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In the 1994 Carlton decision, the United States Supreme Court upheld retroactive federal tax legislation, finding it did not violate due process. The federal law corrected an error in the original legislation, and the retroactive period was just over a year. The United State Supreme Court recently refused to hear a number of taxpayer challenges to retroactive state tax legislation, including one case where the legislation reached back 28 years. In this article, Ryan's Mary Bernard and Mark Nachbar discuss the implications for taxpayers of the Supreme Court's refusal to consider these cases.
By Mary F. Bernard, CPA, CMI and Mark L. Nachbar, Esq., CPA
Mary F. Bernard is a director, and Mark L. Nachbar is a principal, with State Income and Franchise Tax at Ryan LLC.
Ryan LLC is not a CPA or law firm.
The United States Supreme Court has decided not to review the seven cases challenging retroactive state tax law changes.
Multistate businesses hoping for a reprieve from states' arbitrary retroactive law changes were disappointed to learn on May 22, 2017 that the United States Supreme Court (“Court”) denied certiorari in seven cases that were anticipating a clarification of the 1994 Carleton case [512 U.S. 26 (1994)], the last word on retroactive law changes. Six of the seven petitions were seeking review of the Michigan decisions that upheld the state's retroactive repeal of the Multistate Tax Compact (“Compact”). Although these cases challenged the constitutionality of the retroactive repeal of the Compact, it was hoped that the Court would also address the availability of the equally weighted three-factor apportionment formula election of the Compact. The remaining petition denied involved the imposition of a 27-year retroactive period related to a Washington exemption statute.
In 1994, the United State Supreme Court issued the Carleton decision involving the retroactive change in a federal estate tax deduction. In this case, the taxpayer had filed an estate tax return claiming a deduction for the proceeds of sales of stock to Employee Stock Ownership Plans in December 1986. In December 1987, Congress amended a provision of the statute to limit the availability of this deduction to apply retroactively, as if incorporated in the original deduction provision adopted in October 1986. Under audit, the deduction was disallowed because of the retroactive limitation. The taxpayer challenged the constitutionality of the retroactive law change, claiming a violation of the due process clause of the Fifth Amendment.
Upon review, the Supreme Court held that the retroactive implementation did not violate the due process clause as it was supported by a legitimate legislative purpose—raising revenue—furthered by rational means. The factors supporting the Court's holding included 1) the amendment was intended to correct a mistake in the original statute, 2) Congress did not act with improper motive, 3) Congress acted promptly in proposing the amendment within a few months of enactment, and 4) the retroactive period was modest—just over one year.
On one hand, this decision appears to be interpreted as supporting broad powers of the state to retroactively amend laws, as long as there is a revenue raising intent, which equates to a “legitimate legislative purpose.” Under this rationale, all retroactive tax laws would be valid, as long as the result added a tax, removed a deduction, or increased a tax rate.
On the other hand, one would expect that the other supporting factors requiring a prompt action with a modest retroactive period would counterbalance the broad powers relating to legislative intent. Keeping this duality in mind, it becomes apparent that further clarification would have been extremely helpful.
Unfortunately, there seems to be a trend in state taxation surrounding the “legitimate legislative purpose” concept. Some governmental bodies and courts now routinely base tax assessment decisions upon the revenue that will be generated to the state by denying taxpayers their due process rights. In Maryland, after failing to assert nexus over a subsidiary based on the unitary business principle, the Department of Revenue found another way to increase the coffers of the state. Despite the substantial functions performed by the subsidiary, the Department of Revenue (DOR) claimed and prevailed on a theory that the subsidiary was so interdependent with its parent that it could not exist on its own. The state of Iowa has similarly trampled on taxpayers' due process rights, in the name of “legitimate legislative purpose,” as revealed in both the KFC [792 NW2nd 308 (Iowa Sup. Ct., December 30, 2010, cert. denied)] and Jack Daniels [Docket 09 DORFC 02; 004 (Iowa Department of Inspection and Appeals, July 28, 2011)] cases.
Not only have states relied on the “legitimate legislative purpose” doctrine to go after out-of-state taxpayers, they have continued to violate taxpayers' due process rights by altering statutory apportionment formulas to taxpayers' detriment. In the Equifax case [125 So.3d 36 (Miss. 2013)] in Mississippi and Vodafone case [486 S.W. 3rd 496 (Tenn. 2016)] in Tennessee, the respective departments of revenue used their power to require alternative apportionment to impose a market state-based apportionment formula, when the statutory formula called for a cost of performance methodology. In both cases, market sourcing raised additional revenue for the state. Mississippi and Tennessee are not alone in using their powers to overturn statutory authority. The Arkansas Department of Revenue has routinely circumvented its cost of performance statute to impose market-based sourcing.
These abuses of power have continued to permeate the state tax landscape in both the multistate tax commission cases and an exemption to the Washington Business and Occupation (B&O) tax as indicated below.
The six Michigan petitions arose from a 2014 decision [852 NW.2d 865 (2014)] of the Michigan Supreme Court permitting IBM to use the Compact's elective apportionment factor to determine its tax liability under the Michigan Business Tax. Once it was determined that this decision could cost the state more than $1 billion in refunds, the Legislature retroactively repealed the statute providing the elective formula, going back to 2008. Each request for review by the U.S. Supreme Court challenged the constitutionality of the retroactive repeal. In addition to IBM, the taxpayers included Gillette Commercial Operations, Goodyear Tire & Rubber Company, Sonoco Products Company, DIRECTV Group Holdings, and Skadden, Arps, Slate, Meagher & Flom LLP.
In Dot Foods, Inc. v. Washington Department of Revenue [215 P.3d 185 (Wash. 2009)], the retroactive tax law challenged reached back 27 years. In 1983, an exemption from the Business and Occupation Tax was passed for out-of-state businesses soliciting in state through separately organized direct sellers. Although Dot Foods received a letter ruling in 1997 indicating that it qualified for the exemption, the state assessed the company for sales made after January 1, 2000. In 2009, the Washington Supreme Court ruled that Dot Foods was entitled to the exemption, based on the plain language of the statute. When the realization of the financial impact of additional refund requests occurred six months later, the Legislature retroactively changed the exemption to conform to the original intent. Dot Foods challenged the retroactive law change as a violation of due process.
Taxpayers had been waiting a long time for support from the Supreme Court in curbing the runaway power of the states to impose retroactive law changes to subvert taxpayer-friendly judicial decisions. In refusing to review these seven cases, the Court has left the taxpayers with the sometimes vague language of the Carleton case as the definitive word in retroactive law changes. The petitions were filed based on the concurring opinion of Justice O'Connor in Carleton, agreeing with the majority opinion because the retroactive period was relatively short—about one year. She had commented, however, that anything longer than that would raise serious constitutional issues. In the petitions filed, the Michigan cases involved eight years, and the Washington case involved 27 years. A reasonable person would conclude that both of these time periods greatly exceed Justice O'Connor’s guidelines.
The lack of guidance from the Court results in extreme uncertainty where the taxpayer cannot rely on current tax law to still be in effect by the time the return is audited. This greatly impacts the taxpayers' expectations and understanding of compliance with the states' tax laws. Is this really the position in which taxpayers should be placed? With no rein on the state's ability to retroactively change its laws, states, courts, and now legislatures are able to pick taxpayers' pockets. States with poor fiscal management have the untethered ability to raise revenue at will by retroactively changing their tax laws.
The lack of a bright-line test in Carleton to clarify the vague language of the case leaves taxpayers at the mercy of the state's whims, feeling like they are in the Wild, Wild West, and the states have all the guns!
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