What a major income tax case before the Supreme Court means for states

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Welcome back to Route Fifty’s Public Finance Update! I’m Liz Farmer and this week the U.S. Supreme Court heard oral arguments on a highly anticipated case that many say could upend the tax code if the plaintiffs win a broad ruling and could cost state and local governments trillions of dollars.

During oral arguments on Tuesday, the justices seemed keenly aware and at times downright wary of the potential impact of their ruling.

At the center of Moore v. United States are foreign earnings and a provision in the 2017 tax reform called the Mandatory Repatriation Tax. The reform was intended to minimize the incentive for U.S. corporations to hoard money overseas by reducing certain taxes on foreign earnings. In exchange for those reductions, investors and corporations had to pay a one-time, retroactive tax on all foreign income dating back to 1986. The provision helped pay for some of the corporate income tax cuts included in the 2017 Tax Cuts and Jobs Act. 

Charles and Kathleen Moore, who paid $15,000 in taxes on their investment in an India-based company, decided to challenge the provision, contending that it amounted to a tax on unrealized income because they have not recouped their earnings from that investment. While acknowledging it has increased in value by more than a half-million dollars, they argue that because they have not yet received any actual money, they are being unconstitutionally taxed on unrealized income.

The case is viewed as an opportunity for the court to issue a preemptive strike against federal wealth taxes—such as President Joe Biden’s proposed Billionaires Minimum Income Tax—advocated by some Democrats. However, some warn the fallout from such a broader ruling could potentially have ramifications for various taxes that benefit state and local government coffers, including global intangible low-taxed income and property taxes.

All told, the revenue at stake is potentially in the trillions of dollars.

A Cautious Approach

Much of the justices’ questioning during the two-hour hearing revolved around whether or not to define "realization" as it pertains to income and how to apply a ruling narrowly.

“I am quite concerned by the potential implications of the petitioners’ argument, and you stress that in your brief,” Justice Samuel Alito told U.S. Solicitor General Elizabeth Prelogar. “You say if we rule in their favor then large, important pieces of the tax code will logically fall. That’s a fair argument. But I think it's also a fair argument to do the same thing with your position, and I want to understand the limits of your position.”

Justice Brett M. Kavanaugh noted that “the court could resolve this quite narrowly,” an approach Prelogar later urged the court to adopt.

“It would be critically important for the court to do it through Justice Kavanaugh's approach,” she said. “That is, I don't think the court needs to resolve anything about whether the 16th Amendment requires realization.”

If the court explicitly defined the scope of unrealized income, she warned, “there are a number of critically important parts of the tax code that would [not stand up to that].”

Harvey Bezozi, a Florida-based accountant and federal tax law expert, said the court may not have initially intended to rule narrowly when taking up the case and noted that there was considerable pressure exerted by powerful conservative groups to have the case heard in the highest public forum. However, the line of questioning signals the justices' concern about opening “a proverbial Pandora's box of unfair accelerated taxation.” 

“A narrowly applied ruling here,” he added, “would protect various other forms of unrealized income from being automatically included in taxpayers' taxable incomes and subject to immediate taxation.”

What’s at Stake for States

While the Moore case deals with a federal tax, its implications both directly and indirectly affect state taxation. 

Most directly, the Tax Foundation has said a "broader ruling could call into question various taxes that apply to foreign earnings, including global intangible low-taxed income (GILTI),” a new tax that was also part of the 2017 tax reform. GILTI income has been a focus of many state legislatures since its inception. While about half of states have decoupled from that part of the U.S. tax code and don't tax foreign intangible income, 11 states now tax it at the highest level and other states tax it to some degree. 

The dollars at stake are significant. For example Minnesota, the latest state to establish a GILTI tax rate, estimates the tax will bring $437 million more to the state’s coffers during the 2024-25 biennium.

On the other hand, some state attorneys general have argued that a broad ruling allowing a wealth tax could “crowd out” certain taxes that have been the domain of state and local governments, such as property taxes, which rely on the assessed value of a property, or use taxes.

“[T]his division of responsibilities would break down if suddenly the federal government can redefine ‘income’ to encompass even unrealized bumps in value,” argued West Virginia's Patrick Morrisey in a brief signed by 16 other Republican attorneys general. “If any item that can appreciate in value becomes fair game, bad things will follow.”

But a counter brief filed by Arizona Attorney General Kris Mayes and 16 other Democrat attorneys general called that argument “misguided speculation.”

Instead “there is the nonhypothetical, nonspeculative reality that rampant tax avoidance weakens state fiscs today,” they wrote, referring to states who have conformed their codes to directly tax mandatory repatriation revenue in an effort to join the federal codes in encouraging corporations to stop hoarding money overseas. They also point out that, far from making a federal grab at more taxes, the 2017 tax reform implemented sweeping tax cuts. 

“Attacking the [mandatory repatriation tax] in isolation—notwithstanding the accompanying adoption of territorial taxation and overarching taxpayer relief—is like complaining about the cost of postage to claim a pot of gold,” they wrote.

The court is expected to make a ruling before the current term ends in late June.