WASHINGTON -- The Supreme Court yesterday unanimously upheld the authority of Congress to pass tax laws that are applied retroactively, but it suggested that any period of retroactivity must be "modest."

The cour in U.S. v. Carlton said a 1987 law that Congress passed to close an unintended and expensive loophole in the estate tax provisions of the Tax Refort Act of 1986 was rational and served a legitimate purpose.

Retroactive application of the 1987 law does not violate the Fifth Amendment's du process rights of taxpayers who took advantage of the 1986 loophole, Justice Harry Blackmun wrote for the court.

Congress passed the 1987 amendment as a "curative" measure aimed at correcting "what is reasonably viewed as a mistake in the original 1986 provision that would have created a significant and unanticipated revenue loss," the court said.

Congress initially projected a $300 million revenue loss, but it became clear after enactment that the loss could be as much as $7 billion.

The decision has implications for other tax laws that are applied retroactively such as those that might change the treatment of tax-exempt bonds.

The ruling is of particular significance to the Omnibus Budget Reconciliation Act. The act, signed by President Clinton last August, retroactively raised federal income taxes on more than 1 million upper-income taxpayers, effective Jan. 1, 1993, and raised estate tax rates.

The decision portends a defeat for taxpayers challeNging the retroactivity of the 1993 law, said an attorney for the Washington Legal Foundation, a nonprofit public interest law and policy center here.

"It would appear that the Omnibus Budget Reconciliation Act provisions would be upheld as well" on a retroactive basis on the basis of the court's reasoning in the Carlton case, said Paul Kamenar, the foundation's executive legal director.

However, the 1993 law has significant differences because it involves income tax and was not specifically designed to correct a problem that was unintentionally created by a previous statute, Kamnenar said.

The foundation filed a friend-of-the-court brief in the Carlton case arguing against retroactive application on behalf of Sen. Pete Domenici, R-N.M.; Mississippi Gov. Kirk Fordice; and more than 40 other legislators.

Retroactive taxation "is fundamentally antithetial to the 'rule of law,' which in a free society permits individuals to plan and conform their lives in accordance with ascertainable rules," the foundation's brief said.

The 1986 loophold established a tax deduction on half of the proceeds opf any sale of employer securities by an executor of an estate to an employee stock ownership plan, a so-called ESOP.

Jerry W. Carlton, the executor of the will of Willametta Day, who left a large estate after her death in 1985, structured a stock sale to take advantage of the deduction. He bought 1.5 million shares of MCI Communications Corp. stock for an average of $7.47 a share, then resold them two days later to MCI's ESOP for an average of $7.05 per share.

Carlton claimed a deduction from the gross estate for half of the proceeds of the sale, thereby reducing the estate tax by $2.5 million.

To eliminate the loophole, Congress in 1987 said that to qualify for the deduction, the securities sol must have been "directly owned" by the decendent "immediately before death." The Internal Revenue Service subsequently disallowed the deduction claimed by Carlton. The U.S. Court of Appeals for the Ninth Circuit ruled against retroactive application of the amendment, saying Carlton did not have active notice of the tax law change and he relied to his detriment on the 1986 law. These factors rendered retroactively "unduly hardsh and oppressive," the lower court said.

The Supreme Court disagreed, saying that in accord with a due process analysis, "Congress' purose in enacting the amendment was neither illegitimate nor arbitrary ... Congress acted promptly and etablished only a modest period of retroactivity." The actual retroactive effect is "only slightly greater than one year," in keeping with typical congressional practice, it said.

However, Justice Sandra Day O'Connor said in a concurring opinion that the period of retroactivity raises a gray area. Any period "longer than a year preceding the legislative session in which the law was enacted would raise ... serious constitutional questions," she said.

In rejecting the argument that Carlton relied on the 1986 statute, the court said, tax legislation "is not a promise, and a taxpayr has no vested right in the Internal Revenue Code ... In focusing exclusively on the taxpayer's notice and reliance, the court of appeals held the congressional enactment to an unduly strict standard."

Also yesterday, the Supreme Court upheld regulations adopted in 1988 by New York State to prevent abuses of a state cigarette tax exemption for Indians living on reservations.

In Department of Taxation and Finance of New York, v. Milhelm Attea & Bros. Inc., the high court unanimously ruled that the state regulations do not violate federal Indian trader laws.

The state reguations sought to prevent non-Indians from buying tax-exempt cigarettes by setting quotas on the amount of untaxed cigarettes that wholesalers may sell to tribes and imposing record-keeping requirements.

Milhelm Attea & Bros. and other wholesalers licensed by the federal Bureau of Indian Affairs challenged the state requirements, saying they were preempted by federal Indian statutes.

Justice John Paul Stevens, writing for the court, said its decision is condined to alleged defects in the state regulations and does not assess each feature of the tax scheme that might affect tribal self-government or federal authority over Indian affairs. The court also sai that Indian traders are not wholly immune from state regulation that is reasonably necessary to carry out state tax laws.

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