Many provisions of the House and Senate tax reform proposals would affect state and local tax regimes. SALT practitioners should monitor the progress of this legislation and consider contacting their state tax administrators and legislative bodies to voice their opinions.
The White House and Republican congressional leadership released an outline this week to guide forthcoming legislation on federal tax reform. The states conform to the federal tax laws to varying degrees and the extent to which they will adopt any federal changes is uncertain. This memorandum outlines some of the key areas—individual taxation, general business taxation and international taxation— with which the states will be concerned as details continue to unfold.
Retroactivity is an endemic problem in the state tax world. In this year alone, we have seen retroactive repeal of the Multistate Tax Compact (MTC) in Michigan, as well as significant retroactivity issues in New York, New Jersey and Virginia. But after decades of states changing the rules on taxpayers after-the-fact, relief may be on the way if the Supreme Court of the United States grants certiorari in a Washington estate tax case, Hambleton v. Washington, with retroactivity that makes you say “What the heck?”.
The taxpayers filed a petition for certiorari on June 5, 2015. The Court requested a response, which is now due by September 9, 2015. The Tax Executives Institute filed an amicus brief on July 6, 2015.
The case involves two widows’ estates. As stated in the petition:
Helen Hambleton died in 2006, and Jessie Macbride died in 2007. Each was the passive lifetime beneficiary of a trust established in her deceased husband’s estate, and neither possessed a power under the trust instrument to dispose of the trust assets. Under the Washington estate tax law at the time of their deaths, the tax did not apply to the value of those trust assets. In 2013, however, the Washington Legislature amended the estate tax statutes retroactively back to 2005, exposing their estates to nearly two million dollars of back taxes.
In 2005, Washington state enacted an estate tax that was intended to operate on a standalone basis, separate from the federal estate tax. In interpreting the new law, the Department of Revenue issued regulations that the transfer of property from the petitioners’ husbands to the petitioners through a Qualified Terminable Interest Property (QTIP) trust was not subject to the Washington estate tax. The Department then reversed its position and assessed tax. Petitioners, along with other estates, challenged the Department’s position and won in Washington Supreme Court (In re Estate of Bracken, 290 P.3d 99 (Wash. 2012)). Then in 2013, the Washington legislature amended the estate tax to retroactively adopt the Department’s position, going back to 2005. The petitioners challenged this law up to the Washington Supreme Court, which held in favor of the Department and concluded that the retroactive change satisfied the due process clause under a rational basis standard.
The petition urges the Supreme Court to take the case to resolve the uncertainty as to “how long is too long” when it comes to retroactive taxes, citing multiple examples of past and ongoing litigation in which lower courts have taken divergent approaches to the length of retroactivity that is permissible. Of particular interest, one of the cases cited is International Business Machines Corp. v. Michigan Department of Treasury, 852 N.W.2d 865 (Mich. 2014). The retroactive repeal of the MTC election in Michigan is a central issue in that ongoing litigation. If the Supreme Court takes Hambleton, its decision would likely impact the Michigan MTC litigation. The recent decision by the New York Court of Appeals, allowing retroactivity that a lower court had voided, Caprio v. New York Department of Taxation and Finance, no. 116 (slip op. Jul. 1, 2015), is another example of a retroactive tax that could be affected if the Supreme Court takes up Hambleton.
It is hard to imagine a more sympathetic situation for a due process retroactivity challenge to a state tax. The taxpayers took a position on their returns consistent with the law and regulations, challenged the Department’s arbitrary re-interpretation of the law and won. The Supreme Court of Washington had made a definitive interpretation as to the application of the law as then in effect. Unfortunately, the legislature then retroactively amended the statute in an effort to raise revenue, subjecting the petitioners to a tax that was not owed under the law at the time. This type of chain of events is inherently unfair, and if allowed, potentially subjects taxpayers to new tax liabilities at any time. For instance, if the imposition of an entirely new tax is allowed, then what could stop a legislature from raising money by retroactively increasing the corporate income tax rate for the previous few years on all taxpayers because the legislature did not budget correctly with the initial passage of the rate?
It will be interesting to see if the Court takes up this case as a vehicle to address the retroactivity question, as the Court has had opportunities in the past to review other retroactive state tax impositions but has declined (e.g., Miller v. Johnson Controls, Inc., 296 S.W.3d 392 (Ky. 2009), cert. denied, 560 U.S. 935 (2010)). There is some hope for certiorari given the Roberts Court’s recent willingness to take state tax cases (e.g. Direct Marketing Association, Wynne, Hyatt); until the decision on certiorari this fall, we won’t know whether both death and taxes are truly certain.
State courts generally have allowed legislatures a fair amount of flexibility in adopting retroactive statutes, but a recent New York case held that, under the circumstances presented, the retroactive application of a statute was unconstitutional. In Matter of Jeffrey and Melissa Luizza (DTA No. 824932) (Aug. 21, 2014), Mr. Luizza agreed to sell all of the stock of an S corporation to an unrelated buyer in a transaction governed by Section 338(h)(10) of the Internal Revenue Code. Under Section 338(h)(10), Mr. Luizza’s sale of his stock was ignored for income tax purposes and the transaction was treated as if the corporation had sold its assets and distributed the proceeds to Mr. Luizza. Under the Subchapter S rules, the liquidation was essentially tax-free. The corporation’s gain was passed through to Mr. Luizza as the sole shareholder. Mr. Luizza was a nonresident of New York and under the law in effect when the sale occurred (March 2008) it appeared that a nonresident shareholder was not taxed on the gain in a 338(h)(10) sale because the transaction was treated as a sale of stock.
In 2009, the State Tax Appeals Tribunal confirmed that although a 338(h)(10) transaction was treated as a sale of assets by the corporation for federal income tax purposes, it was in fact a sale of stock and, since nonresidents are not subject to New York State income tax on gains from the sale of stock, even of a corporation doing business in New York, a nonresident selling stock of an S corporation in a 338(h)(10) transaction cannot be taxed by New York State on the resulting gain. In Matter of Gabriel S. and Frances B. Baum, et al., (DTA Nos. 820837, 820838) (Feb. 12. 2009) (McDermott Will & Emery filed an amicus brief supporting the taxpayer’s position in that case.)
The State Department of Taxation and Finance was not happy about the result of this litigation. It convinced the legislature to reverse that result by amending the statute to provide that a shareholder’s share of the corporation’s gain in a 338(h)(10) transaction would be treated as New York source income that was taxable to nonresidents. The legislation was adopted in 2010 and was made effective retroactively to all years open under the statute of limitations.
Mr. Luizza objected to the retroactive application of the statute to him, and the administrative law judge agreed that, on his facts, the retroactivity was so harsh as to be unconstitutional under the Due Process Clause of the United States Constitution. The ALJ pointed out that the taxpayer relied on the law as it existed in 2008 and that at the time of the sale the prevailing authority was that the transaction was not taxable. Mr. Luizza was advised by his tax advisors that there would be no additional New York tax due. Because of his reliance, he did not have an opportunity to seek a higher sale price or to require the buyer to indemnify him for any additional taxes resulting from the 338(h)(10) election. He “had no forewarning of the change in the legislation and . . . he reasonably relied upon his advisers as to the state of the prior law.” The ALJ said that there was no hard and fast rule as to the period of time that a statute could be made retroactive and that the decision should be based on the taxpayer’s unique circumstances. In the case before him, he held that the retroactive application of the statute to an unsuspecting taxpayer was unconstitutional.
Retroactive legislation has been allowed to correct an obvious mistake by the legislature. In the U.S. v. Carlton, 512 U.S. 26 (1994), the United States Supreme Court allowed the estate tax laws to be amended retroactively because Congress had overlooked the fact that an amendment to the Internal Revenue Code that it had adopted to encourage employee stock ownership plans could have inadvertently repealed the estate tax by creating a loophole so wide that anyone could drive a truck through it. The ALJ in Luizza distinguished that line of cases. The Department argued that the retroactive legislation was designed to correct a mistake by the Tax Appeals Tribunal, but the ALJ disagreed. Moreover, the legislative history led the ALJ to conclude that the purpose of the retroactive feature of the legislation was to raise money for the State, which was “not a compelling reason for retroactivity and is insufficient to warrant retroactivity when considerations would support doing otherwise.”
The case stands for the proposition that retroactive application of a tax statute, even if only for a few years, may be set aside if it results in such manifest unfairness as to violate Due Process principles. An ALJ decision is not precedent under New York Law, but the ALJ relied on part on the decision of Caprio v. New York State Department of Taxation and Finance, 117 AD 3d 168 (2014), which held to similar effect. Accordingly, taxpayers in New York and elsewhere should be prepared to argue that retroactivity, when manifestly unfair, is unconstitutional.