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U.S. Supreme Court approves retroactive estate tax change.

When it passed the Tax Reform Act of 1986, Congress added Internal Revenue Code section 2057, which went into effect after October 22, 1986. The section allowed an estate tax deduction of half the proceeds of the sale of employer securities by an estate's executor to an employee stock ownership plan (ESOP). (Section 2057 was repealed in 1989.) To qualify for the deduction, the employer securities had to be sold an ESOP before the estate tax return's due date (including extensions).

In December 1987, Congress, wishing to close an inadvertent loophole, amended section 2057. The amendment applied retroactively to October 22, 1986. Under the amendment, to qualify for the estate tax deduction, securities sold to an ESOP had to be directly owned by a decedent immediately before death. The bill containing the change was introduced in Congress on February 26, 1987.

Carlton, the executor of an estate, bought 1.5 million shares of MCI Communications Corp. for $11,206,000 with estate funds on December 10, 1986, and sold them (before the due date of the estate tax return) on December 12, 1986, to the MCI ESOP for $10,575,000. Carlton claimed a deduction of about half the proceeds ($5,287,000). The transaction's purpose was to obtain the section 2057 deduction.

The IRS disallowed the deduction on grounds that the stock had not been owned by the decedent immediately before death. In Carlton's claim for refund, he argued that the retroactive change violated the due process clause of the Fifth Amendment. A California federal district court ruled in favor of the IRS.

On appeal, the Ninth Circuit reversed, holding that the due process clause was violated because (1) there was no notice of the amendment and (2) the taxpayer reasonably had relied on the law's original wording to his detriment (he sold the stock for less than he otherwise might have obtained). The Ninth Circuit said applying this change retroactively was "so harsh and oppressive as to transgress the constitutional limitation." (This language was used by the U.S. Supreme Court in decisions on retroactivity in tax provisions.

The case was granted certiorari by the U.S. Supreme Court.

Result: For the United States. To pass muster under the due process clause, a retroactive tax provision must be supported by a legitimate legislative purpose furthered by rational means. The retroactive provision meets this standard. Congress had a legitimate purpose in enacting the change--it wanted to correct a mistake in the old law. The ESOP provision was not intended to be used by any estate that had the wherewithal to purchase stock; it was intended to encourage the sale of stock held by decedents before death to ESOPs. The retroactivity of the change was rational because it would prevent revenue loss. Further, the retroactive period was relatively short: a little more than year.

* Carlton (Sup. Ct., 6/13-94).

Edited by Anne Wagenbrenner, JD, LLM, editor, AICPA client newsletters.
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Title Annotation:Carlton case
Author:Wagenbrenner, Anne
Publication:Journal of Accountancy
Date:Aug 1, 1994
Words:489
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