Supreme Court Upholds Constitutionality of IRC’s Transition Tax on Undistributed Earnings of Certain Foreign Corporations

In a much-anticipated decision issued on June 20, 2024, the Supreme Court, in a 7-2 ruling in Moore v. US, determined that Internal Revenue Code Section 965’s transition tax, a tax on US shareholders of a foreign corporation’s undistributed earnings, did not exceed constitutional limitations. The case had been closely watched, with many observers positing that an adverse ruling to the government could potentially cast doubt on other existing taxing regimes, such as Subpart F and how partnerships and S corporations are taxed, as well as potentially foreclose enactment of other regimes, most notably a wealth tax.

In 2017, Congress enacted the Tax Cuts and Jobs Act. To help pay for the act’s tax breaks, IRC Section 965 was enacted to impose the tax at issue in Moore. The taxpayers in the case, the Moores, had invested in a foreign corporation controlled, in the aggregate, by them and other US persons. Over time, the corporation generated a great deal of income, none of which was ever distributed to the Moores or the corporation’s other US shareholders. The Moores paid the Section 965 transition tax and sued for a refund, arguing that the tax was unconstitutional.

The Moores reasoned that without actually receiving the undistributed earnings on which they were being taxed – that is, without having realized income – they were being taxed on property (their shares in the foreign corporation), not on income, and that, under the US Constitution, the tax, therefore, had to be apportioned (basically, allocated to each of the 50 states in proportion to their respective populations). In other words, according to the Moores, the Constitution requires that income be realized before it may be taxed without apportionment.

The government argued that the Court did not have to reach the question of whether realization is constitutionally required because there was a realization here by the foreign corporation that was permissibly attributed to its shareholders. Citing and discussing its precedents, the Court agreed, stating the issue and its resolution as follows:

So the precise and narrow question that the Court addresses today is whether Congress may attribute an entity’s realized and undistributed income to the entity’s shareholders or partners, and then tax the shareholders or partners on their portions of that income. This Court’s longstanding precedents, reflected in and reinforced by Congress’s longstanding practice, establish that the answer is yes.

The government also argued that gains need not be realized to constitute income. (Examples include the IRC’s provisions covering mark to market, original issue discount, and gains on expatriation, all of which the government argued were enacted to counter manipulation and other abuses.) The Court declined to decide that issue, determining that it was unnecessary to resolving the case given the precise and narrow question it had decided.

In a concurring opinion, Justice Jackson was of the view that the Constitution does not require that income be realized before it may be taxed without apportionment. In a separate concurring opinion, Justice Barrett, joined by Justice Alito, disagreed, as did Justice Thomas in a dissenting opinion joined by Justice Gorsuch.