United States: Retroactivity Revisited: Has Anything Changed?

Last Updated: April 22 2015

Article by Erica L. Horn, Madonna E. Schueler and Gregory A. Nowak*

The U.S. Supreme Court's decision in United States v. Carlton turned 20 last year, but the core issue within the case remains embattled. In this article, authors Erica Horn, Madonna Schueler and Gregory Nowak discuss the Carlton decision and several 2014 cases on which it had an impact.


Last year marked the twentieth anniversary of the U.S. Supreme Court's decision in United States v. Carlton,1 but the battle continues over the constitutionality of retroactive tax legislation. Taxpayers continue to fight state efforts to amend tax legislation retroactively based on the Due Process Clause of the Fourteenth Amendment, which provides that no state shall deprive any person of ''life, liberty, or property without due process of law.''2 States have fought back with equal zeal, and the results have been anything but uniform. This article revisits the Court's decision in Carlton and then discusses 2014 state cases applying the Court's decision.

Carlton Sets the Stage for Evaluating Retroactive Tax Legislation

Rendered in 1994, United States v. Carlton remains the seminal case on retroactive tax legislation. Carlton involved an amendment to the federal estate tax statute that limited the availability of a recently enacted deduction for proceeds of sales of stock to employee stock ownership plans (''ESOPs''). The Court held that retroactive application of the amendment satisfied the requirements of due process in what has been described as the ''death knell'' for due process challenges to retroactive legislation.3

As part of the Tax Reform Act of 1986, Congress enacted a new estate tax provision applicable to any estate filing a return after Oct. 22, 1986.4 Codified at 26 U.S.C. §2057, the new provision granted a deduction for half of the proceeds of ''any sale of employer securities by the executor of an estate'' to ''an employee stock ownership plan.''5 Under §2057, the sale of securities had to be made prior to the date on which the estate tax return was required to be filed.6

The respondent, Jerry Carlton, was the executor of an estate who sought to utilize the §2057 deduction. Nineteen days prior to the due date of the estate tax return, Carlton used estate funds to purchase shares of a corporation. Two days later, Carlton sold the shares at a loss to the corporation's ESOP. When Carlton filed the estate tax return on Dec. 19, 1986, he claimed a deduction under §2057 of $5,287,000, which was half of the proceeds from the sale of stock to the ESOP. The deduction reduced the estate tax by $2,501,161.7 Carlton stipulated that he engaged in the stock transactions solely to take advantage of the §2057 deduction.8

Shortly thereafter, on Jan. 5, 1987, the IRS announced that pending the enactment of clarifying legislation, it would treat the §2057 deduction as only available to estates of decedents who owned the relevant securities immediately before death. A bill to this effect was introduced in Congress, and on Dec. 22, 1987, an amendment to §2057 was enacted.9 As amended, §2057 provided that ''to qualify for the estate tax deduction, the securities sold to an ESOP must have been 'directly owned' by the decedent 'immediately before death.' ''10 The §2057 amendment was made effective as of October 1986, the date §2057 originally was enacted.11

The IRS disallowed the §2057 deduction taken by Carlton on the ground that the stock he purchased had not been owned by his decedent ''immediately before death.''12 Carlton paid the contested tax liability, filed a claim for a refund, and then instituted a refund action in the U.S. District Court for the Central District of California. Carlton acknowledged he did not qualify for the §2057 deduction under the 1987 amendment, but argued that retroactive application of the amendment to 1986 transactions violated the Due Process Clause of the Fifth Amendment.13 The District Court granted summary judgment in favor of the U.S., but the Ninth Circuit reversed, holding retroactive application of the amendment was unduly harsh and unconstitutional.14 The Supreme Court granted certiorari.15

The Court began its analysis by noting that ''[t]his Court repeatedly has upheld retroactive tax legislation against a due process challenge.''16 The Court noted that the due process standard to be applied to retroactive tax legislation is the same as that generally applicable to retroactive economic legislation, i.e., retroactive application of the legislation must be justified by a rational legislative purpose.17 The Court found there was little doubt the 1987 amendment to §2057 was adopted as a curative measure. Because the pre-amendment version of §2057 contained no requirement that the decedent have owned the stock in question to qualify for the deduction for ESOP proceeds, any estate could claim the deduction by purchasing stock and immediately reselling it to an ESOP, resulting in a potential dramatic reduction, and perhaps elimination, of estate tax liability.18 Although Congress estimated a revenue loss of approximately $300 million over a five-year period when it originally enacted §2057, because the pre-amendment version of §2057 was not limited to situations where the decedent owned the securities immediately before death, it became evident that the revenue loss from §2057 could be as much as $7 billion.19

In concluding retroactive application of the 1987 amendment satisfied the requirements of due process, the Court made several observations.20 First, the Court noted that ''Congress' purpose in enacting the amendment was neither illegitimate nor arbitrary.''21 The Court noted that Congress acted to correct what it reasonably viewed as a mistake in the original provision that ''would have created a significant and unanticipated revenue loss.''22 Second, the Court stated, ''Congress acted promptly and established only a modest period of retroactivity.''23 The Court noted that the retroactive effect of the amendment extended for a period only slightly greater than one year.24

In response to Carlton's argument that he detrimentally relied on the pre-amendment version of §2057 in structuring his stock transactions in 1986, the Court found that his reliance alone was insufficient to establish a constitutional violation.25 The Court stated, ''Tax legislation is not a promise, and a taxpayer has no vested right in the Internal Revenue Code.''26 Similarly, the Court found Carlton's lack of notice of the amendment was not dispositive.27 The Court also noted that the 1987 amendment could not be characterized as a ''wholly new tax,'' and its period of retroactive effect was limited.28 The Court concluded by stating, ''Because we conclude that retroactive application of the 1987 amendment to §2057 is rationally related to a legitimate legislative purpose, we conclude that the amendment as applied to Carlton's 1986 transactions is consistent with the Due Process Clause.''29

Although she concurred in the majority's opinion, Justice O'Connor wrote separately to express her view that there must be some limits to Congress' ability to enact retroactive legislation. She noted, ''the Court has never intimated that Congress possesses unlimited power to 'readjust rights and burdens . . . and upset otherwise settled expectations.''30 ''The governmental interest in revising the tax laws must at some point give way to the taxpayer's interest in finality and repose.''31 She further stated, ''A period of retroactivity longer than the year preceding the legislative session in which the law was enacted would raise, in my view, serious constitutional questions.''32

In a concurrence by Justice Scalia in which Justice Thomas joined, the Court's opinion was criticized as mistakenly focusing on the period of retroactivity, because the test of substantive due process unconstitutionality in the field of retroactive tax legislation is whether the result is ''harsh and oppressive,'' and ''the critical event is the taxpayer's reliance on the incentive, and the key timing issue is whether the change occurs after the reliance; that it occurs immediately after rather than long after renders it no less harsh.''33 Scalia went on to observe:

The reasoning the Court applies to uphold the statute in this case guarantees that all retroactive tax laws will henceforth be valid. To pass constitutional muster the retroactive aspects of the statute need only be ''rationally related to a legitimate legislative purpose.'' Revenue raising is certainly a legitimate legislative purpose, see U. S. Const., Art. I, §8, cl. 1, and any law that retroactively adds a tax, removes a deduction, or increases a rate rationally furthers that goal.34

Scalia happily concurred in the result despite his criticism of the majority's reasoning, observing wryly, ''If I thought that 'substantive due process' were a constitutional right rather than an oxymoron, I would think it violated by bait-and-switch taxation.'';35 but, Scalia concludes, ''I welcome this recognition that the Due Process Clause does not prevent retroactive taxes, since I believe that the Due Process Clause guarantees no substantive rights, but only (as it says) process.''36

In the years following Carlton, courts across the nation have come to various conclusions when understanding and applying the Court's decision. This has led courts to approve statutes with a retroactive effect of up to 10 years,37 and to strike down statutes with a retroactive effect of approximately 16 months.38 The decisions rendered in 2014 were no different.

2014: A Year of Ups and Downs

The past year has been a tumultuous one for rulings addressing retroactive tax legislation. The year started off promising enough when two New York tribunals ruled that retroactive application of an amendment to New York's tax laws regarding recognition of gain on the sale of intangible assets by nonresidents was unconstitutional.39 But, in the second half of the year, a pair of cases—one from Washington and the other from Michigan40—brought disappointing news to tax practitioners who hoped the recent New York decisions signaled a welcome change.

To read this article in full, please click here.

Originally published by Tax Management Weekly State Tax Report, Bloomberg BNA.


* Gregory Nowak is a Principal at Miller Canfield in Detroit.

1. 512 U.S. 26 (1994).

2. U.S. Const. amend. XIV, §1.

3. Faith Colson, Constitutional Law—Due Process—The Supreme Court Sounds the Death Knell for Due Process Challenges to Retroactive Tax Legislation, 27 Rutgers L.J. 243 (1995-1996).

4. Carlton, 512 U.S. at 28.

5. Id. (quoting 26 U.S.C. §2057(b)).

6. Id.

7. Id.

8. Id. at 28-29.

9. Id. at 29.

10. Id. (quoting Omnibus Budget Reconciliation Act of 1987, §10411(a), 101 Stat. 1330-432).

11. Id. (citing §10411(b)).

12. Id.

13. Id.

14. Id. at 29-30.

15. Id. at 30.

16. Id.

17. Id. at 30-31.

18. Id. at 31.

19. Id. at 31-32.

20. Id. at 32.

21. Id.

22. Id.

23. Id.

24. Id. at 33.

25. Id.

26. Id.

27. Id. at 34.

28. Id.

29. Id. at 35.

30. Id. at 37-38 (O'Connor, J., concurring), citing Connolly v. Pension Benefit Guaranty Corp., 475 U.S. 211, 229 (1986) (concurring opinion) (brackets omitted), quoting Usery v. Turner Elkhorn Mining Co., 428 U.S. 1, 16 (1976).

31. Id. at 37-38.

32. Id. at 38.

33. Id. at 40 (Scalia, J., concurring).

34. Id. (emphasis in original, internal citations omitted).

35. Id. at 39.

36. Id. at 40 (emphasis in original) citing TXO Production Corp. v. Alliance Resources Corp., 509 U.S. 443, 471 (1993) (Scalia, J., concurring in judgment).

37. See Miller v. Johnson Controls, 296 S.W.3d 392 (Ky. 2009).

38. See James Sq. Assoc. LP v. Mullen, 993 N.E.2d 374 (N.Y. 2013).

39. See Caprio v. New York State Dep't of Taxation and Finance, 117 A.D.3d 168 (N.Y. Sup. Ct. 2014); In the Matter of the Petition of Jeffrey M. and Melissa Luizza, Determination DTA No. 824932 (N.Y. Div. Tax App. Aug. 21, 2014).

40. See In re Estate of Hambleton, 335 P.3d 398 (Wash. 2014) and Yaskawa America, Inc. v. Dep't of Treasury, Case No. 11-000077-MT (Mich. Ct. of Claims Dec. 19, 2014).

Originally published by Bloomberg BNA, Weekly State Tax Report, April 17, 2015

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