Moore v. United States and The Original Public Meaning of “Taxes on Incomes”

I. Introduction

Moore v. United States is the most significant tax case to be argued before the U.S. Supreme Court in recent history. The petition for certiorari bluntly poses the question as: “Whether the Sixteenth Amendment authorizes Congress to tax unrealized sums without apportionment among the states.” Several of the amicus briefs focus on the original meaning of the amendment phrase “taxes on incomes,” claiming that the public understanding of that phrase at the time of the amendment’s adoption necessarily limited an income tax to a tax on income derived from a narrowly interpreted realization event—when a taxpayer receives something of value such as cash or other property in exchange for goods or services provided or as a payment because of property ownership (for example, a dividend payment on stocks or rental payment on leased property). According to the Joint Committee on Taxation, such an expansive interpretation of the constitutional phrase would call into question the constitutionality of multiple significant tax provisions, including all of Subpart F and the GILTI regime, all of Subchapters K and S, the taxation of REMICs, the original issue discount (OID) rules and the rules for below-market and short-term loans, the mark-to-market rules for securities dealers and regulated futures contracts, imputed rental income, the Subchapter L mark-to-market rules, and section 877A, among others.

As noted by Caroline Rule, the Moore case approaches this substantial issue through a married couple’s challenge to the constitutionality of section 965’s mandatory repatriation tax (MRT)—a challenge that claims a purported “‘judicial consensus’ limiting the Sixteenth Amendment’s apportionment exemption to realized gains.” Rule suggests several possible outcomes for the case, including (i) a narrow victory for individual taxpayers holding that the MRT may be applied only to corporate taxpayers; (ii) a holding that the Sixteenth Amendment requires realization and the MRT satisfies that requirement; (iii) a clear holding for the government that the Sixteenth Amendment covers both realization-based and accrual-based taxation; or (iv) a narrow holding that accrual-based taxation is permissible but that the thirty-one year MRT look-back period is too long because it converts the tax from an accrual-based income tax into some sort of direct tax. Of course, there could also be a broad holding that limits income taxes to taxes on income as determined by narrowly defined realization events.

That broadly applicable outcome dependent on a narrow definition of realization appears to be the goal of those supporting the plaintiffs. More than thirty amicus briefs, available here, have been filed in the Moore case. Many focus on the original public meaning of the Sixteenth Amendment’s term “taxes on incomes” through review of historical court cases, legal treatises, and dictionary definitions to argue that the term clearly included a realization requirement. This article first provides a brief overview of the issues and procedural history in Moore, and then challenges that assumption about the meaning of the phrase directly by examining other historical documents from the time of the amendment’s adoption that clearly contemplated that an income tax would be imposed on a mark-to-market or accrual basis.

II. Substantive and Procedural History of the Case

In Moore v. United States, the taxpayers were 11% shareholders in an Indian company that was a section 957(a) controlled foreign corporation (CFC). The taxpayers obtained their CFC interest in 2006 and had never received any distribution of its earnings and profits. Any CFC income was reinvested into the CFC.

The 2017 tax legislation (TCJA) amended the Code’s Subpart F sections. Prior to the TCJA, CFC income was generally not taxed, providing a major deferral tax advantage until distribution or other repatriation. The TCJA made those earnings subject to current taxation and added the MRT as a one-time transition tax on CFC undistributed earnings and profits earned between January 1987 and December 2017 to ensure those past CFC earnings and profits did not permanently escape U.S. taxation. After passage of the TCJA, the Moores amended their 2017 tax return to include payment for the MRT, and then they sought an MRT refund in federal court. The Moores argued that the MRT is an unapportioned direct tax that violates the Constitution’s Apportionment Clause in Article I, Section 9.

The Moore district court reviewed Supreme Court precedent, decisions regarding foreign income, and statutory provisions outside of subpart F to hold in favor of the government. The Supreme Court in Eisner v. Macomber held that a stock distribution was not taxable income because the “shareholder [had] not realized or received any income in the transaction.” The Moore court noted, however, that Macomber did not set a bright-line rule defining all income—i.e., courts have not treated Macomber as establishing a realization requirement, as demonstrated by the Moore district court’s analysis of opinions from various federal appellate courts and the U.S. Tax Court establishing the constitutionality of Subpart F income inclusion. There are also a number of current statutes that tax deemed or indirectly attributed unrealized income. Based on the cases and statutes that appropriately interpret Macomber as not mandating realization, the Moore district court held that the MRT was a tax on income that did not violate the Apportionment Clause; accordingly, the Moores were not entitled to a refund.

The Ninth Circuit affirmed the district court decision, finding that the language of the Constitution, the Sixteenth Amendment, and previous court cases supported the conclusion that “the revised Subpart F is consistent with the Apportionment Clause.” The court also addressed the plaintiff’s cited caselaw on income and realization. First, it noted that the Moores’ reliance on Macomber and Glenshaw Glass to support the claim that the MRT violates the Apportionment Clause failed because Macomber provided a narrow, not universal, definition of income. Nor did Glenshaw Glass provide such a definition: the opinion made clear that the Macomber definition “was not meant to provide a touchstone to all future gross income questions,” as shown by the use of language noting “[h]ere we have instances of.” The Ninth Circuit noted that Horst provided a bit more detail about realization by explaining its foundation in “administrative convenience” but found that the lack of realization does not mean that a taxpayer can escape taxation permanently merely because no money was received.

A requested en banc review was denied, with four judges dissenting. The dissent claimed that the repatriation tax is an unapportioned direct tax on the Moores’ ownership interest in the CFC that “open[s] the door to expansion of the federal taxing power beyond the limits placed by the Constitution.” The dissent looked to the 1895 Pollock case, which reasoned that the “constitution divided federal taxes into two great classes—the class of direct taxes, and the class of duties, imports, and excises” and viewed taxes on income from personal property and real estate as direct taxes requiring apportionment. The dissent also relied on a 1910 legal dictionary definition of income as including “that which comes in or is received from any business or investment of capital.” As to Macomber, the dissent argued that realization is a requirement since income is “the gain derived from capital, from labor, or from both combined.” According to the dissent, the majority’s discussion of Macomber incorrectly characterized it as “merely an advisory example of ‘what income may be defined as’.” The dissent thus claimed that the Supreme Court has always upheld a realization requirement, stating that the description of the realization requirement as an “administrative convenience” does not establish that the definition of “income” does not require realization.

III. Originalism and the Search for Historical Meaning of Constitutional Language

The historical meaning of the Constitution’s terms, though sometimes hotly contested, is often used to justify a particular interpretation of constitutional language. Justice Gorsuch, for example, has publicly supported originalism—i.e., that “original meaning” should be the guiding constitutional interpretive principle. Justice Scalia said that contemporary writings, such as those of Hamilton, Madison or Jay in The Federalist, reveal “how the text of the Constitution was originally understood.” The late Judge Robert H. Bork was another early proponent of originalism.

[W]hat the ratifiers understood themselves to be enacting must be taken to be what the public of that time would have understood the words to mean. … . Law is a public act. Secret reservations or intentions count for nothing. All that counts is how the words used in the Constitution would have been understood at the time. The original understanding is thus manifested in the words used and in secondary materials, such as debates at the [state ratifying] conventions, public discussion, newspaper articles, dictionaries in use at the time, and the like.

Justice Scalia and Judge Bork both argue that a proper interpretation of the original public meaning of the Constitution, including any amendment, should incorporate not just legal materials such as cases, treatises, and dictionaries; but also the writings of the educated public and reports of public discussions found in newspaper articles and other available secondary sources.

A. Arguments on Historical Understanding in the Amici Briefs

1. Supporting the Moores’ claim

Surprisingly, given the broad range of items that Scalia and Bork suggest are necessary to arrive at the “original meaning,” none of the amicus briefs go much beyond discussions of legal materials, with the rare exception of a few citations to the work of Columbia Professor Edwin R.A. Seligman, a prominent American economist. The taxpayers and amicus briefs in their favor draw primarily on dictionary definitions and selective quotations from legal treatises to support a realization requirement.

For example, a few of the briefs cite Thomas Cooley’s 1876 treatise. The Manhattan Institute’s brief references Cooley’s statement that “one of the principal downsides of an income tax was the fact that ‘those holding lands for the rise in value escape it altogether—at least until they sell’.” This brief cites the same 1910 Black Law Dictionary definition of income cited by the Ninth Circuit en banc denial dissent. The Manhattan Institute brief characterizes Henry Campbell Black, original author of the dictionary and also of a 1913 treatise, as having “elaborated that ‘income’ was not synonymous with a mere ‘increase’ in the value of property, but was characterized by ‘acquisition[]’ or as ‘money coming to one.’” A few other dictionaries provide definitions of income cited by amicus briefs. For example, the Southeastern Legal Foundation brief quotes from six dictionaries (including both general and legal) published from 1856-1913. The brief emphasizes that several definitions use phrases like “proceeds from” or “comes in,” such as in “that gain which proceeds from labor, business, property, or capital of any kind.” Note that these phrases do not necessarily require realization—they can also apply to accrual or mark-to-market taxation.

The Americans for Tax Reform brief quotes Seligman’s statement that “‘income as contrasted with capital denotes that amount of wealth which flows in during a definite period and which is at the disposal of the owner for purposes of consumption, so that in consuming it, his capital remains unimpaired.’” This definition could similarly support an interpretation favorable to accrual or mark-to-market accounting. For example, an owner’s occupation of a residence is a form of consumption, can certainly be measured over a definite period, and does not generally impair the capital (the underlying value of the house, which may well increase). That brief also cites Robert H. Montgomery’s 1919 treatise’s statement that “‘the inquiry naturally extends itself into the right to tax any transaction unless there is an actual realization of income, as distinguished from the apparent income which may be and often is due to the temporary fluctuations in values’” and Charles Clark’s 1920 statement discussing Macomber noting that “‘[M]ere general appreciation in value of capital should not be deemed income so long as it is unrealized to the owner . . . .’”. Note that these latter two are prescriptive statements post-amendment, so they do not demonstrate that this understanding was dominant at the time of its adoption.

One of the strongest amici arguments is from a discussion of a Learned Hand opinion from the early years of the income tax. The Pacific Research Institute quotes Judge Hand as noting that “the meaning of the word ‘income’ was ‘not to be found in its bare etymological derivation,’ but was ‘rather to be gathered from the implicit assumptions of its use in common speech.’” Judge Hand defined “‘income’” with reference to “the current distinction between what is commonly treated as the increase or increment from the exercise of some economically productive power of one sort or another, and the power itself, and it should not include such wealth as is honestly appropriated to what would be customarily regarded as the capital of the corporation taxed.” Although the brief stresses the distinction between income and capital and the word exercise, this phrase from Judge Hand’s opinion could be read to support accrual or mark-to-market taxation: an “increase or increment” can exist because property, such as shares of stock, increased in value through the successful conduct of the business.

2. Supporting the government’s position

There are a number of briefs in support of the government. One of the most developed in favor of a broader reading of the Sixteenth Amendment that does not include a realization requirement is an amici curiae brief from Professors Brooks and Gamage that draws upon various sources contemporary to the Sixteenth Amendment’s adoption to respond to pro-petitioner arguments. Among the most telling points is that none of the dictionary definitions that taxpayers or amici curiae have found include the word “realize” or “realization” even though one or both of those terms were defined in the same dictionary. Brooks and Gamage also focus on the definition of “gain” as the most relevant term defining “income” in most of the dictionaries of the time: they show that “gain” was a broad term that included terms and concepts easily understood as not requiring realization—e.g., “increase,” “profit,” “amassing of profit,” “accumulation,” and “advantage.” Brooks and Gamage also show that the treatises relied on by petitioners (and many of the briefs in their support) do not, in fact, support a realization requirement, in part because the language has been quoted by petitioners and others without the full context that reveals a much broader concept of income. In an earlier version of their paper, Brooks and Gamage discuss Haig-Simons income: they demonstrate that the history of this broad definition of income as including consumption plus change in net worth—although articulated in its most commonly quoted form in 1938—can be traced back to earlier writings from 1921, 1899, and 1896 and so was clearly part of the public understanding of income at the time of adoption.

B. History of State Income Taxes

1. From colonies to statehood to the Civil War period

State income taxes demonstrate that states were not uniform in their understanding of the requirements of an income tax, the definition of income for the purposes of such a tax, or the acceptable means of measuring income. These uncertainties belie the certainty of those that argue that a realization requirement was clearly understood as a necessary part of an income tax by contemporaneous authorities at the time of the Sixteenth Amendment’s adoption. As Delos Kinsman notes, the American colonies were familiar with taxation from the days of English rule, and both colonies and new states instituted a “faculty” tax, lasting until about 1825, “characterized by a loose method of determining the taxpayer’s ability, the levy being made upon an estimated or assumed income of the individual.” The faculty tax—clearly not requiring realization since it was based on an estimate—can be seen as a precursor to today’s income tax. As the colonies became states, each state wrestled with creating the best method of providing revenue. Since the first taxes on income were based on a type of faculty tax, states continued relying on estimates. As the Civil War approached, many of the states that did not have any type of tax on income enacted one—on estimated or actual income—to aid in generating revenues to support the war. From 1776 to almost a decade after the Civil War, many of the northern colonies that became states kept some version of the faculty tax, using assessors to estimate taxpayers’ incomes. The early states struggled with enforcement because almost every locality had its own assessor(s) with their own methods of calculating an individual’s tax based on an estimated or assumed income.

Massachusetts was the first state with a tax that required the taxpayer to “carefully determine and report” their income tax to assessors; nonetheless, assessors “often made rough estimates” and the taxpayer had to pay the assessor’s estimated tax. Vermont continued its faculty tax until the 1850s. Connecticut’s faculty tax lasted until 1771, but assessors continued to calculate taxes on estimated income, with the addition of an appeals process for over-assessed taxpayers in 1819. An excerpt from the 1887 Connecticut Tax Commission describes an income-like tax on real estate with no realization requirement: the property was rated in “proportion to the annual income which, on average, it was deemed likely to produce” rather than according to its value or actual income generated. Starting in 1842 due to its increasing state debt, Maryland taxed all income “from all sources of revenue” and made assessors take oaths “that they would rate all offices, posts of profit, professions, and occupations at what they believed to be the yearly salaries, incomes, emoluments, or profits arising therefrom.” However, if a taxpayer swore that his income did not exceed a certain amount, the tax would be based on that amount.

A few of the southern states instituted a tax based on actual or reported income, but many states kept an estimated tax, including Massachusetts, Connecticut, Vermont, Pennsylvania, South Carolina, and Alabama. South Carolina’s tax on estimated income lasted from 1701 until the early 1900s, with a break between 1868 and 1897. Alabama, like many states needing revenues to cover the costs of the Civil War, began to focus on taxing profits related to businesses: it enacted a tax on estimated net profits, indicating that “the amount of capital actually invested and necessarily employed was to be considered and the profits were to include all gains made by sales or resales either directly or indirectly.” After the Civil War, an Alabama taxpayer had to pay taxes on income from investments in real estate: there was no mention of realization, suggesting that Alabama levied on incomes not received.

In addition to the widespread use of estimates of income that would not necessarily have a realization requirement, there are also specific cases of transactions generating recognized income regardless of realization. For example, Virginia taxed interest received from bonds from other countries, states, and international corporations even if the income was “converted into principal so as to become an interest-bearing subject.” Due to the expenses of the Civil War, Virginia enacted a new law in 1863 that taxed a businessman’s profits and calculated net income or profits by deducting “from his gross income all expenses of carrying on the business during the year, as well as all licenses and other taxes paid by him during the same period.” Notably, there was no realization requirement. Similarly, around 1855, North Carolina focused more on taxing profits: a 3% tax rate was charged “upon all net dividends or profits actually due, or if it was received from money invested in vessels.” The language “due or if received” makes clear that there was no realization requirement. In 1859, North Carolina’s law changed to explicitly state that income from interest was assessed “whether the interest had been received or had simply accrued.”

2. At the time of the adoption of the Sixteenth Amendment

Information for Massachusetts and Wisconsin provides a perspective of state taxes on income at the time of the Sixteenth Amendment’s adoption.

In 1911, Massachusetts Governor Foss focused the attention of the legislature on taxation to remedy the concerns about then-current taxes used to generate revenue using assessors who estimated taxes on incomes according to their own particular methods. He sent a letter in 1912 to the state senate creating a plan to cure the injustice and “intolerable conditions resulting from the present tax laws”, including laws regarding taxes on incomes. Governor Foss’s plan would “also make possible the successful enforcement of our ineffective tax upon incomes from professions, trades and employments.” The governor wanted much of his plan to be administered instead by the “State or under the strictest State supervision.”

In 1908, a statewide referendum in Wisconsin amended the state constitution to tax income and corporations. The goal of the Wisconsin income tax was to “distribute the tax burden” more evenly, not necessarily to generate more revenue. In 1911, Wisconsin enacted a statute in which there would be an assessment of taxes whereby taxpayers who “customarily estimate their income or profits on a basis other than of actual cash receipts and disbursements, may, with the consent and approval of the tax commission” use these estimations to determine their assessment. As part of these changes, the statutes define rent from real estate to include “the estimated rental of residence property occupied by the owner thereof.” They expressly state that the tax commission and county assessors “possess all powers now or hereafter granted by law to the state tax commission or assessors in the assessment of personal property and also the power to estimate incomes. In 1912, Wisconsin relied on the previous referendum and amendments to successfully introduce its first statewide income tax.

C. Academic Economics, Accounting, and Law Income Tax Discussions at the Time of Adoption

Academic papers from the economics and law journals around the time of the passage of the Sixteenth Amendment seldom directly address realization, with a few exceptions. In a discussion of whether capital gains are income, Roy G. Blakey suggests that the word “realized” was used instead of “realizable” to avoid administrative burdens, but that the true meaning of income is logically any valuable or exchangeable gain, whether exchanged or not.

1. Definitions of taxable income

Many contemporary definitions of income do not appear to impose a realization requirement but rather define income broadly, consistent with the Sixteenth Amendment “from whatever source derived” criterion. Harry Hubbard noted that the word “direct” was intentionally stricken from the amendment to make the language defining income as broad as possible. Fred Rogers Fairchild defined income as “services rendered by capital and human beings” and asserted that it cannot be restricted to the receipt of money. Truxtun Beale discussed the “acceptance of net economic income as the proper source and measure of taxation,” while R.M. Haig defined income as “the money-value of the net accretion to economic power between two points in time.” Seligman summarized that income is “that which comes in to an individual above all necessary expenses of acquisition, and which is available for his own consumption.” Seligman later noted that income is generally signified by money, but that it can also be conceptualized as “psychic income”—that is, amounts that flow to the individual not in money, but in money’s worth.

The idea of purchasing power reflecting income, regardless of realization, is supported by various scholars. For example, Blakey highlighted that the increase in purchasing power available from appreciated assets reflects economic income and argued that “it is not the sale or conversion of property which brings in income; the appreciation or gain already exists; the sale merely discloses and measures it.” Dean F. Blackmar shared Blakey’s conception of income as the increase in purchasing power from appreciated assets, arguing that the true basis of assessment should be on “the capacity of the citizen to pay … determined by the earning power of property or else by actual income.”

Some papers do allude to a realization requirement. For example, John M. Maguire made a prescriptive argument for a realization requirement for tax to be imposed on a capital gain, specifically as a “severance from the capital mass in which it has been embedded.” In a 1913 discussion of the Wisconsin income tax, Adams noted that “income is measured after the transaction is consummated,” a statement consistent with a realization requirement. In an address to the State and Local Tax section of The National Tax Association in 1912, Nils P. Haugen responded to a question about general rules in Wisconsin’s income tax for arriving at net income by stating that the decline in the value of a security cannot be recognized as a loss because any future appreciation would not be recognized as a gain.

Some papers are inconsistent in their discussions of income and a realization requirement, suggesting, again, a lack of a commonly accepted definition of income as requiring realization. In a discussion about the nature of income in the context of an income tax, Beale pointed to enhanced value during the year as a measure of income, but then inconsistently calls realization a requirement. Fairchild included the imputed value of owner-occupancy of property and food consumed from farming as economic income but also argued that other increases in value of assets and gains from disposals should not be included.

2. Discussions of accrual accounting

Another common topic around the time of the amendment’s adoption is the use of accrual accounting to determine taxable income. Notably, accrual accounting does not require realization for an income or expense item to be recognized. In a discussion of the corporate excise tax pre-dating the Sixteenth Amendment, Maurice Robinson noted that the Secretary of the Treasury at the time heeded calls by accountants to incorporate modern accounting practice into the definition of income: “it was desirable that the returns for the tax should be made up from the regular accounts, according to the accepted standards of modern accounting practice.” Robinson added that “administrative decisions of the treasury department have transformed the federal corporation tax into a fairly consistent and fairly simple tax upon the net income accruing to corporate stockholders within the United States.” He commented that “it is not unlikely that its main features will be incorporated into a general income tax if such a fiscal measure shall be finally adopted.”

Members of the National Tax Association used the term “accrual” in reference to the income tax base in proceedings of their Annual Conference of Taxation. For example, T.S. Adams argued in favor of allowing administrative authorities to accept the taxpayer’s method of accounting: “If the corporation has been using a system of accrual accounting, you cannot go back and translate that into a system of cash accounting.” According to Luther F. Speer, the income tax applied to “net income accruing to each individual or corporation during a given period.” George E. Cleary stated the Sixteenth Amendment applied to “income of individuals received or accrued after March 1, 1913.”

Joseph K. Moyer, then Chairman of the Special Advisory Committee, Bureau of Internal Revenue, positively discussed the Sixteenth Amendment, noting that the legislative conception of income had shifted towards accounting principles, with income for tax purposes being determined under accrual accounting measurement. Moyer noted the Supreme Court’s use of the word “accrued” as synonymous with having “become due.”

3. Specific examples of taxable income without required realization

Various papers include statements directly counter to required realization in more specific contexts. A common area, with varying viewpoints, is the taxation of unrealized gains. In a discussion at the 23rd annual meeting of the American Economic Association, Robinson shared his view on the importance of taxation of unearned appreciation in land value.

Society … has a large share in creating the so-called unearned increment in land values. On the other hand, the intelligent utilization by individuals of both location and fertility value, is a factor not to be neglected. A sharing of the annual income arising from these sources may prove of large practical importance in solving this problem, by giving the state a larger income to use for educational and other purposes, while at the same time furnishing a sufficient incentive for maintaining a widely diffused individual ownership in land.

Blackmar agreed, stating that “lands that are held for a rise in value because of the cultivation of adjacent lands by other people would pay their just share of taxes,” thus sharing the appreciation with the public through a tax on the unrealized gain. Taxation of land appreciation was seen by others as superior to taxing industry.

From a purely economic point of view, such taxes [on inherited wealth and unearned increment of land] conform to the rule of imposing the least possible burden by means of taxation. Tax the products of industry, and you not only tax the payer but you repress industry. Tax these forms of unearned wealth, and you burden the payer, it is true, but you do not repress industry. There is, therefore, less burden imposed upon the community by this form of tax.

In the broader context of unrealized capital gains, many scholars argued that appreciation of capital was not income. In contrast, others posited that unrealized capital gains could or should be subject to income tax. For example, Blakey argued in 1928 that regardless of whether income is set aside for the future as a capital investment, it does not cease to be income in the year of its receipt.

Similar views supporting the inclusion in income of the rental value of residential property occupied by the owner countered any realization requirement. Fairchild clearly understood imputed income to be taxable income: “The houseowner who lives in his own house enjoys an income from it no less real and no less in amount than the income received by the owner of a similar house which is rented to a tenant.” Seligman provided a detailed comparison of an owner A occupying their home and an owner B selling their equivalent home to become a renter, noting that a tax equivalent to the tax paid by B on the income from his investment of the sales proceeds should in fairness also be paid by A. The British income tax at the time also included the value of owner-occupancy as income, as did the Prussian income tax. Thus, it is clear that the value of owner occupancy was commonly perceived as income in the U.S. and other countries, without any realization requirement, at the time of the passage of the Sixteenth Amendment.

Beale’s suggested use of spending as a way to segregate earnings is another example of a measure of earnings lacking a realization requirement.

Undistributed corporate earnings is another area for which there was an implied lack of any realization requirement. For example, Blakey proposed eliminating all aspects of the corporate tax other than a flat tax on undistributed earnings. Fairchild argued that eliminating the corporate income tax must be accompanied by a tax on undistributed income of corporations. Although this argument was made to maintain equality with partnerships and sole proprietors, it is consistent with lack of a realization requirement.

Treasury decisions from the time also illustrate the deemed taxability of unrealized income under the principle of constructive receipt. Roswell Magill highlighted examples where the Treasury imposed income tax liabilities when the taxpayer did not receive, or could not have received, cash or property. The examples range from the standard of recognizing income when the failure to receive the cash was of the taxpayer’s own volition to when the cash is not actually available to him or the ultimate amount is uncertain or the receipt has been assigned to another taxpayer.

4. Congress and the Sixteenth Amendment

While the Sixteenth Amendment gave Congress the power to tax income, scholars such as Truxton Beale pointed out the freedom Congress had to pass income tax laws as they saw fit.

Our legislative bodies—the power of Congress in the regard being precisely parallel and similar to that of the states—can classify and arrange income for taxation as they please, and can exempt portions of income as they choose, provided that such incomes are classified and exempted according to principles which discriminate in favor of no individual or class of individuals and which place all upon the same basis in so far as they conform to the same requirements and act alike under similar circumstances.

The understood power of Congress to define income subject to tax as they chose, so long as the definition applied equally and consistently to all individuals, suggests that Congress was not viewed as limited by a realization requirement. The principle that the income tax should impact taxpayers equally is commonly expressed at the time, with another example coming from G. Cassel who stated that the “income tax must touch all groups of society with equal force.” This publicly understood principle does not support a realization requirement—i.e., the income tax should not favor taxpayers with unrealized income over those with realized income.

Articles at the time go even further to make that understood power clear. Seligman described the chief argument for the amendment’s passage being that “wealth is escaping its due share of taxation.” Adams noted in 1913 that the federal income tax replaced regressive custom taxes and the state income tax replaced defective property taxes, arguing that the tax burden is redistributed but “[n]o new burden is created.” Carl C. Plehn suggested the tax reform movement at the state level was explicitly motivated by desires to change the incidence of tax due to wealth accumulation. States moved towards income tax systems to capture both untaxed and undertaxed resources that accumulated outside their then-current tax systems, supporting that contemporaneous state income tax regimes did not require realization.

Blakey also emphasized that the concept of income is dynamic, changing with time and purpose. Accordingly, support was expressed for Congress to amend income tax laws over time as the economic, political, and cultural environment changed. For example, Harry Hubbard’s seminal 1920 article on the Sixteenth Amendment argued that the lack of exceptions in the amendment’s language gives Congress the power to exempt income as it sees fit to match current conditions. Fairchild echoed that ability to change the laws over time, noting that broadening the statutory definition of income would allow lawmakers to remedy discrepancies in the taxation of income. Adams highlighted “the possibility of readjustment and correction” as a feature making the income tax superior to a property tax. This would clearly include transition features in new laws needed to avoid distortions created by the new law itself.

D. Newspaper Articles

During the early days of the income tax, major newspapers had advice sections devoted to readers’ questions regarding their tax situations. One particularly noteworthy question and response that goes to the heart of the issue of accrual accounting as a basis of taxable income for taxpayers preparing their first federal income tax returns appeared February 1, 1914 in The New York Times.

[Question:] If the income tax aims to tax only net incomes of over $4,000, what shall [a] physician do whose net income is between say, $1,500 and $4,000, but who has bills due at the end of the year for work done in the current year amounting when added to net income to a sum over the $4,000 mark? ... [The physician] will be compelled to keep records that are not essential for the efficient conduct of his business. Unless he can devise a simple method for separating the bill of each year, he will be compelled to pay yearly a tax on money he has not collected.

[Response:] There can be no question that the physician must include in his net income the amount of bills due from patients. If the bills prove uncollectable, he may deduct the amount from his income for the year in which they are found to be worthless. Many other persons besides physicians will find it necessary to keep personal books, and it is frequently argued that this is a beneficial result, though incidental, of the income tax law. In the case of a physician, the accounting would not be very complicated and might result in better collections.

On February 5, 1914, both The New York Times and The Wall Street Journal reported on a new Treasury Department rule with respect to the nascent income tax law providing for mark-to-market taxation of bond appreciation and loss. The Commercial & Financial Chronicle, the first U.S. national business weekly, published excerpts of the Times report.

Suppose a man purchases bonds in 1910 at 100. In 1911 their value is 105, and a record of that fact is made in the taxpayer’s ledger. In 1913 the bonds are worth 115, and this valuation is also entered in the books of the taxpayer. The increase in value over the year 1912 will then be regarded by the Treasury Department as an increase in assets and should be accounted for as income, provided always that the taxpayer has kept his business accounts in the manner mentioned. The reverse of this example—that is, the depreciation of the value of the bonds and the entering of that fact in the taxpayer’s books—will give the taxpayer the right to make in his income tax return a statement of a decrease in assets and therefore a decrease in income.

Treasury later withdrew the ruling in a July 1914 regulation. The earlier ruling, however, indicates that Treasury did not view taxation of accrued but unrealized income and loss as unconstitutional, even if it ultimately adopted a realization-based system for bond taxation.

The National Tax Association convened a committee on the federal income tax during its first years that included some of the most prominent tax experts of the time, such as Edwin R. A. Seligman, Thomas S. Adams, Kossuth N. Kennan, and R. H. Montgomery. One of the committee’s recommendations supported accrual accounting as an appropriate measure for income taxation: “Taxpayers keeping books of account in accordance with statutory requirements or with recognize (sic) methods should be permitted to make their returns based thereon.”

E. Congressional Debates on the First Income Tax Act

Cordell Hull was both a primary early proponent of an income tax and the primary draftsman of the first income tax act. During the debate on that first income tax act, many members of Congress asked Hull questions about the mechanics of his proposed law. One questioned the taxation of securities.

Mr. Rogers: Suppose the gentleman or myself or anybody should invest in 100 shares of one security and in 100 shares of another security and one goes up and the other goes down. Under the act, unquestionably, other things being sufficiently high, he has to pay an income tax on the fortunate security.

Mr. Hull: Yes: if he is simply making a casual investment of that kind now and then, or here and there, I think he would report his gains for taxable purposes.

Lawrence Zelenak notes that “it is even possible to understand [Hull] as claiming that gain on publicly traded stock is taxable on a mark-to-market basis if the taxpayer has not sold the asset, given that Rogers’ question described the security as having gone up in value and did not describe the taxpayer as having sold the security.” Although this exchange is not conclusive, this sort of legislative history is indicative of the understanding of two intelligent and informed men, Rogers and Hull, as to the operation of an income tax. If mark-to-market taxation was clearly publicly understood at the time as unconstitutional, one would think that either Rogers or Hull would have pointed that out. Neither seems to think that an issue.

IV. Conclusion

The concept of a “tax on income” at the time of the adoption of the Sixteenth Amendment is best understood not from a selective dictionary definition that ignores the lack of reference to realization even when that term (or related terms) is defined in the same dictionary nor from a careful selection of phrases from a treatise but rather from a full public understanding of the term as used by those who professionally studied or practiced taxation. In particular, the misguided reliance on Macomber as establishing a universal realization requirement for all taxable income fails to read either the case or related cases accurately. This article has demonstrated—by reviewing a wider array of dictionary, treatise, case law, contemporary state tax laws, scholarship, and concurrent newspaper and congressional discussion—that there was in fact no publicly understood consensus that realization was an inherent requirement of an income tax during the years leading up to, immediately before, and immediately following the adoption of the Sixteenth Amendment. Instead, many contemporary scholars described it as desirable that an income tax be based on accrual methods and include in its base sources of unrealized income, especially as a means of addressing the large accumulations of wealth and wealth disparity that provided a strong rationale underlying the passage of the amendment. The government was correct in stating that “tax scholars have long agreed” that income taxes include both realization and accrual basis taxes, as should be expected from the breadth of the amendment’s language making constitution a “tax on incomes, from whatever source derived.” If the Supreme Court were to use the appropriately cabined Macomber to create a judicial realization requirement for current and future income tax laws, it would be deeply unsettling to the framework established by the Sixteenth Amendment and create chaos for the administration of the income tax laws.