Earlier this year, President Biden proposed a 2022 budget for the federal government along with a "Greenbook" explaining corresponding proposed changes to the tax code. As expected, the President’s proposal would increase the top marginal ordinary income tax rate from 37% to 39.6% and would apply ordinary income tax rates to capital gains realized by taxpayers with income in excess of $1 million annually. This news is not surprising, but it rather buries the lede: what caught most everyone off guard is the proposal that the increased rates be implemented retroactive to a date in early 2021. As described in the Greenbook, this date will likely fall in April of 2021.
A retroactive tax increase is patently unfair and cannot be constitutional, right? Although it may not seem intuitive, the somewhat surprising answer is “yes” - the Supreme Court has repeatedly upheld the constitutionality of retroactive tax increases.
Congress has broad power to lay and collect taxes. Whether Congress can do so retroactively tests the limits of this power. One such limit, the Due Process Clause, prevents Congress from depriving any person of “life, liberty, or property, without due process of law.” On its face, a retroactive tax provision deprives taxpayers of property without advance notice. However, based on Supreme Court precedent, the validity of a retroactive tax increase under the Due Process Clause depends primarily on whether (1) the provision is illegitimate or arbitrary, and (2) the period of retroactivity is excessive. The seminal case on this issue is United States v. Carlton, 512 U.S. 26 (1994).
To not be illegitimate or arbitrary, the retroactive tax increase must contain a legitimate legislative purpose. Retroactive tax provisions in 1969, 1987, and 1993 withstood constitutional challenges in part because they were designed to create more taxpayer equity and to eliminate loopholes:
- In 1969, during Richard Nixon’s administration, Congress passed the Tax Reform Act of 1969, which raised certain income tax rates with at least twenty retroactive effective dates. One of the stated goals of the Tax Reform Act of 1969 was to eliminate loopholes and to force wealthy taxpayers and corporations to pay their fair share.
- In 1987, when Ronald Reagan was President, Congress amended the Tax Reform Act of 1986 to close a perceived loophole in the original legislation. That amendment was made retroactive to the original date of enactment of the Tax Reform Act of 1986, despite Congress passing the amendment more than a year later. The stated goal of the amendment was to prevent taxpayers from abusing an estate tax deduction to reduce tax liability.
- In 1993, Congress and President Bill Clinton passed the Omnibus Budget Reconciliation Act of 1993, which added higher tax brackets and raised the alternative minimum tax. Although it was enacted in the middle of 1993, the higher rates applied to the entire tax year. The stated purpose of the legislation was to reduce the federal deficit by increasing tax revenue while decreasing spending. The increase in revenue would come from the higher tax brackets, thus forcing high-income taxpayers to shoulder additional tax liability.
The purpose of President Biden’s proposed retroactive tax rates is presumably to prevent taxpayers from selling appreciated capital assets during the time period between the announcement of the proposed legislation (i.e., April, 2021) and its subsequent enactment. Based on historical precedent, that purpose likely constitutes a legitimate legislative purpose.
On top of having a legitimate legislative purpose, the period of retroactivity cannot be excessive. President Biden’s proposed period of retroactivity is shorter than that of similar changes enacted by Congress in the past, and the Supreme Court has routinely upheld two-year periods of retroactivity. If Congress enacts the applicable changes in early 2022, the one-year period of retroactivity will not raise due process concerns.
Many perceive President Biden’s proposed retroactive tax increase to be unprecedented and unfair. However, the practice of imposing retroactive tax increases is firmly grounded in the law. If the proposal passes and is challenged based on constitutional principles, that challenge will likely be unsuccessful. We will continue to monitor developments related to changes in the tax law as they evolve. If you have questions as to how those changes may affect you or your business, we welcome the opportunity to assist you.
Contributing author, Joe Striler, Fennemore Summer Associate and 2nd year law student at Arizona State University, Sandra Day O'Connor College of Law.