Direct taxes and the Sixteenth Amendment
Wherein the Constitution itself equivocates on the meaning of direct taxes.
Last term, the Supreme Court was asked in Moore v. U.S. whether the Mandatory Repatriation Tax, a provision of the 2017 Tax Cuts and Jobs Act, was a constitutional application of Congress’s taxing power. The Moores argued that the MRT, which taxed Americans for certain income earned by foreign corporations in which they held stock, was an unapportioned direct tax in violation of article I, secs. 2 and 9 of the constitution because the income was unrealized and thus not authorized by the Sixteenth Amendment. The court upheld the MRT, as a tax on realized but undistributed corporate income.
Attribution versus realization
The tax code generally distinguishes between C corps and S corps. When a C corp earns income, it’s taxed as income to the company. Then, when the company passes that revenue onto its owners (in the form of dividends or other property or when the owner sells their shares at a profit), it’s taxed again as income to those owners. S corps, on the other hand, enjoy “pass-through” taxation, meaning that the income is only taxed once. When the company receives income, it’s attributed to the owners, who must pay taxes, even though the income has not been distributed to them.
Income from companies organized overseas but owned by Americans are only taxed once, like an S corp, but generally only when that income is received by the owner, like a C corp. An important exception is Subpart F, which attributes “passive income” (like rents from property) received by foreign companies to their American owners, even though they have not been distributed to them. The MRT, however, was a one-time retroactive tax on all the accumulated untaxed income sitting in foreign companies attributable to their American owners.
The Moores, part owners of an American-controlled company located in India, challenged the MRT, arguing that income held in foreign companies was “unrealized” and therefore not authorized by the Sixteenth Amendment. Since the MRT was not permissible under the Sixteenth Amendment, they argued, it was a direct tax that must be allocated among the states according to their respective populations, which the MRT obviously wasn’t.
The Sixteenth Amendment provides:
The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.
The dear reader may observe that the text of the Sixteenth Amendment does not mention, much less apparently require, that income be “realized,” meaning actually received.1 In a 1920 case, Eisner v. Macomber, however, the Supreme Court had said that income must be realized before it may be taxed by the federal government. That statement in Eisner was arguably dicta though, which means that it wasn’t technically necessary to decide the case and therefore is not binding as a matter of state decisis.
The court, in an opinion by Justice Kavanaugh, sidestepped the question of whether income must be realized, observing that the income in question had been realized: by the Indian company. Whether realization was a requirement of the Sixteenth Amendment was not necessary to decide the case. Rather, the issue was whether Congress could attribute the company’s realized income to its American shareholders.
As discussed above, the Internal Revenue Code already regularly attributes income received by companies to their owners, such as in the cases of S corps and Subpart F. And that practice has been upheld in a long line of cases that nobody had ever supposed was impacted by the Eisner dicta. Consequently the MRT was constitutional under the Sixteenth Amendment.
Are income taxes direct?
Justice Kavanaugh mostly dodged the thorny question of what exactly direct taxes are, describing them “generally speaking” as taxes on “persons and property,” based on NFIB v. Sebelius. But, as I discussed previously, NFIB did not attempt to define direct taxes; it only held that the Obamacare individual mandate was not a direct tax. And of course, Justice Kavanaugh’s characterization of direct taxes was itself dicta because he upheld the MRT under the Sixteenth Amendment and not as an indirect tax under the original Constitution.
Justice Kavanaugh rather just assumed that income taxes are indirect because they tax an event (receipt of money) and not a person or property. But the Supreme Court has flip-flopped on that question in the past and in fact the court’s previous capriciousness in this regard was the very reason why the Sixteenth Amendment was passed in 1913.
Congress enacted the first federal income tax in American history in 1861 to fund the Civil War. In Springer v. U.S., the Supreme Court upheld the income tax as an indirect tax in 1880, declaiming conclusively that “direct taxes, within the meaning of the Constitution, are only capitation taxes, as expressed in that instrument, and taxes on real estate[.]”
But the Springer holding wasn’t as conclusive as they thought, because in 1895, the court reversed course and held in Pollock v. Farmer’s Land & Trust Co.2 that a tax on income from personal property (stocks) must be apportioned among the states. I have previously written about how the Gilded Era court thrived on trolling the Constitution by pretending that Congress couldn’t do things that it plainly can. And the court was in fine form in Pollock, disregarding the settled understanding and its own precedents going back to 1796 to expand the definition of direct taxes beyond capitations and real property.
Public consternation at this bonkers ruling was intense. Progressives wanted to reenact the income tax law and dare the court to strike it down again. But President Taft thought a constitutional amendment was the ticket. Conservative Republicans were willing to go along because they thought the amendment had a snowball’s chance in hell. But to everybody’s surprise it passed with popular acclaim, ratified by forty two states.
As we read above, though, the Sixteenth Amendment does not address direct taxation explicitly, any more than it does realization. So the question raised by Pollock was not clearly resolved by the Sixteenth Amendment. Did the amendment confirm that income taxes never were direct taxes in the first place (meaning the Supreme Court got it wrong in Pollock) or did it change the meaning of direct taxes by excepting them from its definition going forward (meaning that the Supreme Court got it right)? In the Sixteenth Amendment, the Constitution speaks only equivocally to us about the enduring enigma of direct taxes.
Unsolved mysteries
The Amar brothers urged the court in Moore to look beyond the Sixteenth Amendment and reaffirm Springer’s limitation of direct taxes to capitations and real estate. On the other hand, Professor Calabresi was adamant that the direct tax provisions establish a wide ranging restriction on federal tax power. The Moore court mostly evaded that constitutional quagmire by focusing on the Sixteenth Amendment. To gain insight into the original meaning of direct taxes, we must delve deeper into the history of the constitution and inevitably encounter the dark legacy of that peculiar institution.
Unrealized income is generally treated as capital gains and only taxed when the person sells the asset and pockets the cash (i.e. it’s realized).
Pollock was decided in two phases, Pollock I and Pollock II.