No Love for Retroactive Tax Legislation

Ask the business community whether state legislatures should have the power to enact retroactive tax legislation, and the answer will be a resounding “no.” Indeed, Richard Pomp, a law professor at the University of Connecticut School of Law, calls it a reprehensible practice, adding that it is “basic to the rule of law that legislation should operate prospectively.”

Pomp says there are five policies behind the “visceral aversion scholars and courts have always felt towards retroactivity.” The first is one of fundamental fairness: “There is a special injury where the law that was in place in the past is retroactively altered. It amounts to nothing more than changing the rules in the middle of the game. Even children understand the unfairness of that,” he says. Second, “the function of the law is to provide a stable framework by which people can be fairly confident of the effects of their actions on their legal rights and liabilities. Retroactive laws are fatal to their ability to plan their financial lives,” he argues. This, Pomp says, is especially true of retroactive taxation and businesses: “There is risk in operating any business, and decision makers must live with the uncertainties of the future, but they ought to be able to rely on the past remaining stable.” Third, he says, “it’s a question of finality and repose. Without the stable background of the law, the structure of economic transactions and social conduct is seriously compromised.” Fourth, Pomp says, “the risk of inequity in retroactive legislation is unacceptably high”; legislators deal in categories of people, “and can only speculate” which particular individuals will benefit from the law. Not so with retroactive legislation — “the victims and beneficiaries can be identified precisely,” he says. Fifth, retroactive legislation encourages legislators to act arbitrarily and irresponsibly, and further discourages litigation “that serves as a check on legislative power. Knowing that a court may overturn a statute encourages precise and careful drafting. If a court’s ruling can be overturned retroactively, it means a legislature doesn’t have to accept the consequences of its poorly thought-out legislation,” he says.

The legislative power to pass retroactive legislation is a fact, yet not all states have empowered their legislators to do so. Several state constitutions, such as those of Georgia and Texas, flatly prohibit the legislature from enacting any law with retroactive application, including tax laws. Other state constitutions, like that of Ohio, allow retroactive legislation, including tax legislation, except in limited circumstances. Legislatures are permitted to enact general legislation authorizing the courts to effectuate “the manifest intention of parties . . . by curing omissions, defects, and errors, in instruments and proceedings, arising out of their want of conformity with the laws of this state.”¹ Minnesota prohibits retroactive legislation by statute; laws are presumed to apply prospectively, unless the Legislature intended retroactive applicability, and that intent is clearly expressed in the law.² There are exceptions, however: laws found by the courts to be clarifying or curative — that is, a law correcting a previously enacted law to reflect that law’s preexisting, original intent. One or more of the following four factors must be present for a newly enacted law to qualify as clarifying or curative:

• “the law inadvertently failed to expressly cover a particular issue;

• the earlier law contained a manifest error or was ambiguous in its coverage and therefore needed language refinement;

• the existing law contained general language that was later found to need more specificity; and

• the courts have misinterpreted the construction of the existing law.”³

Most states have no state constitutional or statutory restriction on legislative power to enact retroactive legislation, including tax legislation.⁴ However, this power is not unlimited. The U.S. Supreme Court created a standard that, if met, allows a retroactive piece of legislation to stand. One may question whether application of this standard results in fairness to the taxpayer, but that is beside the point.

The Carlton Standard

Carlton involved the question of a 1987 congressional amendment to the federal estate and gift tax provision of the 1986 Tax Reform Act, which included a new provision, section 2057, that allowed estates to deduct half the proceeds of a sale by their executor of employer securities to an employment stock ownership plan.⁵ The 1987 amendment applied retroactively to October 1986, when the TRA was enacted. The issue was whether the amendment’s retroactive application violated the Fifth Amendment’s due process clause.

Carlton was the executor of the estate of Willametta K. Day and sought to take advantage of the new section 2057. In December 1986 Carlton bought shares of MCI Communications Corporation for over $11 million. Two days after the purchase, he sold the stock to the MCI ESOP for approximately $10.5 million. Upon filing the estate’s tax return, Carlton claimed the section 2057 deduction, reducing the estate’s tax liability by approximately $2.5 million. In January 1987 the IRS announced that, pending legislation, it would allow the deduction for these sales only if the decedent directly owned the stocks immediately before death; Congress amended the provision in December 1987, retroactively applied to October 1986. The IRS disallowed Carlton’s section 2057 deduction, and Carlton appealed, arguing that while the 1987 amendment would have disallowed the estate’s deduction from its December 1986 transaction, its retroactive application violated the Fifth Amendment’s due process clause.

The Court ruled for the IRS, holding that the 1987 amendment was curative — that is, it fixed an error contained in the TRA 1986. It explained that its prior cases have held that retroactive legislation did not violate the due process clause when the legislation had a legitimate legislative purpose; was not harsh, oppressive, arbitrary, or irrational; and the legislative action was taken promptly, and established a modest retroactive period. The Court noted that at enactment, section 2057 was projected to cost the government $300 million over a five-year period. However a later review showed, as written, the section would cost the government over $7 billion over the same period because the deduction was not limited to transactions in which the decedent directly owned the shares prior to death. Congress, the Court said, obviously did not intend this result when TRA 1986 was enacted — that is, to allow transactions that were purely tax motivated. It acted promptly in 1987 to correct the mistake, resulting in a modest retractive period of just over one year. Carlton’s reliance on the original statute to the estate’s detriment and his lack of notice of the change does not render the amendment unconstitutional. The Court famously said, “tax legislation is not a promise, and a taxpayer has no invested right in the Internal Revenue Code,” and quoted a passage from its prior decision in Welch⁶ that “taxation is . . . but a way of apportioning the cost of government among those who . . . are privileged to enjoy its benefits and must bear its burdens. Since no citizen enjoys immunity from that burden, its retroaction imposition does not necessarily infringe due process.” Nor was Carlton’s lack of notice of the amendment an issue, the Court said, quoting from its decision in Milliken⁷: “A taxpayer should be regarded as taking his chances of any increase in the tax burden which might result from the carrying out the established policy of taxation.”

The key takeaway from the Carlton Court’s standard is that it is heavily weighted in favor of the government. Indeed, as the late Justice Antonin Scalia observed in his concurrence, “the reasoning the Court applies to uphold the statute guarantees that all retroactive tax laws will henceforth be valid.” Practically speaking, Scalia’s statement might be considered hyperbole, but there is no doubt that in cases in which the standard is applied, the government will almost always prevail.

The Case for Retroactive Taxation

Julie Roin, a law professor at the University of Chicago Law School, posits that retroactive tax legislation, while not a panacea, holds a great deal of potential when states are in a period of fiscal stress. The crux of the problem, she says, is the electoral process. Political careers are founded and furthered by hiding the true cost of popular government programs and snowballing public debt from voters, leaving their successors to deal with the inevitable fiscal collapse. Yet it is not just politicians, Roin says; voters bear some responsibility, too. Most voters may not be financially sophisticated, but the information they need to understand their jurisdiction’s fiscal condition is highly accessible. The news media routinely reports, and candidates for public office repeatedly trumpet, the financial shenanigans of incumbents to balance the budget or use debt financing to avoid raising taxes. However, she says, voters have an incentive to vote for incumbents who play these games because they believe it is in their economic best interest to do so. Such voters receive the benefit of valuable public services today, and then have the option to leave the jurisdiction (or in some cases retire) before the debt comes due. The burden of making the debt repayments falls on continuing and new residents, investors, and public employees. But when voters leave, it is that much harder for a jurisdiction under fiscal stress to recover, because it encourages remaining residents to move elsewhere and discourages new residents from relocating. This “death spiral,” Roin says, is not imaginary, and she points to Stockton, California; Gary, Indiana; and Detroit, Michigan as examples.⁸

Since distressed states, unlike municipalities and businesses, have no mechanism for bankruptcy, they need a way to deal with their troubled fiscal situation. This, Roin says, is where retroactive tax legislation comes into play. Though bankruptcy laws are not applicable to states, they do provide a set of guideposts that could be followed. One of these is the idea of a “clawback,” through which a bankruptcy trustee can require the return of monies paid to others by the bankrupt entity before the bankruptcy filing. The clawback periods vary, depending on the transaction. Insiders are subject to a one-year clawback of any amount that was paid by the bankrupt entity, regardless of whether the monies were for valuable services or property. Other types of transactions, such as fraudulent ones, are subject to much longer clawback periods. Another guidepost for determining the extent of the retroactive period, Roin says, might be the statute of limitations for tax deficiencies. At the federal level, the general imitations period is three years from when a return is filed; six years when there have been substantial omissions from gross income; and no statute of limitations in cases of fraud or the failure to file a return. Moreover, the government can collect from other persons than the taxpayer, such as when the taxpayer transferred property or other assets for less than adequate compensation to avoid his tax liability. Of course, these are only examples of how the retroactive period might be calculated. It could be more, or less.

Roin says it is important to understand the rationale behind retroactive taxation: It is to correct the deficiency, to the extent possible, between the taxes paid by former residents and the value of the services received while residents. She stresses that the purpose of retroactive taxation is not based on a question of failure to pay for the debt associated with the services rendered to the former resident; rather, it is a correction related to his unjust enrichment. The rate, then, should be high enough to recoup the unjust enrichment, but no more than what would be placed on future residents for those past expenditures. Roin readily admits that calculating the costs involved and how they should be allocated is a difficult task, but it is not insurmountable.

Of course, there are due process concerns with retroactively taxing former residents, as well as nonresidents. The knee-jerk reaction is that the imposition of a retroactive tax on former residents and nonresidents is that they are being taxed by the state without representation. But if the legislation is structured correctly, Roin says, due process is not an issue. She points out that nonresidents who have no say in the political process are routinely subject to taxation by a state where they have property or earned income — the definite link, the minimum connection, that the due process clause requires before a state may exercise its taxing power. As for former residents, the definite link and minimum connection lies in the fact that they earned income while living in the state or while holding property there. In either case, Roin says, there is nothing irrational about a state requiring these classes of residents to pay the full cost of the benefits provided to them, either in the present, as is the case for nonresidents, or in the past, as is the case for former residents. It is critical, however, that the terms of the retroactive tax not discriminate between the three classes of taxpayers — nonresidents, former residents, and current residents.

Roin emphasizes that the legislative power to pass retroactive tax legislation should be used sparingly — only during a real fiscal emergency, and not whenever a state needs to plug a budget gap. But having that power, she says, could bring on a change in political and voter behavior. The possibility of being subject to retroactive taxation might persuade residents to give all legislative proposals affecting their tax dollars more scrutiny, rather than pay little or no attention to what is being proposed. Politicians who wish to be reelected may be encouraged to be more transparent with voters about the costs associated with their initiatives, because a savvy electorate will not vote them back into office. Roin is well aware than the retroactive taxing power can be abused, but safeguards can be put in place to reduce the possibility. In sum, the power to enact retroactive tax legislation is a useful tool in the legislative toolkit to address serious problems in restoring a state’s fiscal health.

A Rare Taxpayer Victory

A few states do not follow the Carlton standard, but instead have their own. New York is one of these states. The state’s standard is made up of three factors — a taxpayer’s forewarning of the change in law and the reasonableness of their reliance on the old law, the length of the retroactive period, and the public purpose of the retroactive application.⁹

Mackenzie Hughes LLP is a law firm in Syracuse, New York. In 2001 its predecessor was reorganized, and Mackenzie Hughes was formed in 2002. That year, it assumed its predecessor’s 15-year lease for office space in downtown Syracuse. The location of the office space, conditioned on the firm’s remaining in that location, qualified Mackenzie Hughes to receive tax credits through the state’s enterprise zone program. Mackenzie Hughes applied for and became qualified under the program in 2003. In April 2009 the governor signed into law amendments changing the program’s criteria for eligibility, and based on those changes, the appropriate department notified Mackenzie Hughes in June 2009 that its qualification had been revoked, made retroactive to 2008. Meanwhile, Mackenzie Hughes’s partners had filed their 2009 returns, claiming the tax credits. They were initially issued refunds, but on further review, the tax department disallowed the credits and issued deficiencies.

The administrative law judge determined that because the date of Mackenzie Hughes’s revocation was January 2009 (instead of 2008), and the application of the amendments took effect in January 2009, the amendments were not retroactive as applied to the firm’s partners, and even if the amendments were retroactive, the partners’ due process rights had not been violated. The tax appeals tribunal reversed the ALJ’s ruling that the amendments were retroactive but upheld the determination that the partners’ due process rights had not been violated.

The court’s analysis of the length of the retroactive period was quickly disposed of, as it was only 97 days from the date that the amendments were signed into law and the effective date. The court also found that although there was no public purpose in applying the amendments retroactively, which favored the partners, the fact that the retroactive period was so short did not render the lack of public purpose a problem. The notice requirement, however, presented a different story. While it was true that the partners may have had notice that the amendments were introduced in the legislature, that does not constitute forewarning that the law would be changed. Thus, there was no reason for the partners not to rely on the firm’s certification of its qualification to receive tax credits in making investments and expenditures. The partners’ reliance on the old law was therefore reasonable, and the tribunal’s ruling was reversed.

What Mackenzie Hughes illustrates is that determining whether a standard has been breached — whether Carlton or some other standard — is highly dependent on the facts. Regarding the New York standard, a taxpayer’s reliance interest in the prior law might be considered unreasonable if it was based on a faulty interpretation unsupported by any practice, experience, or professional advice. The reasonableness of the length of the retroactive period might be tied to the public purpose of the change. The court found that there was no public purpose to the law change, but even so, the retroactive period was 97 days. It might have been different if there was an important public purpose, such as a curative one. If that is the case, a retroactive period of years, rather than months, might be deemed appropriate.

Conclusion

The question behind retroactive tax legislation is not whether legislatures have the power to enact such laws, but rather whether they should have that power. While there may be practical reasons for having such power, such as curing mistakes in the law, there is a question of reliance that could be to the taxpayer’s detriment when the law changes. There may be situations, however, in which the power to enact retroactive legislation is beneficial not just to states, but to taxpayers too, such as when a jurisdiction is experiencing fiscal distress. The question whether a legislature should have the power to enact retroactive tax legislation is a debate that will rage for some time to come.