Setting the Clock Back? Retroactive Tax Legislation

The question has often been asked whether Congress can enact retroactive tax legislation, in effect “setting back the clock” and making a law effective as if it had been enacted at an earlier point in time. Case law has shown that there is no absolute constitutional prohibition to enforcing retroactive tax laws.  In fact, it is rare that retroactive tax legislation will be held to violate the US Constitution.

The issue may again be brought to the fore.  Recently, the United States Supreme Court was asked by Dot Foods Inc. to hear an appeal involving the question as to what circumstances will constitutionally permit retroactive tax legislation. 

US Supreme Court Asked to Review Retroactive Tax Law

In Dot Foods, Inc. v. State of Washington Department of Revenue, 372 P.3d 747 (Wash. 2016),  the Washington State Supreme Court upheld a state law that retroactively removed a corporate income tax exemption. In justifying the retroactive removal, the state legislature stated that its action was merely intended to reflect its initial intent.  The facts, however, indicated this could not be the case. Not only was it clear that the exemption had been consciously adopted by the legislature, but the law had been upheld earlier by the Washington State Supreme Court when the Department of Revenue had challenged Dot Food Inc.’s earlier use of this exemption.

In Dot Foods, the Washington State Supreme Court held that retroactive application of the tax law was not an unconstitutional violation of the Due Process Clause of the Fifth Amendment.  The court determined that raising money for the state was a “legitimate legislative purpose” that justified enforcing the law retroactively. 

Some practitioners feel the case is very important and believe the Washington Supreme Court has misapplied the US Supreme Court’s Carlton test, more fully discussed below.  In filing an amicus curiae brief, they believe that raising additional revenue, by itself and without regard to the circumstances, is not sufficient to justify a retroactive change in a tax law. 

Due Process – What’s It All About?

The Due Process Clause of the Fifth Amendment is the most likely (although not the only) base for a constitutional challenge to a retroactive tax. Under the Due Process Clause, taxpayers have a right to fairness as well as an economic right which may be violated if retroactive legislation is enacted that does not meet certain standards. The United States Supreme Court has upheld retroactive tax legislation against a Due Process challenge in numerous cases.

Landmark Case

The seminal case regarding Due Process challenges to retroactive tax application is that of United States v. Carlton 512 U.S. 26 (1994).  In that case, the US Supreme Court considered whether the retroactive denial of an estate tax deduction violated the Due Process Clause. 

By way of background, in Carlton, Congress had enacted a provision granting an estate tax deduction when an estate sold employer securities to a so-called Employee Stock Ownership Plan or “ESOP”.  Congress intended that this estate tax  deduction be available only if the stock was actually owned by the decedent at death. However, the law did not include statutory language making this clear. Fourteen months after the law was enacted, Congress amended it and added in the required language, applying the provision retroactively.  In other words, the amendment was made effective as if it had been included in the original statute.

In Carlton, the IRS disallowed the estate tax deduction to an estate based on the retroactive amendment of the law. The estate executor challenged the retroactive application of the amended law on Due Process grounds.

The Due Process argument was rejected by the Supreme Court, which upheld the retroactive tax legislation. The Carlton case established a two-part test which upholds retroactive tax application if: (1) the legislation is not arbitrary and has a rational legislative purpose; and (2) the period of retroactivity is not excessive. The Carlton Court determined that Congress’ actions were designed to correct a mistake that was affording taxpayers an unwarranted tax loophole. Furthermore the period of retroactivity was “modest” since it extended back only fourteen months. In conclusion, the Court determined the retroactive estate tax legislation satisfied both prongs of the test for constitutionality.

All Tax Laws Raise Revenue

Let’s face it, tax laws are designed to raise revenue.  If viewed as a  “legitimate legislative purpose”, the “revenue-raising” rationale will justify just about any retroactive tax increase.  Authors of the amicus curiae brief for Dot Foods Inc. maintain that revenue raising alone should not give rise to the “legitimate legislative purpose” when it upsets reasonable taxpayer expectations and reliance on prior law. The brief points out that, unlike the facts in Carlton, which involved correcting a legislative error when the original statute was enacted but lacked certain wording, Dot Foods Inc. involves a taxpayer that reasonably relied on an exemption that was not enacted by mistake, but rather was consciously adopted.

It will be interesting to see if the US Supreme Court grants certiorari in the case involving Dot Foods Inc.  and if so, the outcome of that case.  The amicus curiae brief mentions that “State legislatures throughout the United States are increasingly resorting to retroactive tax legislation to meet fiscal needs”.  The time is clearly ripe for this matter to be addressed by the highest Court.  

For those wishing more detailed information, an excellent report, “Constitutionality of Retroactive Tax Legislation” (October 25 2012), by the Congressional Research Service can be found here


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