When ‘Realized’ Gains Became the Income Standard

Editors’ Note: MarketMinder favors no politician nor any political party, assessing developments solely for their potential market impact.

In 1916, the Standard Oil Company declared an in-kind 50% stock dividend, awarding shareholders one new share of stock for every two owned (akin to a stock split). Myrtle Macomber—owner of 2,200 shares—was among the recipients. And one of those Uncle Sam tried to tax on the transaction, claiming this constituted income under the then-new federal income tax. Thus began a lawsuit that reverberates today. Now Macomber v. Eisner, as the case became known, is one of several reasons the Biden administration’s proposed 25% tax on “billionaires’” appreciated assets—whatever you think of it—is unlikely to become reality. Let me take you through this important saga and explain.

Prior to the 16^th Amendment’s passage in 1913, America had no federal income tax. The Constitution allowed for one, but it held that any such “direct” tax must be apportioned among the states under the Capitation Clause. This meant Congress would set the total sum to be raised by a tax measure, then the states would divide that, weighted by population. States would then divvy up the resulting sum among their residents, which could result in many different “federal” tax rates. That would quite obviously be problematic politically, if not troublesome economically. Hence, before 1913, the government had overwhelmingly relied on tariffs and “indirect” taxes on things like alcohol production.

The 16^th Amendment changed that, allowing the taxation of income without regard to apportionment. However, it didn’t offer a complete definition of income, leaving that to Congress. The original federal income tax acts passed after the amendment’s ratification included cash dividends as income—but the issue of stock dividends went unaddressed until 1916, when Congress reversed course and deemed them taxable. Hence, the government claimed Macomber owed tax on Standard Oil’s dividend, even though the increased shares didn’t change the value of her position in the company. She paid it under protest and, after the government declined her request for remuneration, she filed suit against the government and Internal Revenue Collector Mark Eisner.

The case quickly flew up the judicial system to the Supreme Court. The government claimed the Standard Oil dividend contributed to Macomber’s wealth by magnifying gains—unrealized gains—in her portfolio. It argued Congress could tax any corporate profit, whether distributed or not, but the dividend was an event that crystallized this. Macomber’s attorneys essentially argued the transaction wasn’t income, it was capital—the shares may have risen or declined after it occurred. They claimed it didn’t enrich Macomber whatsoever.

On March 8, 1920, the Court ruled 5 – 4 in favor of Macomber—establishing a precedent that stands to this day. Not only are stock dividends not income—they are capital transactions—but, critically for our purposes, gains are income only when realized. As the majority wrote, “Secondly, and more important for present purposes, enrichment through increase in value of capital investment is not income in any proper meaning of the term.”^[i] It dismissed the government’s contention that gain was the critical factor—noting that income must be derived from property to be subject to income tax. This, friends, is the formal precedent for our system of gains taxation in America. Sell and realize a gain, get taxed. No sale, no tax.^[ii]

That brings us to today. “Wealth tax” concepts have cropped up in several pieces of draft federal legislation in recent years, only to see Congress scupper them in debate. Now President Joe Biden, in his 2024 budget, has proposed a 25% tax on “billionaires’” unrealized gains—which many seem to fear would be the tip of the iceberg. Such a tax would mark a major shift in century-old tax policy, one that could greatly complicate both financial and tax planning.

We wrote on the Biden budget proposal the other day, and I stand by the conclusion gridlock means the chances this passes are infinitesimally small. It doesn’t even seem certain the administration thinks this is going anywhere, instead using it as an early platform issue ahead of next year’s presidential election. Furthermore, there are scads of implementation problems ranging from valuation to collection to the treatment of unrealized losses. But above all that, Macomber shows any such tax would highly likely face very effective legal challenges. That doesn’t rule out the possibility such a tax survives challenges, but America’s legal system is built on precedent. Macomber is quite clear, marking bright lines about what is and isn’t income from a tax perspective. And it has lasted 103 years as I type.

Of course, none of this precludes states from enacting wealth taxes, like Florida used to have in its Intangibles Tax, which many wealthy individuals used to easily dodge through the use of specialized trusts and other legal vehicles prior to its repeal. Or those under consideration in places like Oregon, California and New York. But people with means can be quite creative in tax avoidance, given enough incentive. And they can move from state to state.