Conservative Ninth Circuit Judges Unsuccessfully Question Constitutionality of Pass-Through Taxation without "Realization" (12/25/22)

We don’t normally encounter constitutional issues in federal tax. There are some, however. See e.g., Justice Ginsburg' successful constitutional attack in Moritz v. Commissioner, 469 F.2d 466 (10th Cir. 1972), cert. denied, 412 U.S. 906 (1973), memorialized in the movie On the Basis of Sex (see Sex and Tax (Federal Tax Crimes Blog 1/7/19) here, where the pre-Judge/Justice Ginsburg with her husband Marty (best tax lawyer ever) in the background succeeded in having a Code provision declared unconstitutional.  

Another instance not yet successful but imagined is asserted by a minority of the Ninth Circuit in a dissent to denial of petition for rehearing en banc. Moore v. United States, 53 F.4th 507 (9th Cir. 11/22/22), CA9 here and GS here, denying the petition from Moore v. United States, 36 F.4th 930 (9th Cir. 2022), CA9 here and GS here. 

While Moore is not a tax procedure case, I mention it because it illustrates the lengths to which conservative-bent judges will go to try to restrain the federal government in a way that can throw a monkey-wrench into settled expectations of our tax system. They often mount these attacks in tax procedure cases, with the APA a tool of their angst (see Bryan Camp, The APA Is Not A Hammer (Procedurally Taxing Blog 6/24/22), here. The judges on the Moore dissent were authoring Judge Bumatay (Trump) and joiners Ikuta (Bush), Callahan (Bush), and Vandyke (Trump). A frequent target for such types is the administrative state. The target this time was Congress in enacting a statute that required a type of pass-through taxation for certain foreign corporations. By pass-through, I mean requiring the owner of an entity to include in the owner’s income for tax purposes the income earned by the entity even if the income is not distributed from the entity to the shareholder. Readers of this blog who, I hope, are familiar with the tax structure we have, know that there are any number of pass-through entities that are essential to the tax we have. To mention a few, S Corporations, partnerships, and some foreign corporations. I cannot recall any serious claims by serious people that the pass-through taxation was unconstitutional.

In Moore, we have a special type of pass-through entity taxation for some foreign corporations. I say special, but not really different in its essential feature of taxing income of the corporation to the owner (shareholder) without distribution. The Moores had a minority interest in a foreign corporation (Indian), which they seemed to have acquired for worthy reasons which Judge Bumatay calls a “good deed.”  (I suppose this is important because interests in some foreign corporations are acquired for not so worthy reasons.)  The pass-through tax in question, 26 U.S.C. § 965, was  enacted by a Republican President (Trump) and a Republican Congress. Tax Cuts and Jobs Act of 2017, Pub. L. 115-97, 131 Stat. 2054, 2218 (2017).

Judge Bumatay, in the dissent, exclaims, starting with irrelevant hyperbole:

            As the Moores would find out, no good deed goes unpunished. In 2018, they learned that under the Tax Cuts and Jobs Act of 2017, they were on the hook for their share of KisanKraft’s lifetime earnings and would owe a one-time tax amounting to $14,729. This surprised the Moores, who had never received any income from KisanKraft and did not expect to pay income taxes just for owning a minority interest in the company. It’s undisputed that the Moores did [*5] not realize income from KisanKraft and lacked the authority to compel a dividend payment constituting realized income. Not only are the Moores minority owners, KisanKraft does not have sufficient cash to distribute its retained and reinvested earnings. But nonetheless, under the Act, the Moores were liable for income tax on income they never earned.

            This was thanks to the Mandatory Repatriation Tax, a one-time “transition tax” to facilitate the repatriation of foreign earnings. See 26 U.S.C. § 965. The Mandatory Repatriation Tax targeted U.S. shareholders who held 10% or more in a “controlled foreign corporation”—a foreign entity with over 50% American ownership, see 26 U.S.C. § 967—that retained and reinvested its prior earnings overseas rather than distributing them to shareholders as dividends. Moore, 36 F.4th at 933. Previously, those shareholders would ordinarily only incur a tax liability when the foreign corporation distributes earnings and the shareholders repatriate those gains. Id. (citing 26 U.S.C. § 951 (2007)). But the Mandatory Repatriation Tax adopted a “novel” approach—it simply deemed the foreign corporation’s retained earnings as the shareholders’ “income” and taxed them according to their proportional ownership stake. Id. at 933–34. 

The majority on the panel opinion held, consistent with other instances of pass-through taxation, that the Moore’s share of corporate earnings could be taxed without distribution or separate “realization” by them. Judge Bumutay and his minority colleagues disagree, thinking that taxation requires a distribution from the entity based on glittering generalities from their constitutional worldview (some type of originalism), just ignoring a lot of history and practice to the contrary. That is likely why they are in the minority. I am reminded of Justice Oliver Wendell Holmes’ famous quote from a tax case that: “a page of history is worth a volume of logic.” New York Trust Co. v. Eisner, 256 U.S. 345, 349 (1921).

Obviously, if Judge Bumatay’s imagined concerns prove to be real, there will be a huge potential disruption to the tax system as we know it.  Perhaps that is one reason, perhaps alone not compelling, not to treat the dissent seriously.