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Just because they pass laws doesn't mean they know them

January 19, 2017

Today I want to use Mr/ Peabody's Wayback Machine.  We're going to look at something that happened in Massachusetts over a decade ago, and I promise there is a lesson to learned that still applies today.

 

The year was 2002.  Jane Swift was acting governor for the Commonwealth of Massachusetts.  Jane inherited the role after former Governor, the late Paul Cellucci was named Ambassador to Canada.  Jane was rather unremarkable, but not terribly liked as her attitude and somewhat out of the ordinary home life (by 2002 standards) and lengthy commute from her home to Boston didn't endear her to voters.  The fact that her name had an (R) after it was an automatic strike against her anyway, in a state with 95% Democrats in the legislature.

 

A little additional history here.  In the late 1990's, the legislature passed a law adjusting the capital gain tax rate in Massachusetts.  Where previously long term gains had been taxed at a flat rate of 5%, the new law imposed increasingly lower rates on gains, depending on the length of time of the gain.  A one year gain was 5%, a two year gain 4%, three year gain 3% and so on.  The lower rates were implemented over a period of time so that by 2001 there was a 0% rate in effect for gains of six years or more.

 

By 2002, the Commonwealth had a budget crisis, as did many states.  The legislature decided to eliminate the graduated reduced capital gain rates and tax all long term gains at a flat rate of 5.3%  The law was enacted in May of 2002 and became effective for transactions as of that date.  Seems pretty straight forward, right?  Well as we will see, not so much.

 

I like most people just worked with the change in the law and the impact it had on filing returns and planning considerations.  Well along comes Mr. Joel Peterson.  Mr. Peterson sold a very large amount of land after the law changed in 2002.  The capital gain on the sale was in the seven figure neighborhood and under the old law would have been taxed at the zero rate.  So there's a lot of money at stake here.  Mr. Peterson had a pretty bright tax attorney named Stephen Politi (I  met him once and not surprised he litigated this).  They looked at the result and the law and came to the conclusion that the law as written violated the Massachusetts Constitution.  

 

The Massachusetts Constitution with regards to taxation is somewhat unique in that it prohibits a graduated income tax like you would see with the IRS.  Now your first reaction is, hey isn't that what the old capital gain law was?  No.  The way Mass General Law was written was to segregate different types of income into different classes.  Ordinary income was one class, short term gains another, and each of the different length long term gain holding periods also another class.

 

What Mr. Peterson's cases pointed out, and ultimately the Supreme Judicial Court agreed with was the the mid year law change with one rate for capital gains from January to May, and another rate for the same type of gain later in the year with another rate constituted different rates on the same class of income.  However the court didn't take action because it couldn't determine what the remedy was.  By this time, we are late into 2005.  Someone named Mitt Romney is now governor, and he is not happy.  The legislature's options were to change the law to be effective 1/1/2002, or to delay it's effective date to 1/1/2003.  Naturally, the Massachusetts legislature being of a particular mindset and party, took no action.  

 

Mr. Peterson took the case back to the SJC, which ruled the tax increase was to be effective as of 1/1/2002 because was the most likely intent of the legislature had it been enacted properly at the time.  Needless to say, there was nearly another Boston Tea Party.  We now have a retroactive tax increase.  Congratulations!  Thousands of taxpayers were going to get bills once the Department of Revenue data mined the 2002 tax returns it had received and imposed the higher tax on the capital gains reported.  Even that bastion of tax and spend philosophy, the Boston Globe decried this result

 

 

 

Thankfully, the people who vote on such laws came to their senses and passed a law near the end of 2005 retroactively LOWERING the tax and making the new law effective as of 1/1/2003.  Now the problem became how to refund the money.  The Department of Revenue decided that it was up to taxpayers to file an abatement for 2002 claiming a refund based on the lower rates for gains later in the year.  The difficulty in that was that the statute of limitations for claiming this refund was expiring on 4/15/2006,only a few short (and busy) months away!  I can tell you from my own experience that the people I worked with at the time made the decision to inform clients of the change, but if the expected tax refund would be less than $1,000 we would not prepare the abatement request due to our cost to them for doing so.

 

But what about Mr. Peterson, the man who started all this?  Well he had a personal stake in all this beyond the tax.  See he sort of had a grudge against the Commonweath the whole time.  Apparently, he had been in a deal to sell his real estate for some time, but the proposed buyer delayed the purchase for a very lengthy period of time because of a cash shortage.  The buyer of the land?  The Commonwealth of Massachusetts!

 

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