Tax Litigation

Congress is constantly tinkering with the tax code. With the 2025 expiration of many aspects of the Tax Cuts and Jobs Act, expect significant changes in the near future. But just how far does Congress’s authority to tax its citizens extend?

The U.S. Constitution, specifically Article I and the Sixteenth Amendment to the U.S. Constitution, provide Congress with near unlimited authority to tax in certain circumstances. Article I, Section 8 provides that “[t]he Congress shall have power to lay and collect taxes, duties, imposts and excises[.]” There are narrow constraints on Congress when passing taxes that fall within its Article I authority.  Article I, Section 8 merely states that such taxes should be “to pay the Debts and provide for the common Defense and general Welfare of the United States” and that all such taxes be uniform throughout the United States. The Sixteenth Amendment to the U.S. Constitution similarly grants Congress broad authority to tax income: “[t]he 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 significant restraint to Congress’s taxing authority is a limitation on its ability to impose “direct taxes.” Article I, Section 9 provides that “[n]o Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or enumeration herein before directed to be taken.” Therefore, Congress has broad authority when imposing “indirect taxes,” with the exception of the general welfare clause and the uniformity requirement.

But because direct taxes must be apportioned amongst the States according to each State’s population, such taxes are difficult for Congress to pass. The Supreme Court gives the following example of what apportionment entails:

So if Congress imposed a property tax on every American homeowner, the citizens of a State with five percent of the population would pay five percent of the total property tax, even if the value of their combined property added up to only three percent of the total value of homes in the United States. To pay five percent, the tax rate on the citizens of that State would need to be substantially higher than the tax rate in a neighboring State with the same population but more valuable homes.

Moore v. United States, 602 U.S. __ (2024). The Court goes on to note that Congress does not appear to have attempted to pass a direct tax since the Civil War. Id.

Within those broad general contours lie many uncertainties. For example, what is a direct tax and what is an indirect tax? And, going back to the Sixteenth Amendment, what is an income tax, and what, if any, limitations apply to Congress’s authority to tax income?

The Supreme Court has rarely addressed Congress’s taxing authority, especially since the New Deal. And Congress has steadily written countless lines of tax law. But a reconstituted Court now seems interested in delineating Congress’s authority to tax. A recently decided Supreme Court case, Moore v. U.S., raises many of these questions, yet, as we will see, fails to provide many definitive answers.

Background: The Moores Pay a Bit More Tax Than Expected

In 2006, Charles and Kathleen Moore invested $40,000 in a (greater than 50%) American-controlled foreign corporation (CFC) located in India. The Moores’ investment bought them a 13-percent interest in the CFC. While profitable, the CFC never distributed any of its income to its shareholders, including the Moores. But in 2017, American shareholders of CFCs were subject to a one-time tax, titled the “Treatment of Deferred Foreign Income Upon Transition to Participation Exemption System of Taxation,” known colloquially as the Mandatory Repatriation Tax (MRT).

To prevent Americans from avoiding U.S. taxes by keeping earnings offshore, the U.S. has long taxed U.S. shareholders of CFCs. For purposes of those tax provisions, a CFC is a foreign corporation that is more than 50% owned by U.S. shareholders. A U.S. shareholder is a U.S. person that owns at least 10% of a foreign corporation’s shares.

Prior to 2017, the U.S. only taxed CFC’s Subpart F income, mainly consisting of passive income. CFCs’ active business income from overseas business activity were generally untaxed. By 2015, according to the federal government, CFCs had accrued $2.6 trillion in untaxed offshore earnings. And this is where things stood with the Moores and their CFC – it had accrued overseas earnings since 2006, but neither the CFC nor the Moores were subject to tax on that income in the United States.

In 2017, the Tax Cuts and Jobs Act (TCJA) was passed and signed into law. The TCJA made significant changes to the taxation of both domestic corporations and CFCs. As relevant here, the MRT was passed as part of the TCJA. Under the MRT, CFCs’ accumulated earnings going back to 1986, which have not been taxed, must be included in Subpart F income in the last tax year before 2018 (generally 2017). Therefore, shareholders holding at least 10% of a CFC must include in income up to 30 years of accumulated corporate earnings (this does not appear to have been the case with the Moores who appear to have owned the company from its inception in 2005 or 2006).

The Parties’ Arguments

The taxpayers questioned whether the Sixteenth Amendment authorizes Congress to tax unrealized sums without apportionment among the states. The important concept here is realization. The taxpayers contended that another taxpayer – their CFC – earned income, but because such income was not distributed to the taxpayers, they never realized it. Without realization, there can be no income.

The taxpayers contended that the MRT is a property tax in that it taxed their ownership interest in the CFC rather than their income from the CFC. Since the MRT is a property tax rather than an income tax, the taxpayers contended that it was a direct tax subject to apportionment. Since the MRT was not apportioned among the states, the taxpayers contended that the MRT was unconstitutional.

The government argued that the MRT is an income tax. Congress has, even before the enactment of the Sixteenth Amendment, taxed shareholders on undistributed corporate earnings. In this context, the MRT appears indistinguishable from Subpart F. Further, significant portions of the tax code are based on taxing owners on undistributed business income, including taxation of partnerships and S corporations.

The government also contended that there is no realization requirement in the Sixteenth Amendment to the U.S. Constitution. It cannot be read into the Sixteenth Amendment term “income,” which encompasses all economic gain. And it cannot be based on the Sixteenth Amendment phrase “from whatever source derived.”

As a secondary, argument, the government asserted that the MRT was constitutional as an excise tax. Prior Supreme Court precedent (Flint v. Stone Tracy Co., 220 U.S. 107 (1911)) upheld a tax on a corporation’s income as an excise tax on the privilege of doing business.

The Court’s View

The Court upheld the MRT as a constitutional income tax. Congress may attribute an entity’s realized and undistributed income to the entity or to its shareholders or partners. Here, rather than attributing the corporation’s income to the entity, Congress instead attributed it to its shareholders. The Court stressed that this was a narrow holding, stating that: (i) taxation of the shareholders of an entity, (ii) on the undistributed income realized by the entity, (iii) which has been attributed to the shareholders, (iv) when the entity itself has not been taxed on that income is constitutional.

The Court’s holding was supported by five justices (Justices Kavanaugh, Kagan, Sotomayor, Jackson, and Roberts). Justices Barrett and Alito concurred in the judgment only on technical grounds. Justices Thomas and Gorsuch dissented.

Justices Barrett, Alito, Thomas, and Gorsuch found that there is a realization requirement within the Sixteenth Amendment. In the context of a taxpayer taxed as a corporation, these Justices would require a shareholder to receive a dividend or sell shares to have a realization event subject to income tax. Though two of these Justices concurred in the result of this case, the concurrence was on very narrow grounds – ultimately, four Justices signaled that they felt that the MRT was unconstitutional.

Justice Jackson, in concurrence, indicated that she does not read a realization requirement into the U.S. Constitution. The other four Justices did not state their view on whether there is a realization requirement, finding that this issue did not need to be addressed to resolve this case.

Though it did not appear to be raised or implicated in this case, the majority noted that there are due process limitations on who can be taxed on income. The Court stated that these limits are based on the taxpayer’s relationship to the underlying income. The Due Process Clause prohibits the arbitrary attribution of income. Remember, the MRT it imposes taxable income on a shareholder even if the shares were purchased long after the income was earned. A taxpayer who owned the shares as the CFC earned the income, but who sold before the trigger date, would pay no tax. This did not appear to be the case with the Moores, but perhaps another taxpayer could attack the MRT on these grounds.

On the distinction between direct and indirect taxes, the Court pointed to prior precedent that indicated that direct taxes include taxes on persons and property. The Constitution specifically references capitation taxes (a head tax or a poll tax). Such taxes are what the Court refers to as a tax on persons. Previous Court precedent provides that a tax on real property is a direct tax. Decisions prior to 1895 limited direct taxes to capitation taxes and real property taxes. See Hylton v. United States, 3 U.S. 171 (1796). Taxes on personal property were not included in the definition of direct taxes. But Pollock expanded direct taxes to include taxes on personal property and income from property. See Pollock v. Farmers’ Loan & Trust Co., 158 U.S. 601 (1895). The Court did not say that it would consider a tax on personal property a direct tax, but it signaled that it would.

What’s Next?

There are other portions of the tax code that appear to impose tax without a realization requirement, without the distinction of whether income is merely being imposed on the entity or its owners. I.R.C. § 475 mark-to-market accounting and the I.R.C. § 877A taxation of covered expatriates – known as the “Exit Tax” – are two such provisions. Both of these provisions require a taxpayer to treat certain assets as having been sold on a specific date without any such sale actually having taken place. These provisions do not appear to fit within the narrow holding of Moore.

The case also left unaddressed Congress’s authority to impose a wealth tax. Such a tax could be structured as a mark-to-market tax similar to sections 475 or 877A. It could also be designed as a mere tax on a taxpayer’s net worth. The current Court would likely find the latter tax to be a direct tax on personal property, making such a tax unworkable. But we will have to wait to see how the Court views mark-to-market taxes.

Lastly, this was a narrow decision, and any future change to the composition of the Court could result in a different result. As the majority stated, the MRT is similar to Subpart F, Subchapter K, Subchapter S, and many other tax provisions that provide for a significant portion of the government’s revenue. A different result could fundamentally change the U.S. tax code.

While many others look to see how tax regulations will be addressed by courts going forward based on the recent Supreme Court decision, Loper Bright Enterprises v. Raimondo, 2024 U.S. LEXIS 2882 (June 28, 2024), let’s focus on the impact of this decision (yet another overruling of Supreme Court precedent) on past court cases that have applied Chevron deference.

Before we discuss Loper Bright, let’s start with two maxims: (1) language is difficult; and (2) Congress cannot legislate quickly or precisely enough to keep pace with society’s need for rules to properly function. Agencies step in (we hope quickly and with reasonable interpretations) to fill the gaps left in statutory text. Courts, then, stepped in to provide clarification on how we should view the role of agencies where the text of statutes and agency’s guidance present ambiguity. In Chevron, USA, Inc. v. NRDC, 467 U.S. 837 (1984), the Supreme Court ruled that as long as an agency’s interpretation was a permissible construction of a statute that was either silent on a specific issue or ambiguous, courts must defer—that is, give the right of way—to an agency’s interpretation (aka “Chevron deference”). In Auer v. Robbins, 519 U.S. 452 (1997), the Supreme Court held that courts must defer to an agency’s reasonable reading of its own genuinely ambiguous regulations, e.g., the agency that poorly drafted the guidance is in the “better position to reconstruct its original meaning” than judges, who are “most likely to come to divergent conclusions when they are least likely to know what they are doing” (aka “Auer deference”). In Kisor v. Wilkie, 139 S. Ct. 2400 (2019), the Supreme Court refused to overrule Auer deference although it did narrow its application. But, just five years later in Loper Bright, the Supreme Court completely abandoned Chevron deference. Confused by the Supreme Court’s mixed signals here? You’re not alone.

What happened in Loper Bright? In Loper Bright, the Supreme Court ruled that “Courts must exercise their independent judgment in deciding whether an agency has acted within its statutory authority” and may no longer defer to an agency interpretation of the law simply because a statute is ambiguous.

What, then, is the effect of Loper Bright to prior court decisions that applied Chevron deference? In various decisions, courts have validated Treasury regulations by applying Chevron. See, e.g., SIH Partners LLLP v. Comm’r, 150 T.C. 28, (2018), aff’d, 923 F.3d 296 (3^rd Cir. 2019), cert. denied, 2020 U.S. LEXIS 140 (2020) (applying Chevron deference to uphold Treasury regulations under I.R.C. § 956 related to controlled foreign corporations). Given that the fundamental reasoning applied by many courts relied on Chevron deference, the question is whether the force and effect of these regulations are open to challenge, again, as a result of Loper Bright?

Although the Supreme Court overruled Chevron, it tossed a thin lifeline to past cases decided based on Chevron deference to mitigate the likely jolt to the legal system of yet another instance of the Court rejecting its own case law:

“[W]e do not call into question prior cases that relied on the Chevron framework. The holdings of those cases that specific agency actions are lawful . . . are still subject to statutory stare decisis despite our change in interpretive methodology. See CBOCS West, Inc. v. Humphries, 553 U. S. 442, 457 (2008). Mere reliance on Chevron cannot constitute a “special justification” for overruling such a holding.”

In her dissenting opinion, Justice Kagan snickered at the majority’s effort to minimize the chaos resulting from the Loper Bright decision to prior cases which were decided using Chevron stating:

“Courts motivated to overrule an old Chevron-based decision can always come up with something to label a “special justification.” Maybe a court will say “the quality of [the precedent’s] reasoning” was poor. Ante, at 29. Or maybe the court will discover something “unworkable” in the decision—like some exception that has to be applied. Ante, at 30. All a court need do is look to today’s opinion to see how it is done.”

The ripple effect from the Loper Bright decision impacts prior cases that applied Chevron and Auer deference.

Where does Loper Bright leave tax professionals looking at a case such as SIH Partners? If you find a Treasury regulation that presents your clients with a problem, then, based on Justice Kagan’s dissenting opinion in Loper Bright, the lifeline keeping aloft any prior cases that validated these regulations looks terribly weak despite the majority opinion’s statement that stare decisis continues to apply to these cases. Likewise, there appears to be nothing left to argue Auer deference for agency interpretations of its own ambiguous regulations.

While everyone recognizes that Congress cannot keep pace with rapidly evolving issues with legislation, with its decision in Loper Bright, the Court has placed agencies on the sidelines or least in the penalty box. On the one hand, the Supreme Court has acknowledged the importance of the doctrine of stare decisis stating in Dobbs v. Jackson Women’s Health Organization, 597 U.S. 215, 263 (2022), it “protects the interests of those who have taken action in reliance on a past decision. It ‘reduces incentives for challenging settled precedents, saving parties and courts the expense of endless relitigation.’ . . . It ‘contributes to the actual and perceived integrity of the judicial process.’” (Citations omitted.)  On the other hand, the Supreme Court has created a vast gulf of uncertainty and endless relitigation ahead.

In the heyday of its enforcement efforts against the “technical” tax shelters that began to proliferate in the nineties, the IRS issued, under the authority of I.R.C. § 6011(a), more than thirty notices identifying various transactions as suspect. (The landscape in those days was, after all, a target-rich environment.) These notices described the notorious “listed transactions.” And upon the enactment of the American Jobs Creation Act in 2004, the failure to disclose “reportable transactions” (which included those listed transactions) meant serious penalties and sanctions for taxpayers and their material advisors. See I.R.C. §§ 6662A, 6707, 6707A, and 6708. (That last code section imposed upon noncompliant material advisors a penalty of $10,000 a day, a pronouncement of doom that caused even some revenue agents to blanche.)

With CIC Services, LLC v. IRS, 141 S. Ct. 1582 (2021), though, we learned that the Anti-Injunction Act, a venerable defense in the Government’s toolkit, did not bar, for example, a pre-enforcement challenge to a listing notice, thus allowing a taxpayer to proceed with its argument that such a notice, in that case addressing micro-captive insurance arrangements, violated the Administrative Procedure Act for failure to follow the notice-and-comment rulemaking process as required by the APA.

Now most recently, the Eleventh Circuit, as did the Sixth Circuit previously in Mann Construction, Inc. v. United States, 24 F.4^th 1138 (6^th Cir. 2022), has moved on to the merits of whether the IRS need follow APA notice-and-comment procedures. In Green Rock, LLC v. Internal Revenue Service, 2024-1 U.S. Tax Cas. (CCH) P 50,159, dealing with Notice 2017-10 as to certain conservation easements, the circuit court found that the IRS did need to so follow the APA.

The opinion explained that no express language could be found in the Internal Revenue Code providing an exemption from the APA. And resort to the reportable transaction regime established by the Treasury regulations under section 6011 was unavailing as an agency regulation could not displace a provision of the APA. The IRS had argued that through section 6707A, Congress must have been cognizant of the whole existing listing-notice process and thereby blessed it as an exception to the APA’s requirements. The circuit court found this too oblique; Congress must exempt “expressly.” Finally, the IRS had also argued that Congress could not have intended all the listing notices to be done away with. The circuit court noted that when most of the notices were issued, they did not entail penalties for non-disclosure of the transactions, but in any event, only Notice 2017-10 was before the circuit court.

But whether we see this trend of litigation continuing is questionable as the IRS appears to have partaken at Belshazzar’s feast and has begun to identify listed transactions in proposed regulations. See Announcements 2022-28 (syndicated conservation easement transactions); 2023-11 (micro-captive insurance transactions); and Policy Statement on the Tax Regulatory Process (March 5, 2019) (“The best practice for agency rulemaking is the notice-and-comment process established by the Administrative Procedure Act (APA).”)

The IRS Office of Chief Counsel is tasked with representing the IRS in tax controversies before the U.S. Tax Court. But its mission is broad:

Serve America’s taxpayers fairly and with integrity by providing correct and impartial interpretation of the internal revenue laws and the highest quality legal advice and representation for the Internal Revenue Service.

While IRS Counsel represents the IRS in litigated cases, its goal in those cases is to get to the correct result. Recognizing that unrepresented taxpayers in pending U.S. Tax Court cases lack access to quality legal advice, IRS Counsel implemented a program to help unrepresented taxpayers receive legal advice and limited representation. The Settlement Days program was first developed at the end of 2019, and timely implemented soon after the onset of the COVID-19 pandemic. In his prior life, our own Nick was part of the initial cadre at IRS Counsel that developed and implemented the Settlement Days program. The program enjoyed wide support within the IRS, and the Settlement Days cadre received a number of IRS awards.

The Settlement Days program brings together unrepresented taxpayers with pending U.S. Tax Court cases with volunteer attorneys. After receiving advice about their case, taxpayers can then meet with their volunteer attorney and an attorney from the IRS Office of Chief Counsel to try to resolve their pending tax dispute. Other personnel from the IRS, including revenue agents and revenue officers, are also available to assist the parties in resolving the tax dispute. Revenue agents are able to help IRS attorneys review documents, and, after cases are settled, if there is a resulting tax liability, revenue officers are available to assist taxpayers in resolving the balances due. Moreover, Taxpayer Advocate Service personnel may be available to assist taxpayers with issues they may have in non-docketed years.

Local IRS Counsel field offices may hold Settlement Days a few months prior to a trial session. Tax professionals can look for opportunities to volunteer for those events with their local Low Income Taxpayer Clinics. In addition, IRS Counsel holds three nationwide Virtual Settlement Weeks, which seek to pair tax professionals with unrepresented taxpayers around the country. Those unrepresented taxpayers are then able to meet with a tax professional and IRS personnel to try to resolve the tax dispute. Tax professionals interested in volunteering to help taxpayers can volunteer for the Virtual Settlement Week here:

https://www.americanbar.org/groups/taxation/tax_pro_bono/virtual-settlement-week/