Retroactive Tax Law Changes

Take-Away: Yes, many federal tax law changes can be made retroactive.

Background: There has been plenty written already with regard to the possible increase in income and transfer tax laws at the federal level with the recent change in administrations. While the Senate could be deadlocked 50%-50% between Republicans and Democrats, Vice-President Harris can cast the tie-breaker vote. Then again, if a filibuster arises, it takes 60 votes to end the Senate filibuster. While the filibuster may seem like a firewall to stop major tax legislation in a Biden-led administration, the filibuster cannot be used with respect to a budget reconciliation act. As a result, if there is going to be major tax legislation coming out of Washington D.C. in 2021, it is most likely to come in the form of budget reconciliation legislation, unless the Senate drops its current filibuster rule, which is doubtful. If there is major tax legislation adopted by Congress in 2021, can it be made retroactive to the first of the year?

Retroactive Tax Legislation: Historically, many tax law provisions have been effective as of the date the provision was introduced in a Bill to the relevant Congressional committee. The reasoning is that the introduction of the Bill puts taxpayers on notice of a possible change in taxes, but timing obviously limits the taxpayer’s ability to plan for, or around, the tax law change. On other occasions, new tax legislation is applied retroactively to the first day of the calendar year in which the legislation was passed. Challenges by taxpayers in the past to retroactive tax legislation have not been very successful.

Rationally Related: A retroactive change in any law must be rationally related to a legitimate legislative purpose. Pension Benefit Guaranty Corporation v. R.A. Gray and Company, 467 U.S. 717 (1984); United States v. Carlton, 512 U.S. 26 (1994). Sometimes called the rational basis test, the question is whether the retroactive application is “supported by a legitimate legislative purpose, furthered by rational means”, which is considered to be a fairly low standard of review by a reviewing court to find the legislation to be constitutional. Raising revenue to deal with a pandemic, to address a mounting deficit, or to pay for a massive nationwide infrastructure improvement program would all seem to be rationally related to warrant a retroactive increase in taxes raised by Congress.
Due Process: Similarly, the retroactive application of an income tax statute to the entire calendar year in which enactment took place has never been deemed by the Supreme Court to deny an individual due process. The Supreme Court in Carlton noted that it has ‘repeatedly upheld retroactive tax legislation against due process challenge” citing a two-prong ‘test’; (i) the legislation has a rational legislative purpose and is not arbitrary; and (ii) the period of retroactivity is not excessive.
Period of Retroactivity: In Carlton, that modest period of retroactivity extended back 14 months. In Miliken v. U.S., 283 U.S.15 (1931) the Supreme Court upheld the retroactive estate tax rate imposed on a transfer that was made two years before the rate legislation’s effective date.
Detrimental Reliance: An argument that regularly appears when there is a retroactive change in tax legislation is that it is unfair to change tax laws once a taxpayer has taken action based on the law as it existed at the time of the transaction. While a taxpayer concluded a transaction in reliance on a prior law, that will not affect the outcome of the new tax law. The Supreme Court held in Carlton that “reliance alone is insufficient to establish a constitutional violation.” In Welch v. Henry, 305 U.S. 134 (1938), the Supreme Court noted: “tax legislation is not a promise, and a taxpayer has no vested right in the Internal Revenue Code.”
Lack of Notice: The lack of notice of the retroactive effect of a tax law is usually not dispositive of whether due process has been violated. However, lack of notice may provide a valid challenge of unconstitutionality when the retroactive legislation enacts a wholly new tax. This occurred long ago when Congress first enacted a gift tax. Blodgett v. Holden, 275 U.S. 142 (1928); Untermeyer v. Anderson, 276 U.S. 440 (1928.) Other than these two cases almost 90 years ago, the Supreme Court has not found any other situations where the lack of notice was an issue or threatened the validity of the new tax. The Supreme Court will distinguish a wholly new tax as opposed to an amendment to an existing tax, even though it might look like a new tax, e.g. imposing ordinary income tax rates to capital gains if the taxpayer’s income exceeds $1.0 million. So long as a taxpayer has some kind of notice that a tax might be imposed, that is sufficient to permit some level of retroactivity to the new tax. In light of all that has been written about what to expect with the Biden administration in the way of new taxes, or tax increases, or ‘loophole’ closings, it will be hard for a taxpayer to claim that he or she lacked notice of the possibility of tax law changes.

Transfer Taxes: President Biden has proposed to drop the current estate and GST tax exemption from $11.7 million to $3.5 million per person, and the federal gift tax exemption from $11.7 million to $1.0 million per person. There have also been proposals to raise the transfer tax rate from t0% go 45%, and possibly impose a surtax on estates valued at more than $100 million at death. Less attention has been given to informal proposals (not coming from President Biden) about limiting the number of annual exclusion gifts ($15,000 per donee) to an aggregate dollar amount, e.g. up to $75,000 in a calendar year, or the number of annual exclusion gifts made in a calendar year by the donor, e.g. no more than five annual exclusion gifts. Most of these proposed transfer tax law changes would impact the wealthy, making them more likely to be considered than changes to the current income tax rules rather than wholly new taxes.

Income Taxes: President Biden also proposed during the Presidential election to increase income taxes, on some individuals, and closing many perceived tax ‘loopholes.’ Mr. Biden has proposed increasing the highest individual income tax rate from 37% to 39 ½ %. His proposed corporate income tax rate would go from 21% to 28%. Examples of some perceived tax ‘loopholes’ to be addressed would be: (i) eliminate the ‘step-up’ in income tax basis on the death of the asset owner (IRC 1014(a)(1)); (ii) eliminate like-kind exchanges of real property (IRC 1031); (iii) cause grantor trust assets to be included in the grantor’s taxable estate at death; (iv) impose a minimum duration on GRATs, e.g. 10 years with a minimum value of the taxable remainder interest in the GRAT, e.g. 25% of the asset value; (v) tax capital gains at ordinary income tax rates if the individual’s adjusted gross income exceeds $1.0 million; and (vi) change the income tax deduction for a contribution to an IRA or qualified plan account, e.g. a 401(k) account to a limited income tax credit, which credit would benefit low earners more so than high earners.

Social Security Tax: Another proposal made during President Biden’s campaign would be to impose the 12.4% Social Security tax on earners whose earnings exceed $400,000, but leaving a ‘donut hole’ between the current earnings ceiling of about $146,000 to $400,000 where there would be no social security tax imposed.

Conclusion: To answer the question on a lot of people’s minds, especially the wealthy, is ‘yes,’ Congress can enact tax legislation and make it retroactive to an earlier date. The best bet would be tax legislation that is made retroactive to January 1, 2021. All bets are off if Congress enacts an entirely new tax, such as a wealth tax. An entirely new tax will probably have an effective date as the date the law was enacted. It is possible that if some perceived loopholes are closed, some pending or existing strategies might be grandfathered, such as a short-term, zeroed-out GRAT, that was created early in 2021. If there is a chance for some ‘grandfathering’ of some planning strategies, now would be a good time to put them in place.