Good tax policy should follow several key principles; for example, any well-structured tax code should be easy to understand and navigate, avoid unduly favoring certain taxpayers over others, and be minimally burdensome to raise the necessary revenue. But perhaps the most obvious and intuitive principle of good tax policy is that it should only ever change prospectively, never retroactively. Unfortunately, recent events serve as a reminder that there are few, if any, protections against changing tax rules retroactively at either the federal or state level.
At the federal level, there have been several recent efforts to impose retroactive tax obligations in the reconciliation bill. As Democrats cast about for revenue-raisers to pay for their enormous spending agenda, Sen. Ron Wyden (D-OR) floated an idea that he has been pushing for for some time — mark-to-market taxation.
Under a mark-to-market system, unrealized capital gains would be taxed on an annual basis just as if they had been realized. There are numerous issues with any mark-to-market scheme, but this version had a unique twist in the form of retroactive enforcement.
Rather than “only” having to pay taxes on future unrealized capital gains, Wyden’s proposal would require affected taxpayers to pay taxes on allaccumulated unrealized gains up to that point as well. For entrepreneurs who have become billionaires through the accumulated increase in value in their shares in their start-ups, this would result in enormous tax bills —roughly $30 billion, in Facebook founder Mark Zuckerberg’s case.
There are all kinds of economic concerns with such a proposal, from the impact of billionaires flooding the market with shares to pay their tax bill to the chilling effect on future entrepreneurship, but it would also clearly be a retroactive tax. Affected taxpayers would have accumulated their wealth at a time when unrealized gains were not taxable until they were realized via a sale, only for Wyden to rewrite the tax code retroactively to make those gains taxable.
This proposal eventually failed to make the final bill, but another form of retroactive tax enforcement at the federal level still might. Though it has received far less publicity, the House-passed reconciliation bill repeals the requirement that Internal Revenue Service agents receive supervisor approval before assessing penalties and makes it retroactive all the way back to 2001.
In 1998, Congress passed into law a rule that the IRS cannot assess penalties against a taxpayer without supervisor approval. The agency largely ignored this requirement until a few years ago, when cases brought against the IRS resulted in numerous penalties being invalidated on the basis of this requirement not being followed.
Eliminating this requirement retroactive to two decades ago would reward the IRS for cavalierly ignoring taxpayer protections, rendering the previously-illegal penalties once again valid.
And it’s not just the federal government that’s guilty of retroactive tax provisions. The Supreme Court’s decision in South Dakota v. Wayfair, which empowered states to impose sales tax obligations on out-of-state businesses selling remotely, opened the door to numerous questions about retroactivity at the state level.
One example was Massachusetts’s “cookie nexus,” which absurdly claimed that the digital “cookies” stored on a Massachusetts computer constituted physical presence for the website’s owner.
These workarounds were often ignored by businesses as being fairly obviously unconstitutional to that point, but Wayfair overruled Quillbefore their legality could be tested. Some states, including Massachusetts, attempted to assert that this was proof of the constitutionality of their laws, and demanded that businesses which had ignored the law to that point pay back taxes — including months prior to the Supreme Court case that ostensibly validated their law.
Fortunately, the Massachusetts Appellate Board ruled recently that that was not the case, and that the “cookie nexus” rule could not be applied retroactively.
Taxpayers deserve certainty that they won’t have the rug pulled out from them months or years down the road, and that the tax code on the books today is what will govern their tax obligations for today’s activities. Passing common-sense protections against retroactive enforcement at both the state and federal levels is the only way to guarantee this.
