Carlton: The U.S. Supreme Court's Jekyll and Hyde Decision Still Raises Questions in State Tax Retroactivity Cases

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Tax Policy

Bloomberg BNA regularly spotlights the insights of state and local tax attorneys at Alston & Bird LLP. In this installment, Zachry Gladney, Matthew Hedstrom and Alexandra Sampson discuss retroactive state tax legislation in light of the U.S. Supreme Court's Carlton decision.

Zachry Gladney Matthew Hedstrom Alexandra Sampson

By Zachry Gladney, Matthew Hedstrom and Alexandra Sampson

Zachry Gladney is a partner in the State and Local Tax Group in Alston & Bird LLP's New York office. Matthew Hedstrom is a partner focusing on state and local tax planning and controversy in Alston & Bird LLP's New York office. Alexandra Sampson is a senior associate in the State and Local Tax Group in Alston & Bird LLP's Washington office.

The U.S. Supreme Court decision in United States v. Carlton512 U.S. 26 (1994) is one of those “illusive” state tax Supreme Court decisions. While the decision appears concise and easy to apply, the court announces fairly broad propositions and arguably provides inconsistent messages, which, when applied to a given set of facts, can be used to support both sides of the argument. A complete reading of all parts of the decision reveals a certain “Jekyll and Hyde” duality. Thus, it is not surprising that Carlton is cited equally by both states and taxpayers as support for the validity (in the case of states) or the invalidity (in the case of taxpayers) of retroactive state tax legislation. This duality makes it difficult to settle the debate and highlights the importance of certiorari review of the retroactivity cases currently before the Court.

The authors share the concerns raised by numerous others regarding the recent state trend in enacting retroactive tax legislation, and firmly believe that the Court should now clarify Carlton to provide some concrete guidance. Of course, the Court recently passed on an opportunity in Estate of Hambleton, but now has another opportunity to weigh in with both Dot Foods and the Gillette line of cases pending before the Court. One cannot help but be hopeful that the Court understands further the importance of this issue given the Court's recent procedural move in which it asked Michigan to respond to petitions for certiorari in the Gillette line of cases and has rescheduled the Washington Dot Foods case. However, if the Court fails to grant certiorari for cases pending in front of it, we are left to wonder if the Court really intended Carlton to be broad and liberally applied—that is, more Hyde than Jekyll as far as taxpayers are concerned.

United States v. Carlton

Carlton involved a taxpayer's challenge to Congress's retroactive limitation on the availability of a federal estate tax deduction. In December 1987, Congress amended a provision of the federal estate tax statute by limiting the availability of a recently added deduction for the proceeds of sales of stock to employee stock-ownership plans (ESOPs). Congress provided that the amendment would apply retroactively, as if incorporated in the original deduction provision, which had been adopted in October 1986. The taxpayer claimed the deduction on an estate tax return filed in December 1986—after the enactment of the original deduction provision and before the amendment. The IRS disallowed the deduction on the ground that the estate did not qualify for the deduction under the 1987 amendment. The taxpayer challenged the disallowance, arguing that the retroactive application of the 1987 amendment violated the due process clause of the Fifth Amendment.

The U.S. Supreme Court held that the retroactive application of the amendment did not violate the due process clause of the Fifth Amendment because it was supported by a legitimate legislative purpose (raising of revenue) furthered by rational means. The Court pointed to a variety of factors that served as support for its holding, including that: (1) the amendment was intended to correct a mistake in the original provision; (2) Congress did not act with an improper motive; (3) Congress acted promptly in proposing the amendment within a few months of the provision's original enactment; and (4) the retroactivity period was modest—just over one year. While the decision seems easy to apply and straightforward, the language that surrounded those factors creates some confusion regarding the Court's actual view of retroactivity.

Carlton’s Jekyll and Hyde Complex

While taxpayers in the state tax realm have often cited to the Dr. Jekyll (that is, good) factors in Carlton—particularly, prompt action and modest period of retroactivity—as the basis for distinguishing the outcome in Carlton from the result warranted in many state tax retroactivity challenges (which often involve amendments years after the enactment of a statute and up to decades long retroactivity periods), a dive into the Court's analysis reveals a Dr. Hyde (let's say, less desirable) aspect of the analysis that may, perhaps unintentionally, suggest that the Court believes most retroactive tax legislation can withstand due process clause scrutiny. After all, the majority did begin its analysis by pointing out that it “repeatedly has upheld retroactive tax legislation against a due process challenge.”

There are at least two facets of the majority analysis that could be misconstrued as support for the argument that there are few limits on a state's power to enact retroactive tax laws. We believe that the Court should clarify these facets to avoid unchecked state action in this regard.

First, the majority opinion could be viewed as establishing an incredibly low bar for states seeking to establish a “legitimate legislative purpose” for a retroactive tax law change. The Court notes that “Congress acted to correct what it reasonably viewed as a mistake in the original 1986 provision that would have created a significant and unanticipated revenue loss. We cannot say that its decision was unreasonable.”

Thus, the majority opinion could be (and has been) interpreted as support for a position that states have broad power to retroactively amend tax laws so long as there is a revenue raising purpose. The Court's holding, unfortunately, only seems to limit that power for egregious circumstances, such as a state's “improper motive” or “the creation of a wholly new tax.”

Justice Scalia's concurring opinion concludes that a straightforward application of the legal analysis set forth by the majority in Carlton would place no limits on retroactive tax laws. Justice Scalia notes:

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.

That is a frightening reality for taxpayers, if true. It is particularly frightening if the Court fails to clarify and put meaningful teeth behind its other “factors”, in particular, requirements that states (or Congress) (a) act promptly and (b) provide a modest period retroactivity. The majority opinion appears to suggest that these factors serve as checks on whether a legislature's legitimate legislative purpose is, in fact, rationally related to its purpose. Citing an earlier U.S. Supreme Court decision the majority opinion notes:

[T]he “‘recent transactions’” to which a tax law may be retroactively applied “must be taken to include the receipt of income during the year of the legislative session preceding that of its enactment.” Here, the actual retroactive effect of the 1987 amendment extended for a period only slightly greater than one year. Moreover, the amendment was proposed by the IRS in January 1987 and by Congress in February 1987, within a few months of [the statute's] original enactment.

While this language is helpful, it merely serves as an example of prompt action and a modest period of retroactivity. The majority stops short of stating that the quoted language serves as the standard all retroactive legislation must meet in order to be rationally related to its purpose. The Court should go one step further. Justice O'Connor’s concurrence in Carlton can be instructive to the Court in this regard where she states that “[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.”

Justice O'Connor further notes that:

In every case in which we have upheld a retroactive federal tax statute against due process challenge, however, the law applied retroactively for only a relatively short period prior to enactment. SeeUnited States v. Hemme, supra, at 562 (1 month); United States v. Darusmont, supra, at 294-295 (10 months); United States v. Hudson, 299 U.S. 498, 501 (1937) (1 month). In Welch v. Henry, supra, the tax was enacted in 1935 to reach transactions completed in 1933; but we emphasized that the state legislature met only biannually and it made the revision “at the first opportunity after the tax year in which the income was received.”

Recent state retroactive legislation has clearly exceeded those periods, but taxpayers can hope that the Court considers Justice O'Connor’s concurrence when reviewing the cases pending before it and the broader state trend.

A second troubling aspect of Carlton is that the Court's analysis could be viewed as establishing a fairly high bar for taxpayers looking to establish a due process violation has occurred. Specifically, in Carlton the Court found both (a) the taxpayer's detrimental reliance on the original law and (b) a lack of advance notice regarding an amendment to the law to be insufficient for purposes of establishing a due process violation. The majority writes:

Although [the taxpayer's] reliance [on the original statute] is uncontested … his reliance alone is insufficient to establish a constitutional violation. Tax legislation is not a promise, and a taxpayer has no vested right in the … Code…. Similarly, we do not consider [taxpayer's] lack of notice regarding the … amendment to be dispositive…. [A] taxpayer “should be regarded as taking his chances of any increase in the tax burden which might result from carrying out the established policy of taxation.”

Despite the narrow facts of Carlton (i.e., an executor's reliance on a tax loophole) this language would have the effect of severely restricting the grounds upon which a taxpayer can assert that a retroactive law change violates its due process rights—essentially concluding reliance in a tax law can never exist. But Carlton did not actually conclude that reliance should never be considered; hence, another reason that the Court should provide clarification.

Taxpayers can be encouraged by Justice O'Connor’s concurrence, which not only suggests some limitation on arbitrary and aggressive revenue raising through retroactive tax legislation, but suggests that taxpayer reliance is a real concern, and one that needs to be addressed:

But “the Court has never intimated that Congress possesses unlimited power to ‘readjust rights and burdens … and upset otherwise settled expectations.’” The governmental interest in revising the tax laws must at some point give way to the taxpayer's interest in finality and repose.

Practical Considerations

Taxpayers may be pondering what to do in light of the lack of clarity from the U.S. Supreme Court regarding the Carlton decision, and in the face of the disturbing trend of retroactive state tax legislation. In addition to following the petitions currently pending before the Court (in the hope that the Court will grant certiorari review in one or more of the cases and provide clarity concerning the standard to be used in determining when retroactive tax legislation is valid), taxpayers will want to keep a couple of practical considerations in mind.

Taxpayers should consider the risk of retroactive state tax legislation when choosing to litigate issues that could lead to a tide of refund claims. If the collective tax refund amount of an issue is significant enough, it may motivate a state legislature to enact a law that will unwind the detrimental state revenue impact of a potentially pro-taxpayer judicial decision. This risk is heightened in jurisdictions that have shown a proclivity for retroactively unwinding taxpayer-favorable court decisions. In this circumstance, taxpayers may find themselves in a “race to the state supreme court” as retroactive state tax legislation is more likely to apply to appeals that are still proceeding through the appeals process rather than to overturn the decision of the state judiciary, which would otherwise open the door to other taxpayer refunds. This is because state legislatures are more cautious when it comes to directly and affirmatively overturning a decision of the state judiciary, which would create a separation of powers issue. As a result, the taxpayer with the lead appeal may be the only taxpayer to receive a refund check while everyone else is left to suffer at the hands of the duality of Carlton.

Further, taxpayers may want to consider the possibility of retroactive legislation when applying existing law to positions taken on a state tax return. Taxpayers may find that considering the possibility of retroactive legislation may be a necessary factor with respect to positions that are technically within the bounds of the law, but may be viewed by a state legislature as unintended results.

Conclusion

On one hand, the Carlton decision appears to involve a unique set of facts—facts that should be distinguishable from the facts commonly involved in many retroactive state tax cases. On the other hand, the Court's analysis can be misapplied to support the position that states have an extremely broad power in enacting retroactive tax legislation. The duality within the Carlton decision serves as support for why the U.S. Supreme Court's review of the pending state tax retroactivity cases is necessary.

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