Tom Talks Taxes - June 26, 2023

Moore v. U.S. and protective refund claims

Today, the Supreme Court granted certiorari in Moore v. U.S., which could be an essential case on what constitutes income under the 16th Amendment. The Supreme Court’s order is here, and the petition for certiorari is here.

Moore asks the Court to consider the following question about the §965 transition tax:

Whether the Sixteenth Amendment authorizes Congress to tax unrealized sums without apportionment among the states.

Article 1, Section 2 of the Constitution restricts Congress’s ability to levy taxes:

Representatives and direct Taxes shall be apportioned among the several States which may be included within this Union, according to their respective Numbers…

The 16th Amendment, ratified in 1913, gives Congress the broad authority to tax income without state apportionment:

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.

Any individual tax that is not an income tax must be collected based on the state's population, making it unworkable. The term income is not defined in the Internal Revenue Code; however, the Supreme Court has looked at the issue in two seminal cases.

In Eisner v. Macomber, 252 U.S. 189 (1920), the Court held that a tax on stock dividends (i.e., a shareholder receives stock shares as a dividend and not cash) was not an income tax and thus required apportionment among the states because the taxpayer did not realize a profit in the transaction:

We are clear that not only does a stock dividend really take nothing from the property of the corporation and add nothing to that of the shareholder, but that the antecedent accumulation of profits evidenced thereby, while indicating that the shareholder is the richer because of an increase of his capital, at the same time shows he has not realized or received any income in the transaction.

It is said that a stockholder may sell the new shares acquired in the stock dividend, and so he may, if he can find a buyer. It is equally true that, if he does sell, and in doing so realizes a profit, such profit, like any other, is income, and, so far as it may have arisen since the Sixteenth Amendment, is taxable by Congress without apportionment.

In Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955), the Supreme Court promulgated a three-prong test for income under the 16th Amendment when considering the taxation of exemplary damages for fraud and punitive damages:

Here, we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion. The mere fact that the payments were extracted from the wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income to the recipients.

Under the Glenshaw Glass test, an amount must be “clearly realized” to be income under the 16th Amendment and avoid state apportionment for a tax on that amount.

Fast forward to 2017, and Congress passed the Tax Cuts and Jobs Act, significantly changing the international tax system. As part of the move to this new system, Congress imposed a one-time transition tax under §965. In its General Explanation of Public Law 115-97, the Joint Committee on Taxation described it as such:

The provision generally requires that, for the last taxable year beginning before January 1, 2018, any U.S. shareholder of a specified foreign corporation must include in income its pro rata share of the accumulated post-1986 deferred foreign income of the corporation.

The §965 transition tax is not a tax on current-year income but on the accumulated prior income not taxed under the pre-TCJA system. The certiorari petition clearly explains the core problem with the §965 transition tax:

Prior to the MRT [mandatory repatriation tax, or §965 tax], these shareholders were usually taxed when the foreign corporation distributed its earnings… The MRT, however, simply deems the corporations’ retained earnings going back to 1986 to be the 2017 income of their U.S. shareholders in proportion to their ownership stakes in 2017… The shareholders are then taxed on that deemed “income”—which, by definition, has not been distributed to them—at a rate based on how the corporation held the retained earnings in 2017: 15.5 percent for earnings held in cash or cash equivalents and 8 percent otherwise.

If the entire §965 transition tax was paid with the 2017 or 2018 returns, those funds are generally outside the §6511 refund statute of limitations, even if the Supreme Court strikes down the statute, unless the taxpayer paid the tax late or filed a timely protective refund claim.

Many taxpayers could not afford the §965 tax hit. Under §965(h), a taxpayer could elect to pay the tax in installments over eight years according to this schedule:

If the Supreme Court strikes down §965, a taxpayer can avoid future installment payments and get a refund of payments made that remain within the refund statute of limitations. It may be prudent to file a protective refund claim for any transition tax payment currently within the refund statute of limitations to preserve the refund.

Under §6511(a), in general (and there is a lot of nuance to the refund statute of limitations), a payment is refundable if a refund claim is filed for that payment before the later of three years from the return filing date or two years from the payment date.

Protective refund claims are unusual and should be submitted to the IRS with precision and care. Internal Revenue Manual (IRM) 4.10.11.2.1.3(4) (09-04-2020) provides an excellent explanation of protective refund claims and their essential elements:

In some instances, a claim may be filed by the taxpayer in anticipation of an expected change in the tax law, other legislation, regulations, case law, or other contingency. A "protective claim" is a claim for credit or refund filed by the taxpayer to preserve the right to pursue a refund based on the resolution of an issue contingent on future events that may not be determinable until after the refund statute has expired. Taxpayers file protective claims to ensure they meet the timeliness requirement. With regard to the requirements of form and content, a protective claim must be in writing, include the taxpayer’s name, address, TIN and signature, identify the contingency affecting the claim, be sufficiently clear and definite to alert the IRS as to the essential nature of the claim, and identify the specific year(s) for which the refund is sought. The exact amount of refund requested may not be known at the time the claim is filed. See IRM 25.6.1.10.2.6.5, Protective Claims, for additional information.

Note: Protective claims filed with the campus are generally forwarded to Technical Services (through PSP) for suspense. The Technical Services Protective Claims Coordinator suspends the case until the contingency is resolved. At that point, if additional information is needed, the case is sent to a group (through PSP) for examination of the claim for refund. Other than noting the timeliness requirement was met by the filing of the protective claim prior to the RSED, there are no differences in how the examiner works the claim for refund. In the event a protective claim is initially filed with the examiner, the examiner should contact their local Technical Services Protective Claims Coordinator for guidance.

IRM 25.6.1.10.2.6.5(2), (3) (05-17-2004) reiterates a protective refund claim must be sufficiently detailed for it to be allowed:

A valid protective claim need not state a particular dollar amount or demand an immediate refund; however, the claim must identify and describe the contingencies affecting the claim; must be sufficiently clear and definite to alert the Service as to the essential nature of the claim; and must identify a specific year or years for which a refund is sought… The Service has discretion in deciding how to process protective claims. In general, it is in the best interests of the Service and taxpayers to delay action on protective claims until the pending litigation or other contingency is resolved. Once the contingency is resolved, the Service may obtain additional information necessary to process the claim and then allow or disallow the claim.

A §965 transition tax protective refund claim is generally filed on Form 1040-X; the first sentence of the narrative should explicitly state, “This is a protective refund claim related to the pending Supreme Court case Moore v. U.S.” The narrative should contain the essential elements the IRM indicates; use good writing skills here. Be sure to mail it via certified mail or an approved private delivery service to document the mailing date if the taxpayer must invoke §7502 for a timely refund claim.

In summary, every taxpayer who paid §965 transition tax and made payments that remain within the refund statute of limitations should consider the need to file protective refund claims. An IRS account transcript will be essential for this analysis.

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