In other words, income generated by the CFC’s own business activities was only subject to U.S. taxation when it was repatriated to the U.S. through dividends, loans or investments in U.S. property. This traditional tax system allowed U.S. shareholders to defer U.S. taxation on foreign earnings as long as those earnings remained offshore. 

But when then-President Donald Trump signed the Tax Cuts and Jobs Act into law, U.S. corporate taxation changed from a worldwide system, where corporations were generally taxed regardless of where their profits were derived, toward a territorial system, where corporations are generally taxed only on their domestic source profits. 

Subpart F was modified by the MRT, and classified earnings derived after1986 as taxable income in 2017, regardless of whether the CFC distributed earnings. After Jan. 1, 2018, a CFC’s income taxable under Subpart F includes current earnings. But the Moores challenged this ruling. 

From Farm Tools in India to SCOTUS

In 2018, the Moores learned that due to the MRT, their tax liability for the year 2017 increased by approximately $15,000, based on their pro rata share of KisanKraft’s retained earnings. The Moores paid the tax, but believing that this provision violated their constitutional rights, specifically the 16th Amendment, took the case to District Court.

The District Court ruled in favor of the government and denied the Moores’ cross-motion for summary judgment, determining that the MRT was a tax on income, and although it was retroactive, it did not violate the Fifth Amendment’s Due Process Clause. Following the upholding of the decision by the Appellate Court, the Moores filed a petition for a writ of certiorari on Feb. 21, 2023, which was granted by the Supreme Court on Jun. 26, 2023.

By agreeing to hear the case, the court faces a challenge that goes far beyond the Moores case and could have implications on the entire U.S. tax system.

The Future of Taxes for High Net-Worth Clients

At stake for the U.S. government is billions in revenue. According to the District Court documents, the government estimates the MRT will generate $340 billion in tax revenue for the United States, helping to offset other individual and corporate tax cuts, as well as broader international tax reform in the 2017 TCJA.

But is there more on the line for affluent investors as the Supreme Court interprets whether the 16th Amendment has a realization requirement for income? If the MRT is upheld, it could possibly introduce a variety of new wealth taxes on anything the government deems income. Yet, if the justices consider the tax unconstitutional, the current partnership and international tax treaties — which routinely tax unrealized income — are at stake.  

Pre-Hearing Controversy

While Moore v United States is expected to be heard “soon,” there is no shortage of controversy within the high court itself regarding the case. On September 8th, The Hill reported that Justice Samuel Alito refused to recuse himself from the case after sitting for two interviews with an attorney involved in the case. The interviews, appearing in the Wall Street Journal Opinions section, prompted Senate Judiciary Chairman Dick Durbin (D-Ill.) and others to call for Alito’s recusal in the Moore case. 

IWTA will continue to keep you abreast of further developments on the Moore v United States case, and advise on how the decisions affect you and your clients’ financial future.