Subject: Bailey v. State of North Carolina; Emory v. State of North
Carolina; Patton v. State of North Carolina
Tax: Individual Income Tax
Statute: G.S. 105-134.5 and G.S. 105-134.6
Issued By: Personal Taxes Division
Date: March 4, 1999
This Directive 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. That court action 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. 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.
Beginning in 1939, the North Carolina General Assembly provided retirement benefits to State and local government employees through various public employee retirement systems. Until August 12, 1989, State law exempted from State and local taxation the retirement benefits received from those systems. At the same time, State law excluded from taxation only a portion of the retirement benefits received by federal retirees.
In 1989, the United States Supreme Court, in Davis v. Michigan, ruled that a state law that taxes federal retirees differently than state retirees is unconstitutional because it violates the principle of intergovernmental immunity. To remedy the State's unconstitutional law, the State had to exclude all retirement benefits paid to both State and federal government retirees from income tax or impose a tax on those retirement benefits equally. The 1989 General Assembly elected to tax all but the first $4,000 of State, local, and federal government retirement benefits. The General Assembly also for the first time provided a partial exclusion of $2,000 for private retirement benefits. Legislation effecting these changes was enacted on August 12, 1989.
In 1990, State and local retirees filed suit against the State in Bailey claiming that the taxing of their retirement benefits beginning in 1989 was an unconstitutional impairment of contract. The Wake County Superior Court agreed and ruled that State and local government retirees who had five or more years of service as of August 12, 1989, could recover the income taxes paid on the retirement benefits since 1989 if they had timely protested the payment of the tax pursuant to G.S. 105-267.
The State appealed the Superior Court's decision in Bailey. On May 8, 1998, the North Carolina Supreme Court affirmed the trial court's decision that the taxation of retirement benefits paid by the State of North Carolina or its political subdivisions to former State and local government employees who had five or more years of service as of August 12, 1989, was unconstitutional. The Supreme Court reversed the trial court's ruling on the requirement to timely protest and held that any qualified State or local government retiree could recover income taxes paid on retirement benefits since 1989. The Supreme Court then sent the case to the trial court for further orders with respect to the determination of who was qualified.
Before the trial court issued a decision, the State and the plaintiffs in Bailey settled the lawsuit. The trial court issued an Order Approving Class Action Settlement on October 7, 1998. The settlement resolves the Bailey lawsuit and two related lawsuits: Emory v. State of North Carolina and Patton v. State of North Carolina. Emory was another lawsuit brought by State retirees offering a different theory as to the basis for recovery of taxes paid. Patton was a lawsuit brought by federal retirees in which they alleged that an unconstitutional discrepancy between the taxation of State and federal retirement benefits still existed because the General Assembly negated the effect of the loss of the full tax exemption afforded to State retirees prior to 1989 by providing an increased amount of retirement benefits at the same time the exclusion was reduced. The settlement resolves those claims without addressing the issues in those lawsuits.
The settlement requires the State to appropriate $799,000,000 for refunds to State, local, and federal retirees and provides that individuals who paid income tax for tax years 1989 through 1997 on State, local, and federal government retirement benefits and who were "vested" for receipt of those benefits are entitled to refunds. The settlement also provides that the plaintiffs will not pay North Carolina income tax in future years on their retirement benefits. Any State, local, or federal government retiree who was not "vested" is not eligible for a refund of taxes previously paid on retirement benefits and will continue to pay tax on retirement benefits received in future years, subject to the $4,000 deduction allowed to all government retirees. For most government retirement systems, a person is "vested" for receipt of benefits if the person had five or more years of creditable service in a qualifying State, local or federal retirement system as of August 12, 1989. For certain retirement systems, the "vesting" period is less.
Qualifying State or Local Retirement Systems
Since the October 7, 1998 order approving the settlement, the Court has issued several orders resolving questions about refund eligibility. In an Order Regarding Class Definition signed by Judge Thompson on November 20, 1998, the following retirement systems were designated as a "North Carolina state or local governmental retirement system:"
|System||Law Creating the System|
|North Carolina Teachers' and State Employees' Retirement System||G.S. 135, Article 1|
|North Carolina Local Governmental Employees' Retirement System||G.S. 128, Article 3|
|North Carolina Consolidated Judicial Retirement System||G.S. 135, Article 4|
|North Carolina Legislative Retirement System||G.S. 120, Article 1A|
|North Carolina Disability Income Plan (both short-term and long-term disability benefits)||G.S. 135, Article 6|
|North Carolina Supplemental Retirement Income Plan||G.S. 135, Article 5|
|North Carolina Supplemental Retirement Income Plan for State Law Enforcement Officers||G.S. 143-166.30(d)|
|North Carolina Deferred Compensation Plan||G.S. 143B, Article 9|
|North Carolina National Guard Pension Fund||G.S. 127A-40|
|North Carolina Sheriffs' Supplemental Pension Fund||G.S. 143, Article 12H|
|North Carolina Registers of Deeds' Supplemental Pension Fund||G.S. 161, Article 3|
|North Carolina Supplemental Retirement Plan for Local Governmental Law Enforcement Officers||G.S. 143-166.50(e)|
|North Carolina Firemen's and Rescue Squad Workers' Pension Fund||G.S. 58, Article 86|
|Charlotte Firefighters' Retirement System||Session Laws 1947, Chapter 926, § 6(c)|
|Firemen's Supplemental Fund of Hickory||Session Laws 1971, Chapter 65|
|Winston-Salem Police Officers' Retirement System||Session Laws 1939, Chapter 296|
In addition to the local plans listed in the table above, there may be other plans created by local governments pursuant to State authorization that enjoyed a tax exemption prior to 1989 pursuant to G.S. 105-141(b)(13) but have not been identified by the Court at this time. Retirement benefits from these plans are also exempt from income tax if the retiree is "vested."
The Court has not identified optional retirement programs for employees of State institutions of higher learning (Internal Revenue Code § 403(b), including TIAA-CREF) as a qualifying State or local retirement system. If the Court identifies these plans as a qualifying State or local retirement system, the Department will issue a supplementary Directive explaining the Court's decision.
"Vesting" Period for Qualifying State or Local Retirement Systems
The general rule is that a participant in a qualifying State or local retirement system listed in the above table is "vested" if the participant had five or more years of creditable service as of August 12, 1989. The general rule does not apply to qualifying optional contribution plans, however, or to certain other qualifying plans.
In the November Order, the Court held that participants in the State's Supplemental Retirement Income Plan (Internal Revenue Code § 401(k)) or the State's Deferred Compensation Plan (Code § 457) are vested in the plan as of August 12, 1989, if they contributed to the plan by August 12, 1989. If the participant contributed any money to a plan before August 12, 1989, tax paid on all withdrawals from that plan is subject to recovery through the settlement. All future withdrawals from that plan are excludable from future tax. Contributions to one plan prior to August 12, 1989, do not qualify contributions to the other plan as vested. If a State employee began contributing to the §401(k) plan in June, 1989, and to the §457 plan in October, 1989, the employee is vested only in the §401(k) plan. Participants in the State's Supplemental Retirement Income Plan or the State's Deferred Compensation Plan may have chosen an annuity as an investment option. In some cases, they receive the annuity payments and the subsequent tax information statement from the annuity company instead of the plan administrator. These amounts also qualify for the recovery and future tax exemption if the retiree was vested.
No local government optional contribution plans, similar to the State's Supplemental Retirement Income Plan and Deferred Compensation Plan, were afforded tax exemption prior to August 12, 1989. Therefore, retirement benefits from local optional contribution plans are not subject to the recovery or future tax exemption.
Participants in the North Carolina Firemen's and Rescue Workers' Pension Plan are vested as of August 12, 1989, only if the individual had both five years of service and had paid five years of contributions to the plan by August 12, 1989. Sheriffs receiving benefits from the North Carolina Sheriffs' Supplemental Pension Fund and Registers of Deeds receiving benefits from the North Carolina Registers of Deeds' Supplemental Pension Fund are vested as of August 12, 1989, only if the sheriff or the register of deeds (not a deputy or assistant) had five years of service as a sheriff or a register of deeds and five years of participation in the Local Government Employees' Retirement System (or equivalent local plan) by August 12, 1989.
An employee in a qualifying State or local government retirement system who was vested prior to August 12, 1989, and who leaves employment remains vested if the employee later returns to work, provided the employee did not withdraw his or her contributions to the retirement system. If the employee withdrew his or her contributions, the employee is no longer vested in the retirement system, even if the employee subsequently buys back the service time, unless the employee returned to employment in time to become vested again before August 12, 1989.
Qualifying Federal Retirement Systems
In an Order Regarding Class Definition-II signed by Judge Thompson on January 14, 1999, the following retirement systems were designated as a "federal governmental retirement system:"
- Federal Civil Service Retirement System
- Federal Employees' Retirement System
- Lighthouse Retirement System
- Thrift Savings Plan
- Foreign Service Retirement and Disability System and Pension Plan
- Military Retirement System
- Coast Guard Retirement System
- Central Intelligence Agency Retirement System
- Commissioned Corps of the Public Health Service Retirement System
- Comptrollers' General Retirement Plan
- Judicial Plans and Pay for Federal Judges Treated as Retirement Pay by Federal
- Judicial Retirement System
- Judicial Survivors' Annuities System
- Court of Federal Claims Judges' Retirement System
- Court of Veterans Appeals Judges' Retirement Plan
- Judicial Officers' Retirement System (for Bankruptcy Judges and Magistrates)
- United States Tax Court Retirement Plan
- United States Tax Court Survivors' Annuity Plan
- Retirement Plans for District Court Judges for the Northern Mariana Islands, the Virgin Islands, and Guam
- Court of Appeals for the Armed Forces Judges Retirement System
- National Oceanic and Atmospheric Administration Retirement System
- Tennessee Valley Authority Retirement System and TVA Savings and Deferral Retirement Plan
- Financial Institutions Retirement Fund (Office of Thrift Supervision Employees)
- Federal Home Loan Bank Board Retirement Systems
- Federal Home Loan Mortgage Corporation Plan
- Federal Reserve Employees Retirement Plans and Thrift Plan
- Nonappropriated fund plans, including:
- Retirement Annuity Plan for Employees of Army and Air Force Exchange Service
- Supplemental Deferred Compensation Plan for Members of the Executive Management Program (Army and Air Force Exchange Service)
- Nonappropriated Fund Retirement Plan for Civilian Employees
- United States Army Nonappropriated Fund Retirement Plan
- Retirement Plan for Civilian Employees of United States Marine Corps Morale, Welfare, and Recreation Activities and Miscellaneous Nonappropriated Fund Instrumentalities
- Navy Exchange Service Command Retirement Plan
- Navy Nonappropriated Fund Retirement Plan for Employees of Civilian Morale, Welfare, and Recreation Activities
- Norfolk Naval Shipyard Pension Plan
- Retirement Savings Plan and Trust for Employees of the Army and Air Force Exchange Service
- Coast Guard Nonappropriated Fund Retirement Plan
- District of Columbia Police Officers and Fire Fighters' Retirement Fund and Related Funds (including payments to Secret Service and U.S. Park Police covered by the Fund)
- District of Columbia Teachers' Retirement Fund and Related Funds
- District of Columbia Judges' Retirement Fund and Related Funds
"Vesting" Period for Qualifying Federal Retirement Systems
Generally, participants in the qualifying federal retirement systems listed above, including military retirees, are vested for purposes of the settlement if they had five or more years of creditable service as of August 12, 1989. The general rule, however, does not apply to the Thrift Savings Plan.
The Thrift Savings Plan has both an employee and an employer component. The employee component is similar to the State's § 401(k) and § 457 plans and allows the employee to voluntarily contribute to the Plan. The employee is vested in the employee component if the employee first made a contribution to the plan prior to August 12, 1989. The employer component includes both contributions by the employer of a fixed percentage of the employee's salary and contributions by the employer that match the employee's voluntary contributions.
The Court has not yet resolved issues about when the employer component is vested and how the settlement and future income tax exclusion apply to the retirement benefits received from the Federal Thrift Plan if the retiree is not vested in both the employee and employer components of the Plan.
Benefits from Other Retirement Plans
Retirees receiving benefits from government retirement plans of other states or territories were not class members in Bailey and are not entitled to recovery of taxes paid in earlier years or to tax exemption in future years, except for the $4,000 deduction provided by G.S. 105-134.6(b)(6). Private retirement benefits remain taxable except for the $2,000 deduction.
Settlement Extinguishes the State's Liability
The $799,000,000 paid under the settlement completely extinguishes the State's liability to all State, local, and federal retirees arising from the taxation of State, local, and federal retirement benefits from 1989 through 1997. A taxpayer may not amend a return for a tax year within the settlement period to recalculate any items arising from the taxation of retirement benefits. Adjustments that may not be made for a tax year within the settlement period include:
- Excluding qualifying retirement benefits from federal taxable income. Any recovery of tax paid in the settlement period years on qualifying retirement benefits will be received from the court.
- Claiming a $2,000 deduction for private retirement benefits included in federal taxable income when the $4,000 deduction has already been claimed on qualifying retirement benefits.
- Carrying forward a tax credit because the tax credit was not needed in the earlier year as a result of excluding the qualifying retirement benefits from federal taxable income.
- Recalculating penalties and interest on reduced North Carolina income tax due as a result of excluding the qualifying retirement benefits from federal taxable income.
Subject to the statute of limitations, taxpayers can amend returns for those years to make adjustments that do not arise from the settlement. The Department of Revenue can also adjust returns that are open under the statute of limitations to make other changes. Qualifying retirement benefits will not be deducted from federal taxable income when determining the amount of any additional tax due.
Exclusion of Qualified Retirement Benefits for Future Years
Retirement benefits paid to a retiree who is vested for purposes of the settlement are exempt from future State income tax, including benefits paid to survivor beneficiaries. A deduction for the entire amount of qualifying retirement benefits may be claimed on the appropriate line for "Other deductions" on page 2 of the North Carolina income tax return. The taxpayer may not also claim the $4,000 retirement benefits deduction for the same retirement benefits but is entitled to the $4,000 deduction for government retirement benefits that remain taxable, such as those from another state or those from a qualifying plan in which the participant was not vested as of August 12, 1989.
If a retiree has not filed a tax return for a year within the settlement period, the retiree should deduct the entire amount of qualifying retirement benefits on the line for "Other deductions" on page 2 of the Form D-400 when filing the delinquent return.
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