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Written by: Eugene Steuerle
In Moore v. the United States, the Supreme Court dodged the issue of whether the Constitution allows for the taxation of unrealized income, concluding that the “disagreement over realization” was among “potential issues for another day.” However, Justices Amy Coney Barrett and Samuel Alito, in a concurring opinion, and Justices Clarence Thomas and Neil Gorsuch, in the dissent, declared that realization was a Constitutional requirement.
This is not a minor issue. As my colleague Steven Rosenthal explains, their declarations open the Court to new challenges to the taxation of unrealized income. If the Court determines that “realization” is a Constitutional requirement, the decision would, at worst, threaten to gut the taxation of capital income. At best, it would require the Court to join Congress and the US Treasury Department in the endless game of whack-a-mole on tax shelters.
It’s a difficult game to play.
Congress and Treasury already struggle to prevent the abuse of tax shelters. Likewise, in Moore, the Court debated the meanings of such terms as “realization,” “constructive realization,” “derived,” “source,” “received,” and “drawn by,” which in application depend upon how contracts, ownership, and complex financial arrangements are “built together,” or “constructed.”
Many assets and businesses or “sources” of income comprise not one asset but a complex compilation of assets, including partnership interests, corporate stock and debts, buildings, inventory, and so on. Meanwhile, borrowings, hedges, offsetting positions, and other liabilities can be defined as part of an individual asset, such as a stock or partnership interest, or separate parts of a portfolio, allowing the taxpayer to take advantage of both tax and bankruptcy laws.
Sometimes, accrued losses don’t have to be realized to be deducted. In particular, Congress has allowed estimates of depreciation to be deducted even before an asset is sold and the losses are “realized.”
Is the Court better equipped than Congress and the Treasury to keep up with the nation’s brightest tax lawyers and their financial legerdemain at converting income into an “unrealized” form?
New and creative forms of tax shelters have been ducking that mallet for a long time.
When the law requires gross income from particular sources to be taxed only when realized, the law effectively creates a discretionary or voluntary tax: No realization, no tax. As long as some types of income receive favorable treatment in the income tax, taxpayers pursue ways to receive income in that favored form.
That’s just the beginning. Through leverage, taxpayers, singly or in combination, engage in what is called “tax arbitrage”—realizing costs and losses while failing to realize revenues and gains.
The consequences for the economy can be severe. In Taxes, Loans, and Inflation (1984), I examined how tax arbitrage opportunities in an inflationary environment led to significant federal revenue losses and stagnation in economic growth.
Shelter instruments were blossoming in the decade before that book was written. One of my first experiences with this issue at Treasury came with the growth of commodity tax straddles. For example, a taxpayer would buy a July wheat future (a promise to purchase wheat in July at a fixed price) and sell short a September wheat future (a promise to deliver wheat in September at a fixed price). July and September wheat futures would rise almost the same amount for a while. The taxpayer would then realize whichever side of the straddle had lost value and hang onto the unrealized gains from whatever had gained value.
Lawyers sometimes limit arbitrage by linking one piece of borrowing to an asset being purchased. For instance, the law limits borrowing directly to purchase tax-exempt state and local bonds. However, it doesn’t take a lot of effort to borrow against one asset in a non-traceable manner to buy another.
Hedge funds, private equity funds, and corporations can borrow even when they are flush with profits. When the expected cost of borrowing is negative after tax, inflation, and bankruptcy protections (as it has often been this century), investors only need to own assets with a less negative return to society. In turn, society, not the tax arbitrager, bears the cost of these bad investments.
This tax arbitrage also occurs when unrealized gains and interest deductions shift toward taxpayers facing the highest tax rates, while ownership of instruments with high rates of income realization and interest receipts shifts to those facing low or zero tax rates, such as foreign owners and nonprofit organizations. As a result, interest payments largely show up on tax returns, but interest receipts do not. The cost to the federal government grows because taxpayers deduct more than their real cost; for example, they deduct at a 5 percent nominal interest rate when inflation is 3 percent, and their real cost is only 2 percent.
Will this whack-a-tax-shelter game be improved if the Supreme Court steps in as umpire?
Congress has written many tax rules designed to limit tax arbitrage and the amount of income that can remain unrealized. Rules that apply to commodity and other straddles, annuities, undistributed partnership income, zero coupon bonds, contingent debt, futures contracts, swaps, and constructive sales prevent some unrealized income from avoiding tax. Arguably, Congress still has been losing this battle.
In a future ruling, the Supreme Court could decide it wants to officiate Congress’ game of whack-a-tax shelter. But if it does, the Court needs to understand how open-ended this game can be, the tax arbitrage and shelter opportunities their decisions could easily create, and the consequences for tax equity and the economy itself.
*Largely reproduced from Tax Vox, July 2, 2024, where views expressed are solely the opinion of the authors and not that of the Tax Policy Center, Urban Institute, or Brookings Institution.
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