Editor's Note: This column was co-authored by Lacy Willis, an Associate Professor at Chapman University.
The Constitution provides constraints on the taxing power of the federal government. These constraints are applicable to tax legislation regardless of whether new tax laws impact a wide swath of taxpayers or only a small number of very wealthy taxpayers.
Kamala Harris is proposing two separate income taxes on wealthy taxpayers with unrealized income. These new taxes would face constitutional challenges on at least four separate issues. If the Supreme Court determined that any of these challenges was valid, the proposed taxes on unrealized gains would be unconstitutional. If each challenge has a 50 percent chance of success, the government would have only a 6.25 percent chance of successfully defending these proposed new taxes.
The proposed new taxes would impact taxpayers with wealth in excess of $100 million and/or taxpayers with unrealized capital gains at death of greater than $5 million.
Taxpayers with wealth in excess of $100 million would face a current 25 percent minimum tax on unrealized capital gains. Amounts paid would be applied against future capital gains taxes on the sale of appreciated assets. Payments would be refunded if the appreciated assets declined in value or were donated to charity. Payments would be initially paid over nine years.
Taxpayers with more than $5 million of unrealized capital gains at death would be required to pay income taxes at death on any excess over the $5 million base.
Either of these proposals would require massive taxpayer sales of assets. The ramifications to stock prices, pension values or the likelihood many or most of the buyers would be sovereign foreign wealth funds appears not to have been considered.
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Many of the taxpayers who would be subject to the proposed tax on unrealized appreciation would have assets almost entirely consisting of zero basis appreciated stock. Such a taxpayer would have a minimum tax liability of $.25 for each $1.00 of appreciation. At the higher capital gains rate proposed by Kamala Harris, a California taxpayer would be required to sell $.46 of stock to pay a $.25 minimum tax. The taxpayer would be paying state and federal income taxes on the sale of his appreciated stock of $.21 before paying the $.25 minimum tax.
In the extreme, a taxpayer owning about $200 billion of a single stock with a zero tax basis would require the sale of about $92 billion of his stock to pay his $50 billion minimum tax. The additional $42 billion of taxes would be the permanent tax cost of raising the cash to pay the potentially refundable minimum tax. For some taxpayers, the taxes incurred by selling their appreciated assets to pay the minimum tax plus the minimum tax would be more than 50 percent of their net worth.
In Court, taxpayers would argue that taxing unrealized income is unconstitutional because (a) The proposed tax would be collected regardless of the possibility that the current appreciation could reverse and never result in any taxes due. The ‘tax’ would be considered a taking under the 5th Amendment, not an income tax. (b) The proposed tax would be a wholly new tax that fails the requirement of due process under the 5th Amendment. (c) The proposed tax is a direct tax and is unconstitutional under Article 1, Section 9 of the Constitution and (d) The proposed tax includes the wealth of the taxpayer in the calculation of the income tax and therefore also violates Article 1, Section 9 as a direct tax.
The proposed tax on unrealized income would appear to be an illegal taking under the 5th Amendment. As after the minimum tax on unrealized income is paid, the tax is returned to the taxpayer or the taxpayer’s estate if the unrealized income declines or the appreciated assets are subsequently donated to charity. Taxpayers would argue that the refunds are indicia that the proposed minimum tax is not an income tax; it is a mandatory interest free loan to the government. A mandatory interest free loan to the government is clearly a taking under the 5th Amendment.
The proposed tax would appear to also fail under the 5th Amendment because it violates the due process clause. Taxpayers would argue that the proposed tax is a wholly new tax. We can conceive of no argument contradicting this position. Taxpayers will look at the period of retroactivity which, in this proposal, is unlimited. The Supreme Court has never ruled favorably on retroactive tax legislation beyond a couple of years. Congress faced the issue of existing gains in 1913 with the original Internal Revenue Code, which created a wholly new income tax. Congress calculated the basis of assets sold as the higher of either cost or fair market value at March 1, 1913. This eliminated any argument regarding retroactive taxation. In previous rulings, the Supreme Court has discussed retroactivity focusing on a requirement that a new tax must have a “legitimate legislative purpose.” If it is constitutional for the only reasons for collecting a proposed tax are that the government needs more revenues or Congress wants to punish wealthy entrepreneurs, due process would become no more than a historical footnote.
Taxpayers could choose two avenues under Article 1, Section 9 of the Constitution to challenge the proposed taxes as unconstitutional direct taxes. First, there is the argument that income must be realized with a transaction taking place before there is a taxable event. In the recent Moore case, the Court determined not to provide any guidance as to whether there must be a realization transaction before income occurs. This argument would reappear before the Court.
The second issue which is with respect to direct taxes has not previously been discussed in any court cases to date. If a tax on wealth is a direct tax (which the authors believe), including wealth in the calculation of the tax rate would make the tax on unrealized income, in part, a wealth tax. That would make the proposed tax unconstitutional.
Taxpayers with more than $5 million of unrealized capital gains at death would be required to pay income taxes on the excess over the $5 million base. This would subject some taxpayers with wealth not currently subject to the estate tax to a new death tax. With respect, subjecting appreciated assets at death to income taxes, for taxpayers currently subject to estate taxes, this proposal would increase the death tax rate on appreciated assets from 40 percent to 60 percent. Some of the arguments above with respect to constitutionality would also apply to this argument as well.
The significant constitutional issues alone should make taxation on unrealized gains a non-starter. The unfairness of taxing unrealized income which would require most impacted taxpayers to sell stock to pay a tax which ultimately might be returned to the taxpayer is, at best, alarming. The potential chaos on financial markets and the possibility that foreign buyers would purchase assets being sold to pay the tax should be a bit terrifying to economists and politicians alike.
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