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Digging Further Into the Question "Is Taxing Unrealized Gains Constitutional?"

Let's look at actual Supreme Court cases to help decide if taxing unrealized gains is constitutional.
Author:
Taxes - Wealth

Are Unrealized Gains Income? 

That remains the key question as it is a method Democrats have chosen to pay for Biden's Build Back Better Plan.

I covered the issue at great length in The Meaning of "Income" Suddenly Becomes Very Important For Tax Purposes

There are a couple of different interpretations of "income" but my bottom line opinion remained was as follows

"The proposal taxes unrealized gains. But is there income before gains are realized? The courts will decide if this goes forward, but the idea is dubious at best."

I also discussed why the method was unwise even if the idea was constitution. I failed to go over actual Supreme Court tax cases which I am now aware of.

What Congress Can and Can't Do

  • CPA Mariano Rivera lectured me "Congress can define income however they choose."
  • CPA Sean says "Congress *can't* define income however it chooses. 

Sean provides the key link.

Eisner v. Macomber, 252 U.S. 189 (1920) Findlaw

In Eisner v. Macomber, 252 U.S. 189 (1920)

Income may be defined as the gain derived from capital, from labor, or from both combined, including profit gained through sale or conversion of capital. P. 252 U. S. 207.

Mere growth or increment of value in a capital investment is not income; income is essentially a gain or profit, in itself, of exchangeable value, proceeding from capital, severed from it, and derived or received by the taxpayer for his separate use, benefit, and disposal. Id.

A stock dividend, evincing merely a transfer of an accumulated surplus to the capital account of the corporation, takes nothing from the property of the corporation and adds nothing to that of the shareholder; a tax on such dividends is a tax an capital increase, and not on income, and, to be valid under the Constitution, such taxes must be apportioned according to population in the several states. P. 252 U. S. 208.

Affirmed.

The Supreme Court ruled that dividends were not income. 

We all know that dividends are now taxed so it's important to understand what happened. 

Eisner v. Macomber Wikipedia 

Eisner v. Macomber, 252 U.S. 189 (1920), was a tax case before the United States Supreme Court that is notable for the following holdings:

A pro rata stock dividend where a shareholder received no actual cash or other property and retained the same proportionate share of ownership of the corporation as was held prior to the dividend by the shareholder was not income to the shareholder under the Sixteenth Amendment.

An income tax that was imposed by the Revenue Act of 1916 on such a dividend was unconstitutional even if the dividend indirectly represented accrued earnings of the corporation.

The stock dividend in this case was the economic equivalent of a stock split, a transaction in which the corporation multiplies the total number of shares outstanding but gives the new shares to shareholders in proportion to the number that they had held. For example, if a corporation declares a "two for one" stock split and distributes no money or other property to any stockholder, a stockholder who held 100 shares at $4 per share will now hold 200 shares with a value of $2 each, both of which with $400 in value.

A shareholder's assets do not grow after this sort of stock dividend. Metaphorically, the "pie" is still the same size, but it has been sliced into more pieces, each piece being proportionately smaller. Of course, the same is true of a cash dividend: the shareholder gains cash, but the corporation that is represented by his shares has also lost cash. The shares thus implicitly decline in value by an equal amount.

In the majority opinion, Justice Mahlon Pitney ruled that the stock dividend was not a realization of income by the taxpayer-shareholder for the purposes of the Sixteenth Amendment:

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 richer because of an increase of his capital, at the same time shows he has not realized or received any income in the transaction.

Aftermath

In any event, the success of investors in avoiding tax was short lived. The following year, the Court ruled that capital gains were income and that they should be recognized as income when the stock was sold. In addition, the exception for stock dividends was narrowed by the Court in such cases as United States v. Phellis, 257 U.S. 156 (1921) (shares in a subsidiary corporation that were issued to stockholders in the parent corporation were taxable as income); Rockefeller v. United States 257 U.S. 176 (1921) and Cullinan v. Walker 262 U.S. 134 (1923) (increases in capital accumulated by corporations over time were taxable when shares were distributed to stockholders in a successor corporation).

In 1940, the Supreme Court departed from the realization concept described in Eisner v. Macomber when it held in Helvering v. Bruun, 369 U.S. 461 (1940) that "severance" is not an element of realization. In Bruun, a taxpayer-landlord repossessed a property from a tenant—property that had been subject to a 99-year lease after the tenant failed to pay rent and taxes. The lease had allowed for the tenant to construct a new building or other improvements. The tenant had removed the existing building and built a new one. The value of the new building, as of the date of repossession, was $64,245.68. The government contended that the landlord realized a gain of $51,434.25, the difference between the value of the building at the date of repossession and the landlord's basis in the old building of $12,811.43. The landlord argued that there was no realization of the property because no transaction had occurred, and that the improvement of the property that created the gain was unseverable from the landlord's original capital.

The Court ruled against the landlord and decided that the landlord had realized a gain upon repossession of the property. The Court also said that "severance" was no longer an element of realization.

Towne v. Eisner 

Let's backtrack a bit to a 1918 case before Eisner v. Macomber.

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In 1918, the Court, in Towne v. Eisner 245 U.S. 418 (1918), had addressed a nearly-identical situation to one in Eisner v. Macomber. (Eisner was responsible for Internal Revenue Collection in both cases).

However, in the aftermath of Towne v. Eisner, the US Congress passed a revenue collection statute that specifically stated that stock dividends were to be considered as income.

Supreme Court Quote Towne v. Eisner

Congress was at liberty under the amendment to tax as income, without apportionment, everything that became income, in the ordinary sense of the word, after the adoption of the amendment, including dividends received in the ordinary course by a stockholder from a corporation, even though they were extraordinary in amount and might appear upon analysis to be a mere realization in possession of an inchoate and contingent interest that the stockholder had in a surplus of corporate assets previously existing. 

Wikipedia Concluded 

Important principles in Eisner v. Macomber are that the word "income" in the Sixteenth Amendment is generally given its ordinary plain English meaning and that wealth and property that are not income may not be taxed as income by the Federal Government.

That is appears to be the interpretation of CPA Sean but not CPA Mariano Rivera.

Sean has the far better legal argument. 

The court eventually went along with taxing dividends as income but it is an incredible further leap of faith to go any further.

I suggest the Supreme Court "should" rule the Democratic proposal unconstitutional. 

That does not mean they will, but it certainly means the Democrats are are very questionable ground. 

Add in the fact that Billionaires will likely find some way around the tax (trusts, flight, etc.) and the provision only raises at most $200 billion out of a needed $1.2 trillion to $1.8 trillion, and the whole setup is just plain nuts.

We probably will have a wealth tax,” House Speaker Nancy Pelosi (D., Calif.) said Sunday on CNN.

Indeed. 

That's what it it is despite Treasury Secretary Janet Yellen's comment “I wouldn’t call that a wealth tax, but it would help get at capital gains, which are an extraordinarily large part of the incomes of the wealthiest individuals and right now escape taxation until they’re realized.” 

The Big Concern

What's Really Going On?

It is incredible that Senators and Treasury Secretaries cannot do a little research into these matters. 

They should have far more legal experts at their disposal than bloggers attempting to dig into these matters.

Actually, they do. 

They just don't give a damn when the constitution gets in the way of their own personal preference to have an illegal wealth tax. 

Thanks for Tuning In!

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