FULL TEXT: CRS REPORT ARGUING RETROACTIVE TAX PROVISIONS IN TRA '86 ARE CONSTITUTIONAL.

                       CRS REPORT FOR CONGRESS

THE 1986 TAX REFORM ACT: CONSTITUTIONALITY OF THE RETROACTIVE APPLICATION OF CERTAIN PROVISIONS

While most of the provisions of the Tax Reform Act of 1986 ¹ are effective for tax years beginning after December 31, 1986, some provisions contain effective dates which predate enactment. ² Those which benefit taxpayers ³ are unlikely to generate controversy. Those which do not, however, have provoked considerable debate. Two provisions which fall into the latter category are (1) the repeal of the regular investment tax credit, ⁴ made applicable to property placed in service after December 31, 1985, and (2) repeal of the three-year recovery rule, ⁵ under which employees who contributed after-tax dollars to a retirement plan were allowed to recover their contributions tax-free before being taxed on the employer paid portion of the retirement annuity provided employee contributions could be recovered in three years or less. The latter was made applicable to annuities where the starting date is AFTER July 1, 1986.

Criticism of the retroactive feature of these provisions focuses on "fairness," a policy consideration with potential constitutional implications. Less sophisticated constitutional objections are frequently predicated on the argument that Article I, section 9, clause 3 of the United States Constitution, barring passage of a "Bill of Attainder or ex post facto Law," precludes this type of retroactive application of tax law by Congress. More sophisticated argument may take the form of urging that retroactive application is so fundamentally unfair that it violates the due process clause of the Fifth Amendment to the Constitution. An examination of case law and traditional legal principles suggests there is little support for either class of objections.

An understanding of the legal definitions of a bill of attainder and ex post facto law should eliminate any serious objections based on those constitutional limits. One constitutional scholar has summarized Article I, Section 9, Clause 3, as follows: ⁶

. . . Clause 3 prevents the passage of any bill of attainder or ex post facto law; the former prohibits all statutes, "no matter what their form, that apply either to named individuals or to easily ascertainable members of a group in such a way as to inflict punishment on them without a judicial trial;" the latter applies only to penal or criminal statutes and prohibits any law which either makes criminal an act innocent when done, or inflicts a greater punishment.

Neither provision here involved singles out any named individual(s) for punishment, specifically or by implication. Thus, neither is a bill of attainder. Neither provision is a penal or criminal provision. Thus, neither is, by definition, an ex post facto law.

Generally, the Supreme Court has upheld the retroactive application of modifications in the tax law against due process challenges. This has been particularly true in the income tax area. ⁷ There have been a few cases in the transfer tax areas (gift, estate, and inheritance), where the Court has found that legislative enactments violated due process. ⁸ Some authorities have suggested that the distinction between those statutes which have been upheld and those rejected lies in the notice given the taxpayer as to potential change in the tax law. If the taxpayer was or should have been aware of the possible modification, the law is likely to be upheld. On the other hand, if there is no way the taxpayer could have known that a particular activity might be taxed, retroactive taxation of that activity might be found to violate the taxpayer's rights to due process. ⁹

Assuming arguendo that some type of SPECIFIC notice is required to overcome due process objections to retroactive application of a modification of tax law, there is little reason to believe that any taxpayer affected by the two provisions under consideration could mount a successful challenge on due process grounds. Clearly, in the case of these provisions the notice has been more than adequate. The effective date of the application of the repeal of the three-year rule was contained in the version of the 1986 Tax Reform Act reported by the House Ways and Means Committee, a report issued before the effective date and in ample time to give eligible employees the opportunity to retire. ¹⁰ Repeal of the investment tax credit could not have come as a total surprise to taxpayers, since such a repeal was contemplated in the original Treasury tax reform proposal, ¹¹ included in the version popularly known as the President's proposal, both providing ample notice to investors, ¹² and it was also contained in the Committee on Ways and Means report. ¹³

The two recent Supreme Court decisions upholding a tax statute against a due process challenge predicated upon retroactivity strongly support the conclusions urged above. In United States v. Darusmont ¹⁴ The Supreme Court said: ¹⁵

In enacting general revenue statutes, Congress almost without exception has given each such statute an effective date prior to the date of actual enactment. This was true with respect to the income tax provisions of the Tariff Act of Oct. 3, 1913, and the successive Revenue Acts of 1918 through 1938. It was also true with respect to the Internal Revenue Codes of 1939 and 1954. Usually the "retroactive" feature has application only to that portion of the current calendar year preceding the date of enactment, but each of the Revenue Acts of 1918 and 1926 was applicable to an entire calendar year that had expired preceding enactment. This "retroactive" application apparently has been confined to short and limited periods required by the practicalities of producing national legislation. We may safely say that it is a customary congressional practice.

The Court went on to point out that it has consistently held that the application of an income tax statute to the entire calendar year in which enactment took place does not per se violate the Due Process Clause of the Fifth Amendment, citing eight cases and two law review articles. It quoted Welch v. Henry, ¹⁶ to explain the reason for permitting this "retroactivity:"

Taxation is neither a penalty imposed on the taxpayer nor a liability which he assumes by contract. It is but a way of apportioning the cost of government among those who in some measure are privileged to enjoy its benefits and must bear its burdens. Since no citizen enjoys immunity from that burden, its retroactive imposition does not necessarily infringe due process, and to challenge the present tax it is not enough to point out that the taxable event, the receipt of income, antedated the statute.

In a more recent case, Pension Benefit Guaranty Corporation v. R.A. Gray & Co., hereinafter "Gray", ¹⁷ which did not involve income taxes, the Supreme Court went even further in its language.

". . . the strong deference accorded legislation in the field of national economic policy is no less applicable when that legislation is applied retroactively. Provided that the retroactive application of a statute is supported by a legitimate legislative purpose furthered by rational means, judgments about the wisdom of such legislation remain within the exclusive province of the legislative and executive branches." ¹⁸

The facts of the Darusmont case offered the Court the opportunity to develop a due process argument that a change in a tax law should not be retroactively imposed, but the Court did not find the case compelling. The taxpayer had to sell a piece of property in 1976. He claimed to have investigated all the tax ramifications of various ways to structure the transaction to minimize his tax liability. In July he sold the property. In October, the Tax Reform Act of 1976 became law. The law retroactively changed the minimum tax, so that the taxpayer became liable for the tax, whereas, under the law in effect at the time of the transaction, he would not have incurred a minimum tax liability. The Court did not buy the reliance on existing law argument. The Court found ample notice that the law might change in the fact that the proposed changes had been under public discussion for almost a year before the change in the law, citing the 1975 House Report on the bill and the 1976 Senate Report. The Court rejected the idea that sn increase in the minimum tax was a new tax which the taxpayer could not have anticipated. The taxpayer knew that the transaction would be subject to some sort of tax, and it was within the discretion of Congress to make the changes retroactively.

Because of this case and the unanimous decision upholding the retroactive statute in the Gray case, taxpayers will have a difficult time making a due process argument that retroactive tax legislation is unconstitutional. Taxpayers who object to the "unfairness" of retroactive legislation are more likely to succeed in convincing their representatives in the Congress that the law should not be adopted in a retroactive form than they are to convince a court that Congress had done something unconstitutional in adopting retroactive legislation.

                                   Thomas B. Ripy

² See, e.g., sections 211, 402, 1122(c), 1132.

³ Expensing architectural barrier, sec. 244; special rules for discharge of certain farm indebtedness of solvent farmers, sec. 405; casualty loss deduction for deposits in insolvent financial institutions, sec. 905; income exclusion for education assistance programs, legal services programs, sec. 1162; qualified campus lodging, sec. 1164; attorneys' fees, sec. 1551; foster care payments, sec. 1707; spouses of MIAs, sec. 1708.

⁴ P.L. 99-514, section 211.

⁵ P.L. 99-514, section 1122(c), (h).

⁶ For Kosch, Constitutional Law (2d ed. 1969) section 164; quoting United States v. Lovett, 328 U.S. 303, 315 (1946) and citing Calder v. Bull, 3 Dall. 386, 390 (1798) and Burgess v. Salmon, 97 U.S. 381 (1878).

⁷ See, e.g., Welch v. Henry, 305 U.S. 134 (1938), rehearing denied, 305 U.S. 675 (1938) (upholding a retroactive Wisconsin tax); United States v. Darusmont, 449 U.S. 292 (1981).

⁸ See, e.g., Nichols v. Coolidge, 274 U.S. 531 (1927) (holding estate tax imposed on transfers prior to act's enactment unconstitutional); Untermyer v. Anderson, 276 U.S. 440 (1928) (holding gift tax on gifts made prior to act unconstitutional).

⁹ Nowack, Rotunda, and Young, Handbook on Constitutional Law 431-432 (1978).

¹⁰ Tax Reform Act of 1985, H.R. Rep. No. 426, 99th Cong. 1st Sess. 734 (Dec. 7, 1985) [contained a July 1, 1986 effective date].

¹¹ Office of the Secretary, Department of the Treasury, Tax Reform for Fairness, Simplicity, and Economic Growth: The Treasury Department Report to the President, vol. 2, ch. 8.02 (November 1984).

¹² The President's Tax Proposals to the Congress for Fairness, Growth, and Simplicity, ch. 7.02 (May 1985).

¹³ Tax Reform Act of 1985, H.R. Rep. No. 426, 99th Cong., 1st Sess. 160 (Dec. 7, 1985), [contained a January 1, 1986 effective date].

¹⁴ 449 U.S. 292 (1981).

¹⁵ 449 U.S. 292, 296-297.

¹⁶ 305 U.S. 134 146-147 (1938).

¹⁷ 467 U.S. 717 (1984).

¹⁸ 467 U.S. 717, 729.