I want to talk about the Moore v. United States tax case. The U.S. Supreme Court hears oral arguments this week. And to date, the media coverage of the pending case? Mostly political. And mostly missing the giant impact the case’s issues have on small businesses and entrepreneurs.
But let’s quickly get into the details. Because not only is the case groundbreaking, it produces actionable insights both for small business owners and individual taxpayers.
Issue #1: Due Process Violations
The Moores’ case, if you’re a layperson and you read their petition, brings up three issues related to a tax that appeared in 2017, the Section 965 transition tax. One of the easiest to understand is the “Due Process” clause in the U.S. Constitution.
You can read the Wikipedia definition here, but a quick analogy comparing your own taxes with the Moores’ makes the point clearest.
You probably have saved a bit of money using a 401(k) account. Or a traditional or Roth Individual Retirement Account. Hopefully you’ve been doing that for years. Maybe decades. And partly you’ve done that because tax law says (and has said for decades) you don’t pay income taxes on your profits until you withdraw the money.
That was the deal, right? And so, it would be really crummy, and pretty unfair, if Congress retroactively decided at this point to change the rules. In other words, to now say you need to pay—today—income taxes on the money earned inside your IRA or 401(k) account in the 1990s or the 2000s using a new tax law we cooked up last month.
And yet, that’s basically what the Section 965 transition tax did. It retroactively changed the tax law and rules. And it made previously earned income from earlier years and decades taxable in 2017.
The Moores explain the situation in their petition. They invested $40,000 in a friend’s small business in India. That decision reflected the fact that any income earned by the corporation would not be taxed as earned. But only later as it was distributed. Or when they sold shares. And then on December 22, 2017, President Trump signed the new law which said, ”Okay. Change of rules. Now we want to tax the income as far back as 1986.” The Moores’ resulting tax, apparently paid in 2018, but for an earlier decade’s worth of earnings, equaled $14,729.
Anyway, that’s the first issue—and one that’s largely been missed or ignored or misunderstood by journalists discussing the Moores’ case: Was this retroactive tax law a violation of due process?
Issue #2: Measurement of Income
A second issue the Moore v. United States case examines? When and how a taxpayer measures income.
This bit of the argument gets a little more complicated. As the news coverage of the case shows.
The common-sense income measurement method used for centuries looks at transactions summarized in income statements. That’s been the approach in the Western world since at least the Renaissance (as documented by the Italian monk, Luca Paccioli). And Indian and Arabic cultures have similar accounting traditions that predate the Europeans.
To illustrate how this works for investors, take the example of you owning stock in some U.S. corporation. Like Microsoft. Or Apple Computer.
You don’t owe taxes on the money the Microsoft or Apple shows on their income statements. And on which they pay taxes. You only owe taxes on dividend income you receive from Microsoft or Apple. Or on the capital gain you enjoy if you sell shares of Microsoft or Apple Computer. In other words, the income shown on your income statement. That’s the way the accounting works. Or always used to.
What the Section 965 “transition” tax, and then a related chunk of tax law the Section 951A “global intangible low-taxed income” tax, do? They say you pay taxes on a chunk of the income earned by a foreign corporation you’ve invested in. Even though you haven’t received, or realized, any income. Even though you wouldn’t show that income on your personal income statement. And even if you really don’t have a clean way to measure the income.
Note: Congress and IRS refer to the Section 951A “Global Intangible Low-Taxed Income” tax as the GILTI tax. And, yes, they pronounce it “guilty.”
A quick sidebar for any tax professionals in the audience. Because I want to make two technical points. First, GILTI and other sections of Subpart F do work similarly to how U.S. partnership accounting works. But one noteworthy difference between typical partnership accounting and the Section 965 transition tax is, with a partnership, the income attributed to the partners is earned in the same year the income is attributed—and notably, the attributed partnership income is earned after Congress enacted the law imposing the tax.
A second technical point: Some critics of the Moores’ petition say Subchapter S corporations already force shareholders to report and pay income taxes on corporation income. Thus, Sections 965 and 951A aren’t really a new way of doing the tax accounting. What those folks miss though? With an S corporation, shareholders unanimously consent to this tax accounting treatment before it occurs. Often because the tax accounting both simplifies a small business’s accounting and saves tax.
Summing up, the measurement issue seems more complicated to me. Presumably the Court will consider a bunch of issues as they look closely at how the mechanics need to work. Furthermore, the issue raises more unanswered questions than casual analysis might predict. One issue connected to the complexity, in fact, I discuss next.
Issue #3: Compliance Costs of the Section 965 and 951A Taxes
A third issue is missed in most of the reporting I’ve seen or read: The compliance costs. So let me explain.
In their petition, the Moores note that the Section 965 transition tax equaled, as noted, $14,729. That was the tax per their petition on a $40,000 investment made a decade or so earlier.
The Moores didn’t disclose what the tax accounting costs for determining this tax bill were. Mr. Moore said in an interview said the accountants were costly.
But know this: The costs to calculate Section 965 and 951A taxes in general? Astronomical for a small business investor.
The IRS Form 5471 forms used to calculate these taxes, for example, take roughly a week to prepare according to the IRS. That’s not counting the time to learn the law. Or the time to collect the needed data.
Furthermore, the preparer? She or he needs to be a tax specialist who understands both the federal tax laws for international taxpayers. And she or he needs to understand generally accepted accounting principles since the form incorporates GAAP financial statements.
Rough numbers, you’re probably talking $300 or $400 an hour for roughly 40 hours. That’s $12,000 to $16,000 for just a part of the annual 1040 tax return.
People haven’t thought or talked much about this issue. But it’s an important part of the story. And one small business owners and managers should understand.
Three Closing Comments
Our CPA firm publishes this blog to share actionable insights for small business entrepreneurs and investors. So, let me try to do that regarding the Moore v. United States tax law case.
First, a specific tactical insight. If you’ve invested in a small corporation or LLC in another country? Maybe a family business where your people came from? Or some friend’s foreign venture? Or, heaven forbid, you used a corporation or LLC to hold some foreign rental property? Oh my gosh. You need to see if you should have been filing 5471s. And then if you should have been but haven’t? You want to get with a CPA firm who handles this to see how to bring yourself into compliance. The penalties for bungling the Section 965 and 951A taxes are brutal. (In general, the penalties are assessed in $10,000 increments.)
A second, more general insight. Whatever you or I may think of these sorts of increased regulatory burdens and compliance costs? The increases appear to reflect a trend or pattern entrepreneurs should plan for. And stay alert to.
As just another example, next year the Financial Crimes Enforcement Network (aka “FinCEN”) will require 30 to 40 million small businesses to file “Business Ownership Information” or BOI reports. Failing to file potentially triggers financial penalties that rise as high as $10,000 and, in a worst-case, results in up to two years in prison. (We blog on this topic next month, by the way.) The only practical response to this sort of stuff? Plan ahead. And budget time and dollars.
Finally, a third important takeaway from the Moores’ case for taxpayers. We all want to allow for the possibility that tax law changes—possibly even retroactive changes—may upset carefully laid plans.
Some Related Resources
We’ve got quite a bit of information about international taxes available here at the blog. And you might find other posts useful. For example, if you need to understand the basics of how one handles foreign business tax reporting? Check out this earlier blog post: Reporting Foreign Business Investment
And this related comment: The Section 965 transition tax is what the Moores’ case looks at but a companion tax is the Section 951A GILTI tax. Small businesses facing or dealing with that tax might be interested in either of these two posts too: Section 951A GILTI Tax Avoidance: Ten Tricks and Section 962 Election: An Answer to GILTI?.