This Supreme Court Could Blow a Quadrillion Dollar Hole in The Budget

This is one of the most technical articles we’ve ever distributed. I encourage you to read it, but I wouldn’t blame you if you quit halfway. That’s OK; I’ll do my best to explain it in plain English right now.

The Sixteenth Amendment to the U.S. Constitution created the Federal income tax. It was ratified in 1913 and says, “The Congress shall have the 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.” This permitted the U.S. to collect income taxes from individuals based on their individual incomes.

Prior to the Sixteenth Amendment, Congress relied mostly on tariffs and excise taxes. Some income taxes were passed by Congress, but the Supreme Court struck them down on the view that direct taxes on wages, dividend, interest, rents, etc. had to be apportioned among the states based on population. The Sixteenth Amendment, in effect, overruled the Supreme Court and allowed the direct income taxes we have today.

Still, that begs the question: What is income?

It has long been the case that income must be realized before it can be taxed. A paycheck or dividend distribution is certainly realized. But what about stock gains?

If you buy a share of NVIDIA at $10 and it goes to $500, do you have to pay tax on that gain? The answer is no, unless you sell it. If you buy and hold, no gain has been realized and no tax is due. Once you sell it for $500, you have to pay tax on the $490 gain.

So far, so good. But over the past 100 years, Congress, the Treasury, and the IRS have created hundreds of exceptions to the realization requirement. For example, if you own stock in a private company and you transfer the shares to an offshore company that you also own, there is no realization. You did not get any cash or other property on the transfer.

Still, the IRS says there is a “deemed” realization and some tax is due. This is designed to prevent citizens from later selling the stock offshore outside the U.S. taxing jurisdiction.

Other examples include partnership taxation where a withdrawing partner may be deemed to have income on the unrealized value of partnership assets even though she received no cash. It gets more complicated from there, but you get the idea.

Now a taxpayer has challenged the entire system of “deemed” realization and says that there is no income unless the asset is actually sold or exchanged for cash or other property. No tickee, no shirtee.

To the surprise of many, the U.S. Supreme Court has taken up the case and will hear oral arguments in the next two weeks. If the court rules in favor of the taxpayer, this could blow a $1 quadrillion hole in the U.S. budget (a quadrillion is $1,000 trillion). That’s how much revenue is currently collected by the IRS on deemed sales.

It will also give a boost to investments in stocks, bonds, and private partnerships because investors will have much greater flexibility in terms of how they arrange and dispose of assets. This case may be technical, but it’s a very big deal. It’s well worth watching in the coming weeks.

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