High Court May Reverse Retroactively Imposed Tax : Litigation: Newport Beach estate case could provide a check on Congress. Income tax not likely to be affected.


The Supreme Court appears poised to reverse nearly 60 years of giving Congress and the states virtually unchecked power to impose taxes retroactively.

Next Monday, the justices will consider the case of a Newport Beach tax attorney who lost $630,000 for a client in 1987 because Congress retroactively repealed an estate tax deduction that it had created in 1986.

Some tax experts are predicting the high court will use the case to say that Congress finally has gone too far. “The bottom line is the Supreme Court will hold this retroactive tax unconstitutional,” predicted University of Minnesota law professor Ferdinand Schoettle.


“This will mean for the first time there is some constitutional limit on what Congress can do,” said Richard Samp, chief counsel of the Washington Legal Foundation, which is representing 22 Republican senators who want the court to restrict retroactive taxing.

But the millions of Americans who find themselves paying higher taxes this spring because of the retroactive provisions included in last year’s tax bill should not take heart. Tax experts and constitutional lawyers are nearly uniform in predicting that the court will not tamper with that sort of retroactive provision.

Congress historically has made changes in tax rates retroactive to the first of the year because the Internal Revenue Service cannot easily calculate income taxes if the rates shift in midyear.

Last year’s tax bill passed Congress on Aug. 10, and its higher tax rates were made retroactive to Jan. 1, 1993. The law also retroactively raised the top rates for estate and gift taxes.

Republican senators opposed backdating the rate increases and contended that the Constitution prohibits imposing taxes retroactively. But the Supreme Court has not shared that view except during a brief period in the 1920s and early 1930s.

The Constitution clearly bars ex post facto, or after-the-fact, laws. Since 1798, the high court has interpreted that provision to limit only criminal laws, not civil ones.


The Fifth and 14th amendments also prohibit Congress and the states from taking a person’s money “without due process of law.” Usually, due process means that the person must be on notice of the law--but not necessarily on notice in advance.

Before the mid-1930s, the Supreme Court routinely scrutinized new laws affecting businesses or taxpayers to see whether they violated the “due process” provisions. For example, the justices provoked a political uproar by striking down laws mandating a minimum wage and overtime pay rates as violations of the rights of the workers and employers to negotiate their own contracts.

But during the New Deal, all of that changed. President Franklin D. Roosevelt appointed justices who would take a hands-off approach to business and economic matters. Since then, the court has given Congress virtually a free hand to regulate the economy and to impose taxes.

A recent Duke Law Journal analysis of retroactive laws since 1938 concluded that the high court’s policy has been one of “judicial rubber-stamping.”

“They’ve been extremely deferential (to Congress). They have allowed virtually anything,” said Andrew Weiler, author of the article.

The Supreme Court admitted as much in a 1984 decision upholding the retroactive provisions of a new pension law.


“The strong deference accorded legislation in the field of national economic policy is no less applicable when that legislation is applied retroactively,” the court said. “Provided the retroactive provision . . . is supported by a legitimate legislative purpose furthered by rational means, judgments about the wisdom of such legislation remain within the exclusive province of the legislative and executive branches.”

Now, the case of U.S. vs. Carlton, 92-1941, may provide the vehicle for rethinking that approach.

It began in 1986, when Jerry W. Carlton, a Newport Beach lawyer, began preparing the estate tax return for Willametta Keck Day, an heiress to an oil fortune who had died late in the previous year.

That October, Congress passed the 1986 Tax Reform Act, which included several provisions to encourage stock ownership by a company’s employees. One section gave a tax deduction to the estate when the executor sold shares of a company’s stock to an employee stock ownership plan, or ESOP.

So Carlton bought $11.2 million of MCI stock on the open market on Dec. 10, 1986, and sold it privately two days later to MCI’s ESOP for $10.57 million. The estate lost $630,000 on the sale but, thanks to the new tax break for sales of stock to ESOPs, the deal reduced the estate’s tax bill by $2.5 million.

On Dec. 29, Carlton filed the tax return for Day’s estate and paid the $18 million that was owed. Two days later, the Wall Street Journal wrote a story questioning the new estate tax deduction for stock sales to an ESOP.


“This is a loophole you could drive a truck through,” one accountant was quoted as saying. Apparently, key members of Congress had intended the deduction to apply only to stock owned by the estate before death. The law did not include that restriction, however.

The IRS soon announced it would seek a change in the law. In the fall elections, the Democrats had won enough seats to reclaim control of the Senate, and Sen. Lloyd Bentsen (D-Tex.), the new chairman of the Finance Committee, introduced a bill in February, 1987, to repeal the estate tax deduction. The tax code should not encourage “essentially sham transactions,” Bentsen said.

The new Congress passed Bentsen’s bill by the fall of 1987 and made its provisions retroactive to October, 1986. In short order, the IRS wrote Carlton and said the estate owed another $2.5 million in taxes, leaving it with nothing to show for its purchase and sale of the MCI stock but a $630,000 loss.

“The government mousetrapped Jerry,” said Russell Allen, who--like Carlton--is a partner in the Los Angeles firm of O’Melveny & Myers. “They held out the bait, he took it and then they slammed the trap shut.”

After paying the disputed tax, Allen and Carlton filed a suit challenging the retroactive provisions as unconstitutional. And to the surprise of government lawyers, they won a ruling from the U.S. 9th Circuit Court of Appeals invalidating the retroactive tax imposed on Day’s estate.

In the court’s opinion, a retroactive tax provision is unconstitutional if the taxpayer did not have “actual or constructive notice” of a later change and if he “relied to his detriment” on the law as it was.


Both were true in this case, the San Francisco-based appeals court said. “Carlton had no notice, actual or constructive. The estate entered into a transaction that cost it $630,000 based solely on the inducement of a tax deduction the government now wants to take away,” wrote Judge Diarmuid O’Scannlain for the majority.

The case reached the Supreme Court last fall just as the National Taxpayers Union was going to court to challenge some of the retroactive provisions in the 1993 tax hike.

“We strongly oppose any form of retroactive taxes,” said David Keating, vice president of the group.

In its friend-of-the-court brief, the Washington Legal Foundation urges the justices to rule that a retroactive tax is absolutely unconstitutional when applied to “completed transactions.”

If the high court adopted that view, the provisions in the 1993 legislation affecting estate and gift taxes could be in jeopardy. For example, Congress in August raised the top rate on estate taxes from 50% to 55% and applied that provision to estate tax returns filed after Jan. 1.

In its lawsuit in a federal district court here, the National Taxpayers Union is challenging that increase as unconstitutional.


But even critics of the new law concede that the court will not tamper with the retroactive income tax provisions because those were not “completed transactions” when the bill became law.

“The chances are about zero” that the court will invalidate the income tax increases, Schoettle said.

For their part, Clinton Administration lawyers are fighting hard against Carlton’s claim and seeking to preserve Congress’ unchecked authority to increase taxes.

“Retroactive legislation rationally drawn to achieve a legitimate purpose”--whether to close a loophole or raise revenue--is constitutional, they contend in their court brief, “even if the statute imposes a liability that was not anticipated or upsets otherwise settled expectations.”

The high court is expected to issue a ruling by July.