No Taxation Without Realization? | Tax Policy Center
Earlier this year, our teenage children invested some money in the stock market. Tracking their investments, they would cheer when they “made” money. We explained that wouldn’t technically occur until they received a dividend or sold their stock at a higher price than what they paid and collected the cash.
“So it’s as if that money isn’t real,” my daughter observed. “We just watch it grow.”
It is real, though, not only to us but to the IRS. Whether they ultimately record a gain or loss from this investment, that figure will be a part of a future tax return. And if the companies are doing well enough, the kids may soon receive a Form 1099-DIV, which documents the dividends profitable firms pay to their shareholders. Unlike the stocks our children now own, dividends are “realized income” and taxable, whether received in cash or paid out in shares that are reinvested.
Charles and Kathleen Moore of Washington State view “income” differently. If we care about sustaining an efficient, fair tax code, we should all try to understand why.
The Moores have sued the US government, arguing they cannot owe a tax on an investment they watched grow from afar – an investment in a company based in India – because they never actually received “income.” The Supreme Court has decided to hear their case this fall.
Some background: Prior to 2017, US-based corporations faced a 35 percent tax rate on their overseas income when the earnings were returned, or “repatriated,” to the US. To defer US tax payments, corporations didn’t repatriate, parking trillions of dollars offshore. The Tax Cuts and Jobs Act (TCJA) lowered the corporate tax rate to 21 percent and changed corporate tax from a “worldwide” system to a more “territorial” system common in other developed countries, in which earnings are taxed based on where they’re earned (with some exceptions to prevent tax avoidance). But what about that stockpile of overseas income? The TCJA included a transition: A one-time, mandatory repatriation tax.
Back in 2006, the Moores invested $40,000 in their friend’s company in India and received 13 percent of the company’s common shares. The firm reinvested all earnings and became a public limited company in October 2017.
In 2018, the Moores learned that the mandatory repatriation tax applied to their reinvested earnings between 2006 and 2017, proportional to their stake in their company (a total of $132,512). Their resulting tax bill was $14,729.
In a video explaining why they are suing, Charles Moore asserted, “I had received nothing… no return whatsoever” on the initial $40,000 investment. In Kathleen Moore’s words, there was an “emotional return” on the investment. They liked seeing the company grow and help people in India. They argue their investment gains were not “realized” and therefore not “income.”
Generally, the IRS does not tax income or gains that have not been “realized,” which means income that has been actually or constructively received. That includes wages, salary, interest, rent receipts, business income, and dividends (including those that are reinvested). All of these are taxable.
By contrast, “unrealized” income or gains refer to the increase in the value of an asset, like a stock, that has yet to be sold. There are some situations in which unrealized income is subject to tax. They include interest from certain types of bonds (original issue discount debt instruments), gains on regulated futures contracts, and gains on assets owned by those who give up their US citizenship.
The TCJA repatriation tax paid by the Moores was designed to prevent a windfall for corporations that had earnings abroad. Post-TCJA, earnings of a US firm’s foreign subsidiaries became essentially exempt from tax thanks to a 100 percent dividend-received deduction. Under current law, the Moores may never owe tax on their investment’s dividends again.
I can understand if the Moores feel the one-time tax they paid wasn’t fair. As a married couple, they are not a large multinational corporation that was holding millions or billions of dollars in earnings offshore, paying no taxes on them prior to the TCJA.
From their own account, they did not invest in their friend’s company to earn money. They were happy simply to “make a difference.” Nevertheless, depending on how the Supreme Court rules, the Moores could end up making a major difference in the tax code. My colleague Steve Rosenthal and University of Michigan Professor Reuven Avi-Yonah explore the constitutional aspects of the case and what it could mean. The implications are mind-boggling.
So, we’ll be teaching our children not only to invest wisely over the long term, but to pay close attention to tax rules. When they see returns on their investments, they need to understand their tax liability. It’s what responsible investors do.
As for the Moores? Maybe they would have been better off giving their friend a $40,000 gift or loan. I wonder why they didn’t.
The Tax Hound, publishing once a month, helps make sense of tax policy for those outside the tax world by connecting tax issues to everyday concerns. Have a question or an idea? Send Renu an email.
