New Tax Laws on the Way…. Can They be Retroactive?

The question has often been asked whether Congress can enact retroactive tax legislation, in effect “setting back the clock” and making a law effective as if it had been enacted at an earlier point in time. The topic takes on special importance today as the Biden Administration is considering a vast magnitude of tax increases.  Taxpayers and professionals may wonder whether the inevitable tax increases will be retroactive not only to the date the bill may be introduced, but to the very beginning of 2021. This is an important question in today’s tax landscape! Today’s post explores this area of tax law.

US Supreme Court Decisions

In 2017, in the case Dot Foods v. Washington Department of Revenue, the US Supreme Court denied petitions for a writ of certiorari seeking review of whether a retroactive change in tax law violates the Due Process clause of the US Constitution.  Although the facts varied in the cases for which review was sought, each petition involved the Supreme Court’s prior decision in  United States v. Carlton 512 U.S. 26 (1994) which involved the question as to what circumstances constitutionally permit retroactive tax legislation. More on the Carlton case below.

Due Process – What’s It All About?

The Due Process Clause of the Fifth Amendment is the most likely (although not the only) base for a constitutional challenge to a retroactive tax. Under the Due Process Clause, taxpayers have a right to fairness as well as an economic right which may be violated if retroactive legislation is enacted that does not meet certain standards. The United States Supreme Court has upheld retroactive tax legislation against a Due Process challenge in numerous cases.

Landmark Case

The seminal case regarding Due Process challenges to retroactive tax application is that of  United States v. Carlton. In that case, the US Supreme Court considered whether the retroactive denial of an estate tax deduction violated the Due Process Clause.

By way of background, in Carlton, Congress had enacted a provision in the Internal Revenue Code granting an estate tax deduction when an estate sold employer securities to a so-called Employee Stock Ownership Plan or “ESOP”.  Congress intended that this estate tax  deduction be available only if the stock was actually owned by the decedent at death. However, the law did not include statutory language making this clear. Fourteen months after the law was enacted, Congress amended it and added in the required language, applying the provision retroactively.  In other words, the amendment was made effective as if it had been included in the original statute.

In Carlton, the IRS disallowed the estate tax deduction to an estate based on the retroactive amendment of the law. The estate executor challenged the retroactive application of the amended law on Due Process grounds.

The Due Process argument was rejected by the Supreme Court, which upheld the retroactive tax legislation. The Carlton case established a two-part test which upholds retroactive tax application if: (1) the legislation is not arbitrary and has a rational legislative purpose; and (2) the period of retroactivity is not excessive. The Carlton Court determined that Congress’ actions were designed to correct a mistake that was affording taxpayers an unwarranted tax loophole. Furthermore the period of retroactivity was “modest” since it extended back only fourteen months. In conclusion, the Court determined the retroactive estate tax legislation satisfied both prongs of the test for constitutionality.  In a concurring opinion, Justice O’Connor agreed with the majority but made it clear that the decision was correct because the retroactivity period which was approximately one year, was for a “relatively short period”; otherwise Justice O’Connor believed it would raise “serious constitutional questions.”

All Tax Laws Raise Revenue

Tax laws are designed to raise revenue.  If “revenue-raising” is viewed as a  “legitimate legislative purpose”, the  rationale will justify just about any retroactive tax increase.   Various tax scholars submitting an amicus curiae brief in the Dot Foods Inc. case, maintain that revenue raising alone should not give rise to the “legitimate legislative purpose” when it upsets reasonable taxpayer expectations and reliance on prior law. The brief pointed out that, unlike the facts in Carlton, which involved correcting a legislative error when the original statute was enacted but lacked certain wording, Dot Foods Inc. involved a taxpayer that reasonably relied on an exemption that was not enacted by mistake, but rather was consciously adopted.

Nothing Really Stands in the Way of Retroactivity

Precedent has shown that there are few constitutional constraints on adopting retroactive tax legislation.  The fact of the matter is that Congress has been given wide discretion in exercising its constitutional power to tax.  The effective date of a new law involves a delicate balancing act. Lawmakers attempt to  give taxpayers certainty for tax planning purposes, yet at the same time, they must prevent tax avoidance and negative market consequences (e.g., a market free-fall brought on by a huge sell-off of stocks in anticipation of an increase in capital gains rates). The current Congress may decide not to make the proposed tax increases retroactive, mainly because of issues of practicality.  For example, it is doubtful that a new tax bill will be finished quickly and provide sufficient time for the Internal Revenue Service to incorporate changes into its tax forms and software prior to the time many taxpayers begin filing 2021 tax returns early next year.  Regardless, if enough money is involved, retroactivity may be right around the corner.

For those wishing more detailed information, an excellent report, “Constitutionality of Retroactive Tax Legislation” (October 25 2012), by the Congressional Research Service can be found here.

Posted: May 13, 2021

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