The U.S. Supreme Court recently heard oral arguments that could lead to a landmark ruling that affects how unrealized income is (or isn’t) taxed.
As summarized here, Moore vs the United States deals with a relatively new mandatory repatriation tax (MRT) that the plaintiffs claim is unconstitutional. “The one-time tax is supposed to prevent shareholders from obtaining windfalls on undistributed offshore earnings. The IRS levies the tax on U.S. taxpayers with a specified amount of ownership in certain foreign corporations,” explains Kiplinger’s Kelley R. Taylor. In the Moore’s case, the change resulted in a nearly $15,000 tax on a $40,000 investment in a foreign company. But, as with most investments like theirs, those dividends or income weren’t yet realized when the tax was levied.
That’s the point of contention: the taxing of unrealized income. The IRS says it taxes realized capital gains, which is the difference between the adjusted basis (usually cost) in the asset and the amount made on the asset’s sale. Taxing unrealized income is a slippery slope, many say.
As Economist Richard B. McKenzie points out in the Wall Street Journal, “[A firm’s] future profits, the estimates of which cause portfolios to rise or fall in value, haven’t yet been realized. A tax on unrealized capital gains thus amounts to a tax on unrealized future profits that, in many cases, will never be realized, except at losses—especially if added taxation increases the likelihood of unrealized profits.”
But the government already taxes some unrealized income. As Forbes’ Alison Durkee explains, “Business owners in partnerships can be taxed on their company’s profits without selling their stake in it, for instance.” She points out that other taxes that could be affected include a tax on foreign earnings from things like trademarks and copyrights. Democratic-led states argue it could ‘destabilize’ state taxes “because over a dozen states have tax provisions that conform to affected federal laws.”
Therefore, the Tax Policy Center at the Urban Institute & Brookings Institute claims that disallowing the taxing of unrealized income through this case would have dire economic consequences. There are also several federal “wealth tax” proposals circulating right now that include taxing unrealized income.
A ruling is expected later this year, and, as Durkee points out, the justices seem split on which ruling would be more overreaching. For this reason, the case is being criticized as being a pawn in a bigger game (for instance, the Moore’s side is being backed by the Competitive Enterprise Institute, a libertarian think tank funded in part by the Charles Koch Foundation).
Small business owners and investors should monitor the situation and how it could affect their tax obligations. The headlines point to this being an issue affecting the uber-wealthy, but at the core is a nearly $15,000 tax on a $40,000 unrealized investment, a scale many can relate to. Feel free to contact us with questions.
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