Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
HATTEM V. SCHWARZENEGGER: TERMINATING PREEMPTION CHALLENGES TO STATE TAXATION OF ERISA PLANS’ UNRELATED BUSINESS TAXABLE INCOME
In Hattem v. Schwarzenegger, the Second Circuit held that the Employee Retirement Income Security Act of 1974 (ERISA) did not preempt the California law taxing the unrelated business taxable income (UBTI) of tax exempt trusts, including those trusts covered by ERISA. The court held that the state law neither referred to nor had a connection with ERISA plans. Accordingly, it did not “relate to” ERISA plans, as described in ERISA’s preemption clause.
Hattem is significant for two reasons. First, it is one of only two cases discussing the applicability of ERISA’s preemption clause to the common state practice of taxing the UBTI of tax exempt qualified plans, which include ERISA retirement trusts. Of the two cases, it was the only one to be decided in federal court and also differed in its outcome, since in the other case, the New York State Tax Appeals Tribunal held that ERISA preempted New York’s UBIT although the invalidated New York law was similar to the California law at issue in Hattem. Second, Hattem is unique for addressing ERISA preemption of state tax laws following a series of Supreme Court cases that redefined the “connection” prong of ERISA preemption. Prior to these decisions, courts on several occasions found that various state taxes relate to ERISA plans and were thus preempted. Hattem’s contrary finding in relation to a state tax, and its general deference to state taxation, suggests that the older decisions must be revisited in light of the Court’s paradigm shift on ERISA preemption. Hattem’s practical impact on ERISA plans and state treasuries is significant in light of the many state UBITs and other tax measures that it protects from preemption, and the considerable limit to the states’ taxing power that could result if its reasoning is rejected.
This Note examines Hattem’s approach to the connection prong of ERISA preemption and identifies flaws in its analysis. Part I provides an overview of ERISA’s preemption clause. Part II briefly describes the Hattem litigation and the court’s opinion. Part III examines the Supreme Court’s changing approach to ERISA preemption and the considerations that the Court has identified as relevant to the preemption analysis. Moreover, it explains why, in light of this precedent and the similarity of the California and federal UBITs, Hattem may have reached the correct outcome, but identifies four flaws in Hattem’s analysis that lead to an overly broad holding, which improperly shields state UBITs and other measures that may impact ERISA plans more significantly. Part IV concludes that Hattem has set the bar to ERISA preemption at an improperly high level, and that courts wishing to give effect to ERISA’s objectives and the Supreme Court’s precedents governing ERISA preemption should reject Hattem’s reasoning.