Directive PD-98-2

Subject: Taxation of Retroactive Benefits Paid as a Result of Faulkenbury
Tax: Individual Income Tax
Statute: G.S. 105-134.5, G.S. 105-134.6, § 72 and § 408 of the Internal
Revenue Code, and Bailey v. State of North Carolina
Issued By: Personal Taxes Division
Date: July 16, 1998
Number: PD-98-2

This directive addresses the State and federal income tax consequences of the retroactive award of additional disability retirement benefits paid to class members in the North Carolina Supreme Court case of Faulkenbury v. Teachers' and State Employees' Retirement System.

The Faulkenbury Case and Decision

The 1982 General Assembly enacted legislation amending the manner of calculating disability retirement benefits paid to State and local government employees retiring on disability on or after July 1, 1982. As a result, many employees retiring on disability after that date received smaller monthly benefits than they would have received under the formula used prior to July 1, 1982. Class action lawsuits were filed by members of the Teachers' and State Employees' Retirement System of North Carolina and the North Carolina Local Governmental Employees' Retirement System who had been employed for more than five years as of July 1, 1982, and who had retired on disability after that date, alleging that the actions of the State in reducing their benefits impaired the obligations of a contract in violation of Article 1, Section 10 of the United States Constitution. The Court ruled in favor of the plaintiffs and awarded retroactive payment of the difference in the monthly benefits that would have been received under the pre-July 1, 1982 method of calculation and the amounts received. The amount received by each class member is ten percent (10%) less than the amount awarded because attorneys' fees of ten percent (10%) are deducted from the amount awarded.

Award is Rollover Distribution or Payment to Recipient

Class counsel and the Retirement System have consulted with the Internal Revenue Service and determined that the payment of retroactive benefits qualifies as a "rollover distribution." Most award recipients may elect to have the distribution rolled over directly into an individual retirement account (IRA) in lieu of being paid directly to the recipient. Those recipients who are eligible for this election include the retiree, the surviving spouse of the retiree, and a spouse or former spouse who is an "alternate payee." An alternate payee is a person whose interest in the Retirement System results from a qualified domestic relations order. A beneficiary other than a surviving spouse, such as a child of the deceased retiree, may not elect a rollover of the award; the award will be paid to the beneficiary.

Income Tax Consequences of Direct Payment

A recipient who receives some or all of the award instead of rolling it over into an IRA must include the amount of the award received in federal taxable income in the year received. The Retirement System is required to withhold federal income tax equal to twenty percent (20%) of the amount of the award that is not rolled over. The recipient may deduct the attorneys' fees paid from the recipient's award as a miscellaneous itemized deduction on the recipient's federal income tax return. Miscellaneous itemized deductions are deductible only to the extent that the deductions exceed two percent (2%) of the taxpayer's adjusted gross income.

In contrast to the federal income tax treatment of a direct payment of the award, an award paid directly to a recipient will not be subject to State income tax. This exclusion is a result of the North Carolina Supreme Court's decision in Bailey v. State of North Carolina, in which the Court held that North Carolina could not impose an income tax on retirement benefits paid to former State and local government employees who were vested in the retirement system with five or more years of service as of August 12, 1989. The awards in Faulkenbury are limited to those employees who had five or more years of service as of July 1, 1982, and are therefore not subject to State income tax.

On the North Carolina income tax return, a recipient receiving a direct payment of an award may deduct the amount as an "Other deductions from federal taxable income" on page 2 of Form D-400. The deduction is necessary because the award is included in federal taxable income, which is the starting point for determining North Carolina taxable income. The total amount of the award paid directly to the recipient, including the amount deducted as attorneys' fees, is excludable. This applies even if some or all of the attorneys' fees were deducted on the federal return as a miscellaneous itemized deduction. The law does not contain a requirement to add back the attorneys' fees that were deducted on the federal return.

Income Tax Consequences of a Rollover Distribution

A recipient electing to roll over some or all of the award into an IRA will pay no federal or State income tax on the amount rolled over in the year the award is rolled over. The amount eligible for rollover is the gross amount of the award less the ten percent (10%) attorneys' fees and the twenty percent (20%) federal tax withheld on the attorneys' fees. No federal tax is withheld from the amount that is rolled over. The portion of the award that is rolled over will be taxed for federal purposes in later years when the recipient receives distributions from the IRA. The IRA distribution will also be taxable for State income tax purposes, subject to the $2,000 exclusion provided by G.S. 105-134.6(b)(6)c.

Under section 408 of the Internal Revenue Code, an IRA is a trust created for the benefit of an individual or the individual's beneficiaries and the entire interest of the owner is nonforfeitable. Any nontaxed contribution to an IRA is includable in gross income in the year distributed. The assets invested into the trust and the type of income earned by the trust bear no relationship to the treatment of the distributions for income tax purposes. Accordingly, a distribution from an IRA is a distribution from a trust taxable pursuant to the provisions of section 408 of the Internal Revenue Code and the distributions are includable in North Carolina taxable income to the same extent includable for federal income tax purposes.

If you have 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 Post Office Box 871, Raleigh, North Carolina, 27602-0871.