Written by: Dan Pilla
The Court is set to issue a ruling in June that could redefine taxable income, potentially opening the door to a whole range of new taxes.
The “base” of our federal tax system is “income.” And that base functions by capturing the amount of “income” an individual or business earns over the course of a year, then subtracting various deductions, credits, and exemptions from that income, and, finally, applying the applicable rate of tax to the remaining income in order to assess the correct income-tax liability.
The concept might seem simple enough at first glance, but at least three factors make the system massively complex. The first is that the federal tax code consists of more than 4 million words seeking to define and apply the various deductions, credits, and exemptions expressed in the law; second (and worse), the code has been amended more than 6,000 times since 2001 alone. Finally, and seemingly bizarre, within those more than 4 million words, there is no comprehensive definition of the word “income.”
The touchstone of the modern income tax is the 16th Amendment, ratified in 1913. It provides no definition of “income.” Rather, it merely authorizes Congress to “lay and collect taxes on incomes, from whatever source derived.” The Internal Revenue Code does contain Section 61, which purports to be a definition of the term “income,” but on careful review, we find that it’s merely a tail-chasing exercise that, in the end, provides only a list of possible sources from which “income” may be derived.
Section 61 begins with the following phrase:
Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items . . .
The law proceeds to list 14 different “sources” from which “income” may be derived. You probably learned in grammar school that you should never attempt to define a word by using the very word you’re seeking to define. Yet that is exactly what Congress did when it wrote that “income” means “income.” Thus, we are no closer to understanding what “income” is for purposes of the tax law.
This lack of clarity has resulted in seemingly endless litigation between taxpayers and the federal government since the introduction of the income-tax code in 1913. Early decisions of the U.S. Supreme Court that addressed the issue defined the term using court authority growing from the Corporation Tax Act of 1909. That law imposed an excise tax, measured by income, on the business of carrying on corporate activity. In the 1918 case of Doyle v. Mitchell Bros. Co., the Supreme Court said that the purpose of the act was “not to tax property as such, nor the mere conversion of property.” Rather, the Court said,
The act employs the term “income” in its natural and obvious sense, as importing something distinct from principal or capital, and conveying the idea of gain or increase arising from corporate activities. Doyle, supra, at 179.
In 1920, the Supreme Court, in the case of Eisner v. Macomber, addressed the issue again, this time directly in the context of the 16th Amendment. There the Court stated that:
Income may be defined as the gain derived from capital, from labor, or from both combined, including profit gained through sale or conversion of capital. Mere growth or increment of value in a capital investment is not income; income is essentially a gain or profit, in itself, of exchangeable value, proceeding from capital, severed from it, and derived or received by the taxpayer for his separate use, benefit, and disposal. Eisner, 252 U. S. at 207.
Thereafter, a number of Supreme Court decisions wrestled with the question over several decades. In 1955, the Supreme Court revisited the question in the case of Commissioner v. Glenshaw Glass. In Glenshaw Glass, the Court offered a definition applicable to the facts of that case. The Court stated that in order for an item to be considered income, there must be: “(1) undeniable accessions to wealth, (2) clearly realized, and (3) over which the taxpayers have complete dominion.”
This is consistent with the Eisner definition and would seem to be a logical and quite simple application of the term. Let’s examine the elements one at a time:
Accession to wealth: If there’s no increase in one’s wealth as a result of a transaction, it can hardly be argued that one incurred income. For example, the mere return of capital from a transaction does not increase one’s wealth. Selling a share of stock for $10 after you purchased it for $10 does not increase your wealth.
Realization: The “realization” of income occurs when all events have occurred that determine the taxpayer’s right to receive the income and the amount can be determined with reasonable accuracy. For example, if one purchases a share of stock for $10, and the market value of the share increases to $12, there’s no “realization” of a $2 gain until the stock is sold. Only at that point is the amount of gain fixed and determinable because that is when all events have occurred that allow for the calculation.
Complete dominion: It cannot be said that one has income if he does not have complete control over the use, enjoyment, and disposition of the money alleged to be income. Suppose a corporation in which the taxpayer is a shareholder earns a profit equal to $10 per share. The profit is not distributed, but retained by the corporation. Undistributed gain over which the individual taxpayer has no control (he cannot use, enjoy, or dispose of it) cannot be income to that taxpayer.
All of this seems logical and introduces some level of simplicity and understanding to the equation. The problem is that no U.S. court, including the U.S. Supreme Court, has fixed the definition of income so solidly as to make it universal and applicable in all situations. In fact, that’s exactly the conclusion that the Ninth Circuit Court of Appeals came to in its decision in Moore v. United States (2022), which stated that the crisp definition provided in Glenshaw Glass was never meant to be a “universal definition, or even a broadly applicable test.” Instead, it was limited only to the facts specifically before the Supreme Court at that time.
Citing its own 1964 decision in United States v. James, in Moore, the Ninth Circuit commented on the difficulty of finding a simple way of defining what constitutes income. It observed that, “The courts have given a wide scope to the income tax, but have realized that the borderline content of ‘income’ must be determined case by case. Essentially the concept of income is a flexible one.”
Moore concerns an investment made by Charles and Kathleen Moore in a “controlled foreign corporation” which increased in value over time. It was considered a “controlled” foreign corporation because the taxpayers owned more than 10 percent of its shares. Specifically, they owned 11 percent of its shares — but they never participated in its day-to-day operations and made no decisions on such operations, and the corporation never distributed any earnings to them. As such, the Moores never actually received any money from their investment; they did not “realize” any income (as defined by Glenshaw Glass) from their ownership interest.
The problem for the Moores is the Mandatory Repatriation Tax (MRT), which was imposed by the Tax Cuts and Jobs Act of 2017. This law requires shareholders with more than 10 percent ownership to report income from a controlled foreign corporation even if such income was not realized. So, regardless of the lack of any distribution of corporate earnings to the Moores, they were taxed on their pro rata share of such earnings, just as if they’d received a check from the corporation.
The taxpayers argued that the MRT was unconstitutional since it ran afoul of the Glenshaw Glass definition of income, and the broader general rule that unrealized income was historically never taxed under our tax code.
The Ninth Circuit dismissed these objections, pointing out that the Glenshaw Glass definition was not, as explained above, a universal definition, and that it didn’t control in this case. Specifically, as to the “realization” argument, the court cited Helvering v. Horst (1940) in stating that:
“[T]he rule that income is not taxable until realized . . . . [is] founded on administrative convenience . . . and [is] not one of exemption from taxation where the enjoyment is consummated by some event other than the taxpayer’s personal receipt of money or property.”
What constituted the “enjoyment” of purported “income” that admittedly was never received was not addressed by the court. One must wonder how an individual can “enjoy” the fruits of income he or she does not possess and cannot use or dispose of. Yet the Ninth Circuit ruled that the MRT was a constitutional assessment for which the Moores were liable, regardless of the fact that the income subject to the tax is, in a very real way, phantom income.
The Moore case is before the Supreme Court right now, and a ruling is expected in June. If the Court agrees with the Ninth Circuit, this will open the door to a wide range of potential new taxes, including perhaps — and most notably — a wealth tax imposed on unrealized capital gains from an endless list of assets, such as has been promoted by the Biden administration and others over the past several years. It will, to say the least, be worth watching how the Court rules.
DANIEL J. PILLA is a tax-litigation specialist and the author of 15 books.
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