President Biden Proposes to End Federal Income Taxation upon “Income Realization,” but the Constitution is in the Way

income tax

President Biden proposes that all transfers of property by gift or as a result of death give rise to income taxable “as of” the times of transfer, based upon the difference between the property cost and its fair market value on the transfer date.  Furthermore, all property that has been held in trust, a partnership  or other non-corporate entity since 1940, which property has not been the subject of a realization event, viz., a sale or receiving in exchange other, materially different property, will be income taxable on the difference between cost and at its fair market value as of December 31, 2030.  General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals, May 28, 2021.

In terms of federal income tax history, President Biden proposes to do away with “income realization” as the trigger for federal income taxation in these broad circumstances. President Biden also proposes the first one or two million of such hypothetical gain be income tax exempt, but this does not change his basic principle.  A serious Constitutional issue comes to mind.

In Eisner v. Macomber252 U. S. 189 (1920), the Supreme Court held that the 16th Amendment requires “income realization” as a prerequisite for Congress’ taxing income.  The Supreme Court has reaffirmed this holding on a recurring basis as against periodic IRS challenges in various contexts.  In particular with decisions issued in 1938, 1955 and 1990.   Consequently, the background to and facts and rationale of the case are worth knowing about.

The Progressives’ 16th amendment to the Constitution (1913) reads as follows:

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

The Progressives’ Revenue Act of September 8, 1916, included a retroactive provision taxing the value of additional common stock received as a result of a common stock dividend in kind, as follows:  “a [common] stock dividend shall be considered income, to the amount of its cash value…”  On January 1, 1916, the Standard Oil Company of California had outstanding shares of common stock, par value $100 each, amounting in round figures to $50,000,000.  In January, 1916, in order to readjust its stock capitalization to reflect a corporate earnings surplus, the board of directors decided to issue additional common shares sufficient to constitute a dividend equal in number to fifty percent of the then outstanding stock.  The new stock was issued and apportioned among the stockholders relative to the number of shares each owned on the declaration date.

To make a long procedural history short, one Mrs. Macomber paid the income tax under protest and fought to the end.  She won. The Supreme Court reasoned as follows (paraphrased):

The 16th Amendment must be construed in connection with the taxing clauses of the original Constitution, Article I, § 2, cl. 3, and § 9, cl. 4, and the effect attributed to them before the 16th amendment was adopted.   Pollock v. Farmers’ Loan & Trust Co., 158 U. S. 601 (1895) held that the  income tax the act of August 27, 1894, which taxed rents from real estate and returns on securities,  was, in effect, a tax upon the property from which such income arose, was imposed by reason of ownership, and that Congress could not impose a tax based on ownership without apportioning it among the states according to population as required by Article I, § 2, cl. 3, and § 9, cl. 4.

The adoption of the 16th Amendment did not extend Congress’ taxing power to new subjects,[1] but merely removed the necessity for an apportionment among the states based population in the case of taxes on income.  A proper regard for the 16th Amendment’s genesis, as well as its very clear language, requires that it shall not be extended by loose construction so as to repeal or modify Article I, § 2, cl. 3, and § 9, cl. 4.   Moreover, the 16th Amendment “income” limitation is not to be overridden by Congress.  Congress cannot by legislation alter the Constitution from which alone it derives its power to legislate, and within whose limitations alone that power can be lawfully exercised.

It therefore becomes essential to distinguish between what is and what is not income.  For the present purpose, we require only a clear definition of the term income as used in common speech, in order to determine its meaning in the amendment. After examining dictionaries in common use (Bouv. L.D., Standard Dictionary; Webster’s International Dictionary; Century Dictionary), we find little to add to the succinct definition adopted in two of our cases arising under the Corporation Tax Act of 1909.  “Income may be defined as the gain derived from capital, from labor, or from both combined, provided it be understood to include profit gained through a sale or conversion of capital assets…”

The definition indicates the characteristic and distinguishing attribute of income essential for a correct solution of the present controversy: the gain derived from capital… Here, we have the essential matter:  not a gain accruing to capital; not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value, proceeding from the property, severed from the capital, however invested or employed, and coming in, being derived — that is, received or drawn by the recipient [the taxpayer] for his separate use, benefit and disposal — that is income derived from property.  Nothing else answers the description.

The essential and controlling fact is that the stockholder has received nothing out of the company’s assets for her separate use and benefit. Every dollar of her original investment, together with whatever accretions and accumulations have resulted from employment of her money in the business of the company still remains the property of the company.  She has received nothing that answers the definition of income within the meaning of the 16th Amendment.

In our view, a person transferring appreciated property as a gift or devise or a non-corporate legal entity holding onto appreciated property from before 1940 until 2030 simply does not, in the fewest words commonly found in tax treatises: realize income.  We recognize that Eisner v. Macomber (and its progeny) are not all that can be argued about President Biden’s proposal.  Some Supreme Court decisions addressing the assignment of income have a bearing going the other way.  We anticipate that until the Supreme Court comes to grips with the proposal should Congress enact it, different taxpayers will take different tax reporting positions.  Meanwhile, if you have concerns about the probable taxation of your unrealized gains in the not too distant future, we recommend that you contact our attorneys Robert S. Schwartz or Joseph L. Lemond at 908-647-1022.

This writing is not and should not be interpreted as the rendering of legal advice or performance of legal services to any person by Herold Law, P.A.  In accordance with professional ethical rules, Herold Law, P.A., renders legal advice and performs legal services only in the context of an attorney-client relationship entered into before rendering advice or performing services.

[1]  Fast forward to today. We find Progressives are intent upon an enactment of a federal wealth tax.  Ordinarily, a wealth tax fixes a person’s non-exempt property value as of an annual date and applies a flat rate or progressive tax brackets to that value.  The wealth tax is due a few months later.  Income realization is irrelevant.

[1]  Fast forward to today. We find Progressives are intent upon an enactment of a federal wealth tax.  Ordinarily, a wealth tax fixes a person’s non-exempt property value as of an annual date and applies a flat rate or progressive tax brackets to that value.  The wealth tax is due a few months later.  Income realization is irrelevant.