Democrats Are Turning New York Into An Exit State: The Retroactive Tax That Should Terrify Founders

Imagine a founder who spent two years building a company, structured her equity carefully under federal law to qualify for a statutory capital gains exclusion, closed her deal in the spring of 2025, and received the proceeds. The transaction is done. The lawyers are paid. The escrow is released. Now, imagine the state of New York, in early 2026, passing a law that says: we have decided to tax those proceeds after all, retroactive to January 1, 2025. You had no warning. You cannot undo the deal. You simply owe.

Here is the question every entrepreneur in New York should be asking: is this legal? The honest answer, grounded in a century of constitutional jurisprudence, is almost certainly yes. And that is precisely the point.

New York’s Senate budget bill S9009B, in its Part PP, proposes to eliminate the state-level exclusion for gains qualifying federally under Internal Revenue Code Section 1202, the Qualified Small Business Stock exclusion, or QSBS. Section 1202 is a federal incentive under which a founder or investor who holds stock in a qualifying small business for at least five years may exclude up to 100% of the capital gain from federal taxable income. It was designed explicitly to pull risk capital toward early-stage companies. A companion bill, S8921A, contains identical provisions. Both instruct that the change shall apply to taxable years beginning on or after January 1, 2025. If enacted in late March or April 2026, the reach-back extends at minimum 15 months. That is retroactive taxation in its plainest form.

When most people hear “retroactive tax,” their first instinct is to reach for the Constitution. The Ex Post Facto Clause, they assume, must prohibit this. The instinct is understandable and wrong, and it has been wrong for more than two centuries. The Supreme Court established in Calder v. Bull, decided in 1798, that the Ex Post Facto Clause applies exclusively to criminal and penal laws. The majority in Calder explicitly declined to extend the clause to civil legislation, and that holding has never been overruled. Ex post facto protection does not shield a taxpayer from retroactive civil liability. The relevant constitutional provision is the Due Process Clause, and here the law has evolved in a direction deeply unfavorable to challengers.

The governing framework comes from United States v. Carlton, decided by the Supreme Court in 1994. The facts illuminate just how far the Court’s permissiveness extends. In 1986, Congress enacted a provision granting estate executors a deduction for proceeds of sales of employer securities to employee stock ownership plans. Carlton, serving as executor, read the statute, purchased $11.2M worth of stock, sold it to the relevant ESOP two days later at a $600,000 loss, and claimed the deduction. He acted in exact accordance with the law as written. Congress then amended the provision in 1987 and applied the amendment retroactively. The IRS disallowed Carlton’s deduction, and he eventually reached the Supreme Court arguing that retroactive application violated the Due Process Clause of the Fifth Amendment.

The Court upheld the retroactive application, ruling that a tax statute need only be supported by a legitimate legislative purpose furthered by rational means. Justice Scalia, concurring, described what Congress had done as “bait-and-switch” taxation, in which the government extended a benefit, invited reliance, and then withdrew it without compensation. Even Scalia concurred in the outcome. The Court announced that lack of notice does not render a retroactive tax unconstitutional, and that detrimental reliance on prior law is insufficient to establish a due process violation. Then came the phrase every founder should read carefully: tax legislation is not a promise, and a taxpayer has no vested right in the Internal Revenue Code.

This is not a modern invention of Democratic legislatures. Congress has been adopting retroactive tax increases essentially since the 1930s, and the 1913 Revenue Act carried an effective date before its actual enactment. The Clinton administration supplied the most vivid modern example. Signed on August 10, 1993, the Omnibus Budget Reconciliation Act increased the top federal income tax rate from 31% to 39.6%, applied retroactively to January 1, 1993, meaning income earned in January through July, before any vote occurred, was taxed at the new higher rate. Courts upheld it. The same legislation increased the highest federal estate and gift tax rates retroactively to January 1, 1993 as well, and courts upheld that too. The IRS separately applied final rules issued in 1993 retroactively to tax years beginning in 1984, requiring companies to re-file returns going back a decade. The pattern spans parties. Retroactive taxation is a bipartisan tradition of betrayal, though Democrats have most enthusiastically deployed it as a revenue extraction tool at the precise moment taxpayers are least able to respond.

Federal constitutional law sets a floor but does not displace state review. New York courts apply a balancing-of-the-equities framework, weighing fairness concerns against public purpose, with particular attention to notice and the taxpayer’s ability to adjust behavior. In James Square Associates v. Mullen, the Court of Appeals invalidated a retroactive tax change because the taxpayer received no forewarning and could not reorganize its affairs. In Matter of Caprio v. New York State Department of Taxation and Finance, the court upheld a change covering approximately three and a half years, finding adequate constructive notice and insufficient reliance injury to override the presumption of validity. What distinguishes the winning cases from the losing ones is the factual record on reliance and notice, not the legal standard itself.

A challenge to S9009B Part PP would face long odds under Carlton. The state will argue that revenue generation is legitimate, that denying QSBS conformity rationally serves it, and that a 15-month reach-back falls within the range courts have accepted. Those arguments may well prevail. However, this particular provision creates more litigation exposure than a routine rate change. The QSBS exclusion is not a passive deduction. It requires affirmative structural decisions made years before the taxable event: C-corporation status, sub-$50M asset limits, five-year holding requirements, original issuance. A founder cannot reconstitute her company or renegotiate closed deal terms after Albany changes the rules. The Carlton Court also noted that the ESOP amendment was acceptable partly because Congress acted promptly, proposing the correction within months of the original provision. New York’s reach-back is not a prompt correction of an unintended loophole. It is a deliberate revenue increase applied retroactively to transactions already complete. That distinction weakens Albany’s Carlton defense. Combined with the absence of any 2025 legislative signal that founders could have acted upon, the James Square reliance argument is stronger here than in most retroactive tax cases.

Whether a challenge ultimately succeeds, New York is engaged in a slower and more consequential form of self-destruction that operates through signals rather than court verdicts. Entrepreneurs do not wait for due process rulings before adjusting their geography. IRS-based migration data for 2021 and 2022 shows net adjusted gross income inflows of approximately $36.05B to Florida and $10.21B to Texas, with additional multi-billion inflows to other Southeastern states. High-tax coastal states lost corresponding billions. Those movements preceded this proposal and reflect the accumulated weight of prior policy signals. Retroactive taxation sends a signal more corrosive than high rates alone. It tells wealth creators that the tax environment is not just expensive but unreliable, not just burdensome but untrustworthy. The QSBS exclusion matters here precisely because it is used by the founders of high-growth technology and biomedical companies, exactly the population Albany should be competing to attract. When the state taxes gains the federal government explicitly exempted to encourage startup formation, and does so after the deals are already closed, it broadcasts a message that the most mobile earners in the economy know how to decode.

The Carlton framework reflects a deliberate judicial choice to give legislatures near-unlimited deference on economic retroactivity in a way the courts would never accept in criminal law. The Court’s reasoning treats retroactive tax changes as indistinguishable from any other economic policy adjustment, which means that as long as a legislature can identify a revenue rationale, the constitutional challenge will almost certainly fail. The protection against retroactive taxation does not come from courts. It comes from elections, from capital flight, and from whatever remains of the norm that a government should not impose liability on conduct already completed before the law was written.

New York’s Democrat-controlled legislature is testing that norm. The test is legal. It may survive every challenge filed against it. It will not survive the judgment of founders and investors deciding, at the margin, whether to build something in a state that reserves the right to revise the deal after you have already signed. A legislature can change tomorrow’s incentives. That is its proper function. When it changes yesterday’s settled expectations instead, it tells entrepreneurs that the contract they made with the tax code is voidable at Albany’s pleasure. That is how you convert a tax state into an exit state, and that conversion, unlike the transactions Albany is now targeting, is entirely irreversible.

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