Gambling With the Irs: the Enforcement of Retroactive Tax Statutes in United States v. Carlton - Stewart Haskins

• Jurisdiction: United States,Federal
• Publication year: 1996
• Citation: Vol. 47 No. 4

Gambling with the IRS: The Enforcement of Retroactive Tax Statutes in United States v. Carlton

In United States v. Carlton,¹ the Supreme Court rejected a Due Process challenge to the retroactive elimination of an estate tax deduction.² In 1986, Congress revised the Internal Revenue Code to allow a deduction under 26 U.S.C. Sec. 2057 for half the proceeds of a sale of employer securities by the executor of an estate to an employee stock ownership plan (ESOP).³ Jerry W. Carlton was the executor of Willametta K. Day's estate.⁴ In December 1986, Carlton used estate funds to purchase MCI stock valued at $11,206,000.⁵ Two days later, Carlton sold the stock to the MCI ESOP for $10,575,000, losing $631,000 in the transaction.⁶ Carlton filed a timely estate tax return, claiming a deduction under section 2057 for half the proceeds of the sale of stock, which amounted to a tax liability reduction of $2,501,161.⁷ In January 1987, the IRS announced it would interpret the deduction to be available only to estates of decedents who owned the securities immediately before death.⁸ In February 1987, a bill was proposed in the House and Senate to codify the IRS interpretation.⁹ On December 22, 1987, the amendment to section 2057 was enacted.¹⁰ It provided that in order to qualify for the deduction, the securities sold to the ESOP must have been "directly owned" by the decedent "immediately before death."¹¹ The amendment was made effective as if it had been included in the original statute of October 1986.¹² The IRS disallowed Carlton's section 2057 deduction.¹³ Carlton paid the asserted tax deficiency, plus interest, filed a claim for a refund, and initiated a refund action in the United States District Court for the Central District of California, claiming that the retroactive application of the statute violated the Due Process Clause of the Fifth Amendment.¹⁴ The parties stipulated that if the statute could not be retroactively applied without violating the Constitution, Carlton would be entitled to a refund; else the Government would prevail.¹⁵ The court held the tax was not so "unduly harsh and oppressive" as to violate due process and entered summary judgment for the United States.¹⁶ The court focused on: (1) whether the statute was a "wholly new tax" or a rate change in an existing tax; and (2) whether the change (amendment) was reasonably foreseeable.¹⁷ The court found the statute was simply a "rate change" and the change was foreseeable; therefore, the amendment did not violate the Due Process Clause.¹⁸ The Ninth Circuit Court of Appeals reversed the district court in a two-to-one decision, using a different test than the district court.¹⁹ The United States Supreme Court granted certiorari and reversed.²⁰ The Court held retroactive application of a tax statute does not violate the Due Process Clause if the application of the statute is rationally related to a legitimate legislative purpose.²¹

Retroactive laws are disfavored in the Constitution. The Constitution provides several restrictions against retroactive application of laws. Ex Post Facto laws are prohibited.²² Bills of Attainder, laws that apply to specific individuals, are prohibited.²³ The Contract Clause prevents laws impairing contract obligations, reflecting the Framer's disapproval of retroactive laws affecting contracts.²⁴ The Takings Clause of the Fifth Amendment restricts retroactive laws unduly affecting property rights.²⁵ Most commonly, it is argued that retroactive application of a statute may violate due process rights under the Fifth Amendment.²⁶ There are many policy reasons for this historical disapproval of retroactive application of statutes. Citizens should be able to plan their conduct with reasonable certainty of the legal consequences. There is a public need for stability with respect to past transactions. Retroactive laws may be passed with exact knowledge of who the law will benefit or harm, which increases the potential for corruption in the political process. Despite these policy arguments, retroactive tax laws were initially upheld against constitutional challenges. In a 1874 decision, Stockdale v. Atlantic Insurance Co.,²⁷ the Court upheld a retroactive tax on corporate dividends as a "legitimate exercise of the taxing power by which a tax, which might be supposed to have expired, was revived and continued in existence for two years longer."²⁸ Later, in Brushaber v. Union Pacific Railroad,²⁹ the Court relied on the decision in Stockdale to uphold another retroactive tax statute.³⁰ The Court stated "the Constitution does not conflict with itself by conferring, upon the one hand, a taxing power, and taking the same power away, on the other, by the limitations of the due process clause."³¹ Despite these holdings, in the early 1900s, the Court struck down some retroactive statutes as violating the Due Process Clause. In Nichols v. Coolidge,³² the Court struck down a statute that taxed property conveyed before the statute was enacted.³³ The Court relied on earlier cases, including Brushaber, which stated that a retroactive tax statute may be "so arbitrary and capricious as to amount to confiscation and offend the Fifth Amendment."³⁴ In Blodgett v. Holden,³⁵ the Court used this same "arbitrary and capricious" language in striking down the retroactive application of a gift tax.³⁶ The Court focused on the lack of notice of the taxpayer as to the retroactivity of the tax, stating the taxpayer acted "in entire good faith and without the slightest premonition of such consequence."³⁷ In Untermyer v. Anderson,³⁸ the Court again struck down the application of a gift tax to gifts made during the prior year.³⁹ The gift was made while Congress was considering the statute in question.⁴⁰ Nonetheless, the Court held the statute to be "arbitrary and invalid under the due process clause of the Fifth Amendment."⁴¹ The Court required actual notice to the taxpayer of his tax liability.⁴² The Court stated "[t]he taxpayer may justly demand to know when and how he becomes liable for taxes."⁴³ Other cases interpreted a statute to not apply to the taxpayers retroactively to avoid holding the statute unconstitutional.⁴⁴ The Court's early interpretations of retroactive gift and estate tax statutes dealt with a "wholly new tax." Thus, the courts primarily focused on the taxpayer's lack of notice as to future new tax laws in finding their retroactive application "arbitrary and capricious." As gift and estate tax laws became commonplace, the Court abandoned its reliance on the "actual notice" test and struck down only those retroactive statutes that were "harsh and oppressive." In Welch v. Henry,⁴⁵ the Court upheld a retroactive tax on dividends received some two years earlier.⁴⁶ The Court articulated a test to determine whether a retroactive tax is unconstitutional: "In each case it is necessary to consider the nature of the tax and the circumstances in which it is laid before it can be said that its retroactive application is so harsh and oppressive as to transgress the constitutional limitation."⁴⁷ The Court further explained that actual or constructive notice and timing were the most important circumstances to consider.⁴⁸ In Estate of Ekins v. Commissioner,⁴⁹ the Seventh Circuit Court of Appeals used this Welch "harsh and oppressive" standard to uphold the retroactive application of a tax on the value of an insurance policy in the decedent's estate.⁵⁰ The court focused primarily on the circumstance of the tax, which the court considered to be merely a change in an existing tax.⁵¹ Thus, the court held the taxpayer had "constructive notice" of the retroactive statute because life insurance policies historically were included under estate taxes.⁵² Unlike the earlier cases, the court did not address or consider the taxpayer's actual expectations. The Seventh Circuit also employed this type of analysis in Reed v. United States.⁵³ In Reed the court focused on the nature of the tax, which it characterized as a mere change in an existing tax, to uphold the retroactive elimination of an estate tax exclusion for gifts made within three years of death.⁵⁴ Rejecting the actual notice test of the earlier cases, the court held the decedent had "constructive notice" that at least part of the gift would be taxed.⁵⁵ The court did not find that changing this existing tax was "so harsh or oppressive as to be invalid."⁵⁶ The Supreme Court has also relied on the Welch "harsh and oppressive" standard, focusing on the characterization or nature of the tax. In United States v. Darusmont,⁵⁷ the Court upheld retroactive application of an income tax statute to the entire...