Quirky Case Hits at Legality of Retroactive Tax
Jerry W. Carlton doesn’t want to battle the Clinton Administration over retroactive taxes. But when the U.S. Supreme Court earlier this month agreed to hear his estate tax case, he became an unwitting champion of the anti-retroactive tax cause.
And now, less than three months after President Clinton pushed through a massive tax law packed with retroactive taxes and tax incentives, Carlton’s case may prove significant regardless of whether he wins or loses.
If he wins, millions of taxpayers may challenge retroactive taxes anew. They have been challenged--and upheld--in the past, Carlton notes. A government loss at this stage could cost the U.S. Treasury billions.
On the other hand, Carlton believes that if he loses, the government’s ability to advance social aims through the tax code could be in jeopardy. And Clinton’s newly passed tax law is also stacked with incentives for people who invest in ways the government likes.
But to understand why Carlton is presenting such vexing concerns, you need to know a little bit about his quirky case.
Carlton, a Newport Beach-based attorney with O’Melveny & Myers, became executor of his mother’s generous estate when she died in late 1985. As executor, he was required to file an estate tax return by December, 1986.
But in October of 1986, Congress passed a law that gave special tax breaks to people who sell stock to Employee Stock Ownership Plans. Congress wanted to favor these plans because legislators thought it was good for the country when people have a vested interest in the success of their companies, as they did when they became shareholders.
Carlton realized he could take advantage of this new law and score a huge deduction for his mother’s estate in the process. So on Dec. 10, he directed his mother’s estate to buy $11.2 million worth of MCI stock, which he quickly agreed to sell to MCI’s ESOP plan for just $10.6 million--$631,000 less than his purchase price.
Despite the trading loss, the deal made sense because Carlton could claim a tax deduction of nearly $5.3 million, which saved his mother’s estate a cool $2.5 million in taxes.
A few days later, the IRS decided to disallow deductions similar to Carlton’s. Until 1989--when the law changed again--an estate could still deduct half the value of shares sold to an ESOP plan, but only if the person who died had owned the shares while living. The IRS called this a “clarification” of the law. Carlton called it a change.
In any case, Congress adopted the IRS ruling in December, 1987--a year after Carlton’s ESOP sale was completed--and applied it retroactively. Carlton’s estate tax return was audited, and he had to fork over the $2.5 million he’d saved in the ESOP transaction. But he appealed, charging that his mother’s estate was denied due process by the retroactive tax.
Notably, the loophole Carlton jumped through was open for less than three months before the IRS “gave notice” that it was subject to change. As a result, experts believe very few taxpayers are in a similar position.
Oddly enough, that’s why people are concerned about Carlton’s case. When the Supreme Court reviews a case, it can decide broad theoretical issues, or it can look at narrow issues that won’t drastically alter the way the country operates.
Court observers note that the justices generally make narrow rulings primarily when a narrow issue affects a lot of people. Carlton’s case wouldn’t, so there is speculation that the court agreed to look at Carlton so that it could consider much weightier, precedent-setting questions such as the government’s right to approve retroactive tax increases.
The IRS would not comment on Carlton’s case but emphatically states that “retroactive tax changes are constitutional.”
If nothing else, they are plentiful. Congress has passed 13 laws that included retroactive tax increases since 1917. And that doesn’t include the retroactive taxes in the 1993 bill, which affect estate taxes and income tax rates for wealthy Americans.
Congress also sometimes makes prospective changes such as those that pummeled the economics of previously sold real estate tax shelters, notes J.D. Foster, senior economist for the Tax Foundation in Washington. These tax shelters arguably never would have been sold if it wasn’t for the previously offered tax breaks.
But Carlton argues that the issue is not retroactive taxes but inducement. He never would have entered into the money-losing stock sale if he wasn’t “induced” by the tax code, he argues. It’s not fair for Congress to lead taxpayers down a primrose path, only to replant it with poison ivy when it’s too late to detour, he maintains.
Although many tax shelters were eliminated in 1986, it’s worth mentioning that the U.S. tax code is still crammed with inducements. People are encouraged to buy homes so they can write off their mortgage interest expenses, encouraged to buy stocks because capital gains are taxed at comparatively lower rates and encouraged to invest in low-income housing deals for the generous tax credits. The 1993 tax law added several inducements--ranging from lower rates to tax deferrals--for those who invest in small businesses.
If it’s legal for lawmakers to induce taxpayers into certain activities with the promise of economic benefit, then change the rules and pull the benefits, people would be crazy to take the inducements, Carlton argues.
“If I lose, the logical course of action (for other taxpayers) is to never follow Congress’ invitation when they ask you to do something,” Carlton says. “If I were the government, I don’t know that I’d want to win this case.”
