Subject:Bailey v. State of North Carolina; Emory v. State of North
Carolina; Patton v. State of North Carolina
Tax: Individual Income;
Tax Law: G.S. 105-134.5 and G.S. 105-134.6
Issued By: Personal Taxes Division
Date: May 19, 2000
This Directive supplements Directive PD-99-1, issued on March 4, 1999, and
Directive PD-99-2, issued on November 5, 1999. Directive PD-99-1 explains the
income tax consequences of the North Carolina Supreme Court's decision in Bailey
v. State of North Carolina and the subsequent settlement of that case and the
two related cases of Emory v. State of North Carolina and Patton v. State of
North Carolina. The Bailey settlement affects the taxation of retirement benefits
paid to former employees of the State of North Carolina, its local governments,
and the federal government, including persons receiving these benefits as survivor
beneficiaries. Directive PD-99-2 addresses questions concerning the Bailey settlement
that were answered by a court order issued after March 4, 1999, but before November
5, 1999, or by administrative decisions made during that time period. Topics
addressed in Directive PD-99-2 include distributions other than retirement pay,
the settlement period, additional qualifying State or local retirement systems,
and the vesting period for the Federal Thrift Savings Plan.
This Directive addresses questions concerning the Bailey settlement that have
been answered by a court order issued after November 5, 1999, or by an administrative
decision made after that date. If you have any questions about this Directive,
you may call the Personal Taxes Division of the North Carolina Department of
Revenue at (919) 733-3565. You may also write to the Division at P.O. Box 871,
Raleigh, North Carolina 27602-0871.
Qualifying State or Local Retirement Systems
Directive PD-99-1 lists the qualifying State and local retirement systems designated
by the Court in its Order Regarding Class Definition signed by Judge Thompson
on November 20, 1998. Directive PD-99-2 addresses the Order Supplementing Order
Regarding Class Definition, signed by Judge Thompson on March 26, 1999, in which
the Court clarified that the Optional Retirement Program (ORP) created by G.S.
135-5.1 is a qualified retirement system. That Directive identified the three
carriers authorized to administer the ORP and advised that the carriers also
administer retirement plans that are not qualifying State or local retirement
systems. The plans that do not qualify include optional contribution plans established
pursuant to § 403(b) of the Internal Revenue Code, retirement plans of private
educational institutions in North Carolina, and retirement plans of public or
private educational institutions in other states. Although the March 26, 1999
Order identifies the ORP as a qualified retirement system, it does not address
when a participant in the ORP is vested nor how to determine the portion of
the retirement benefits that are subject to recovery or future State tax exemption
under the settlement.
In an Order regarding the Optional Retirement Program for State Institutions
of Higher Education, signed by Judge Thompson on November 19, 1999, the Court
addresses these issues. The Court ruled that a participant is vested in the
ORP if the participant enrolled in the ORP prior to August 12, 1989. The determination
of whether retirement benefits received from the ORP are recoverable under the
settlement and exempt from future State income tax is not as simple as the determination
of vesting. The answer depends on the participant's investment history.
A principle advantage of the ORP is that a participant who moves from one institution
of higher learning in the United States to another can transfer the accumulated
ORP account balance at the first institution to the other institution. An ORP
participant who moves from one institution to another also has the option of
not transferring the ORP account balance. Instead, the employee may establish
a separate account with the new institution or simply add the contributions
and earnings with the new institution into the existing ORP account. The transfer
option selected by the participant may impact the participant's right to recover
the taxes previously paid or the future State tax exemption of benefits received.
If the ORP participant leaves the University of North Carolina system and becomes
employed at another educational institution contracting with the same carrier,
the retirement benefits are exempt from State income tax only if, and to the
extent that, the ORP contributions and earnings have retained their character
as ORP contributions and earnings. To the extent that distributions received
from one of the three carriers are ORP benefits, taxes paid on the distributions
in tax years 1989 through 1997 by ORP participants, beneficiaries, including
survivor annuitants and estates, and former spouses receiving the benefits under
an equitable distribution order or qualified domestic relations order, are recoverable
through the settlement and those benefits will be exempt from future State income
The following rules determine when the distributions received by an ORP participant
are recoverable under the settlement and excludable from future North Carolina
- Not exempt - If an ORP participant leaves service with the University
of North Carolina System, takes a position with an institution of higher learning
outside of the UNC System, and transfers the ORP account into the benefit
plan of the new employer, the ORP contributions and benefits lose their character
as ORP benefits and are not exempt from North Carolina income tax.
- Exempt - If the ORP benefits are not transferred to the new institution's
retirement plan, the participant maintains separate accounts for each institution,
and receives a separate check from the ORP account at the time of retirement,
the ORP benefits have retained their character and will be fully exempt from
State income tax.
- Prorated Exemption - If either of the following circumstances applies,
the participant may exclude from State income tax a portion of the retirement
(1) The ORP benefits are not transferred to the new employer's retirement
plan, the participant maintains separate accounts, but the participant combines
the multiple retirement accounts at the time of retirement for payment purposes.
Note: Participants retiring on or after January 1, 2000, must receive a
separate check for their ORP benefits to qualify for an income tax exclusion.
(2) The ORP benefits are not transferred and the contributions and earnings
with the new employer are added in with the existing ORP account.
If sufficient documentation is available to determine the portion of the
multiple accounts balance at the time of retirement that is from the ORP
account or the portion of the single account balance that is from the ORP
employment period, the participant may exclude that percentage of the retirement
benefits received each year. If sufficient documentation is not available,
the participant may exclude a portion of the retirement benefits based on
the percentage of total service time in which the participant was employed
by the University of North Carolina system.
- IRAs - If an ORP participant leaving service with the University
of North Carolina system rolls over his or her ORP account into an IRA, the
ORP contributions and earnings lose their character as ORP funds. Benefits
ultimately paid from the rollover IRA are therefore not exempt from State
income tax under the terms of the Bailey settlement.
A taxpayer claiming a deduction on the North Carolina return to exclude retirement
benefits received as a result of participation in the ORP should attach information
to support the exclusion. Supporting information can include a statement from
the plan administrator identifying which of the participant's separate accounts
were from the ORP participation or a statement from the administrator as to
the total service time during which the administrator received contributions
and a statement from the University of North Carolina system as to the service
time within the University system.
Qualifying Federal Retirement Systems
Directive PD-99-1 lists the qualifying federal retirement systems designated
by the Court in its Order Regarding Class Definition - II signed by Judge Thompson
on January 14, 1999. In an Order Supplementing Order Regarding Class Definition
- II signed by Judge Thompson on December 22, 1999, the Court identifies three
additional federal retirement plans that are qualifying federal retirement systems
under the settlement. Those plans are:
(1) the Uniformed Services University of the Health Sciences Plan;
(2) the Smithsonian Institution Defined Contribution Retirement Plan; and
(3) the USDA Graduate School Plan.
Each of the three plans listed are administered by TIAA-CREF, which is also
one of the administrators for the ORP discussed in the previous section of this
Directive. The Uniformed Services University of the Health Sciences Plan is
also administered by Fidelity Investments. The Court held that participants
in these three federal plans are vested and qualify for recovery of taxes previously
paid on and the future income tax exclusion of retirement benefits from the
plans to the same extent as participants in the ORP.
Income Tax Treatment of Refunds
The income tax refunds received by retirees from class counsel are included
in gross income for federal income tax purposes in the year received to the
extent the tax being refunded was deducted in a previous year and the deduction
provided a tax benefit. The following example demonstrates how to determine
the portion of a refund that is reportable on the federal income tax return.
As the example illustrates, a taxpayer who claimed the standard deduction in
determining federal taxable income for a taxable year is not required to include
in gross income a refund of the tax paid on retirement benefits for that taxable
year. A taxpayer who claimed itemized deductions is required to include in gross
income a refund of the tax paid on retirement benefits for that taxable year
to the extent the taxpayer claimed a deduction for North Carolina income tax
paid and received a tax benefit from that deduction.
Taxpayer A received a refund of $3,600 from class counsel in 1999. The Form
1099-G issued by class counsel indicates that the total refund consisted of
refunds of $1,100 for 1995, $1,200 for 1996, and $1,300 for 1997. Taxpayer A
had claimed the standard deduction on his 1995 federal return. Taxpayer A claimed
itemized deductions of $5,300 for 1996, including state income tax paid of $1,200,
and $5,150 for 1997, including state income tax paid of $1,300. Taxpayer A claimed
a filing status of single for all three years.
Taxpayer A must include $2,200 in gross income for 1999, consisting of
$1,200 from 1996 and $1,000 from 1997. The refund of $1,100 for the tax year
1995 is not reportable because Taxpayer A claimed the standard deduction on
the 1995 federal return; therefore, Taxpayer A received no tax benefit from
the state income tax paid that year.
The total amount of refund for the tax year 1996 is reportable. The standard
deduction for a single taxpayer for 1996 was $4,000. Because the itemized deductions
claimed of $5,300 exceeded the standard deduction by more than $1,200 (the amount
of state income tax paid), Taxpayer A received a tax benefit for the entire
amount of state income tax deducted.
Only $1,000 of the refund for the tax year 1997 is reportable. The standard
deduction for 1997 was $4,150. Because the itemized deductions claimed of $5,150
exceeded the standard deduction by only $1,000 (which is less than the amount
deducted for state income tax paid), Taxpayer A received a tax benefit of only
$1,000 of the state income tax deducted.
Treatment of Refunds for Inheritance and Estate Tax Purposes
We have received several inquiries about whether refunds received under the
Bailey settlement by the estate or beneficiaries of a deceased retiree are subject
to North Carolina inheritance or estate tax and, if so, when should a previously
filed inheritance or estate tax return be amended. The answers to these questions
depend on the decedent's date of death.
North Carolina's inheritance and estate tax (for a decedent whose date of death
was prior to January 1, 1999) and North Carolina's estate tax (for a decedent
whose date of death was on or after January 1, 1999) are determined based on
the value of the decedent's assets at the date of death. The Order Approving
Class Action Settlement was issued by the Court on October 9, 1998, meaning
that a retiree whose date of death was prior to October 9, 1998, was not entitled
to a refund at the date of death and the refunds paid to the estate or beneficiaries
are not includable in the inheritance or estate tax returns. Refunds are subject
to inheritance or estate tax, however, if the retiree's date of death is on
or after October 9, 1998.
The total refund will be issued in installments; therefore, an amended North
Carolina inheritance or estate tax return should not be filed until the final
refund installment is received. Because North Carolina's estate tax is equal
to the credit for state death taxes on the federal estate tax return, the federal
estate tax return must be amended before the North Carolina estate tax return
can be amended. Interest will not be assessed on the additional North Carolina
inheritance or estate tax if the additional tax is paid within 90 days after
the date class counsel issues the final refund installment.
Last modified on:
10/31/07 03:37:03 PM.