Directive PD-99-2

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: November 5, 1999
Number: PD-99-2

This Directive supplements Directive PD-99-1, issued on March 4, 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. As explained in PD-99-1, 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.

Distributions Other Than Retirement Pay

A qualifying retirement system can make several kinds of payments to beneficiaries of the system. One kind of payment is retirement benefits paid to former employees who have met the requirements to retire from active service. The tax treatment of this kind of payment was addressed in PD-99-1. Two other kinds of payments are a distribution to an individual who terminates employment before qualifying to receive retirement benefits and a distribution to beneficiaries of an individual who died and was still employed at the time of death. The tax treatment of these two payments has been addressed by the Court since PD-99-1 was issued.

In an Order Regarding Class Membership signed by Judge Thompson on September 3, 1999, the Court ruled that the Bailey settlement applies only to the first kind of payment, which is retirement benefits paid to retired vested employees or to beneficiaries of retired vested employees. The Bailey settlement does not apply to the latter two kinds of payments. Therefore, individuals, including beneficiaries of deceased individuals, receiving a return of contributions or other distributions (other than retirement benefits) from qualifying retirement systems are not part of the settlement and will not recover the North Carolina income tax they paid on these distributions through the settlement process.

Although the Court decided that taxes paid on the latter two kinds of payments cannot be recovered in the settlement process, the Court did not determine whether it is legal to impose tax on these payments. It is the Department's position that it is not legal to impose tax on these payments and that the payments are, therefore, exempt from North Carolina income tax to the same extent as retirement benefits paid from those same systems. Consequently, an individual who was vested in a qualifying retirement system as of August 12, 1989, and who receives a distribution from the system because of termination of employment prior to retirement may exclude the distributions from North Carolina taxable income. Similarly, an individual who receives a distribution from the system as a beneficiary of an individual who was vested in the system and who died while employed may exclude the distributions from North Carolina taxable income.

A refund of taxes paid on these distributions for returns filed on or before October 9, 1998, is allowed only if the taxpayer meets the requirements of G.S. 105-267. The three-year statute of limitations applies to refunds of taxes paid on these distributions for returns filed on or after October 9, 1998.

Settlement Period

The Court's Order Approving Class Action Settlement was issued on October 9, 1998. The settlement requires the State to appropriate $799,000,000 for refunds to State, local, and federal retirees. It 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. It also provides that the plaintiffs will not pay North Carolina income tax in future years on their retirement benefits.

After the order was issued, some taxpayers filed returns for a tax year covered by the settlement and paid tax on benefits that are not subject to tax under the settlement. Some also made payments for back taxes owed for a covered tax year that included retirement benefits that are not subject to tax under the settlement. The question arose as to whether these tax returns filed and payments made after October 9, 1998, are to be refunded under the settlement.

On June 25, 1999, the Court issued an order addressing this question. The Court held that, with two exceptions, Class Counsel is not required to recognize tax returns, including amended tax returns, filed after October 9, 1998, or taxes paid after October 9, 1998, in calculating the payout of the settlement to that Class member. The first exception is for a 1997 return timely filed by October 15, 1998, under a proper extension of time to file. That return must be considered in the calculation of the payout to a class member. The second exception is for a late or an amended return that results in a decrease in the payout to a class member. In this circumstance, Class Counsel can, but is not required to, consider the return in calculating the payout.

As a result, some issues involving returns filed and payments made after October 9, 1998. must be addressed by the Department of Revenue or the taxpayer rather than the Court. If the Department receives a delinquent return after October 9, 1998, that is for a tax year covered by the settlement and includes retirement benefits that are not subject to tax, the Department may adjust the return or the taxpayer may amend the return to exclude the retirement benefits from taxable income. Any tax payments received after October 9, 1998, and any resulting offsets of refunds for taxes that are owed for tax years 1989 through 1997 on retirement benefits that are not subject to tax may be refunded. A refund of a tax payment on qualifying retirement benefits received after October 9, 1998, is subject to the general statute of limitations rule requiring the overpayment to be discovered by the Department or the refund to be demanded in writing by the taxpayer within three years after the date set by the statute for the filing of the return or within six months after the payment of the tax alleged to be an overpayment, whichever is later.

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. Since that date, the court has issued several orders concerning qualifying State and local retirement systems. The orders address the Separate Insurance Benefits Plan for State and Local Governmental Law Enforcement Officers, the New Hanover County School Employees' Retirement Plan, optional retirement plans available to administrators and faculty of the University of North Carolina system, and optional contribution plans available to public school teachers and employees.

In an Order Supplementing Order Regarding Class Definition, signed by Judge Thompson on June 25, 1999, the Court clarified that the Separate Insurance Benefits Plan for State and Local Governmental Law Enforcement Officers (G.S. 143-166.60) is a qualifying State or local retirement system. The Separate Insurance Benefits Plan is a noncontributory benefits plan that, prior to August 12, 1989, was afforded an exemption from State income tax.

In another Order Supplementing Order Regarding Class Definition, signed by Judge Thompson on October 22, 1999, the Court found that Chapter 1307 of the 1979 Session Laws had exempted from North Carolina income tax retirement benefits paid to New Hanover County school employees from the New Hanover County School Employees' Retirement Plan. Therefore, the New Hanover School Employees' Retirement Plan is a qualifying State or local retirement system.

In another Order Supplementing Order Regarding Class Definition, signed by Judge Thompson on March 26, 1999, the Court clarified that the Optional Retirement Program (ORP) created by G.S. 135-5.1 is a qualified retirement system. Directive PD-99-1 identifies the North Carolina Teachers' and State Employees' Retirement System (TSERS) as a qualifying State retirement system. By law, administrators and faculty of the University of North Carolina system have the option of participating in the TSERS or in the ORP created by G.S. 135-5.1, a provision of Article 1 of Chapter 135. The ORP is offered in lieu of participation in the TSERS and the election is irrevocable.

There are three carriers authorized to provide investment options and pay retirement benefits under the ORP. They are (1) Lincoln Life Insurance Company; (2) Teachers Insurance and Annuity Association/College Retirement Equities Fund (TIAA-CREF); and (3) The Variable Annuity Life Insurance Company (VALIC). Although the Order identifies the ORP as a qualified retirement system, significant issues remain as to how to determine the portion of the retirement benefits that are subject to recovery or future tax exemption under the settlement. When the Court resolves these issues, the Department will issue another Directive explaining the Court's decision.

In an Order Regarding Certain Plans not Included Within the Class Definition, signed by Judge Thompson on June 25, 1999, the Court clarified two issues concerning plans established pursuant to sections 401(k), 403(b), and 457 of the Internal Revenue Code. First, the Court clarified that plans established pursuant to § 403(b) of the Code are not qualifying State or local retirement systems. Teachers and other employees of North Carolina's public schools have the option of contributing to optional contribution plans established pursuant to § 403(b) of the Code, and the same carriers that administer the ORP may administer these plans. Because the § 403(b) plans are not qualifying State or local retirement systems, benefits from these plans are not recoverable under the settlement and are not exempt from future taxes.

Second, the Court clarified that the only State or local plans established pursuant to sections 401(k) or 457 of the Code that are qualifying State or local retirement plans for the purposes of Bailey are those the Court previously identified in its Order Regarding Class Definition. That Order, signed by Judge Thompson on March 26, 1999, as well as Directive PD-99-1, identifies the North Carolina Supplemental Retirement Income Plan and the North Carolina Deferred Compensation Plan as qualified State retirement systems. Both of these are optional contribution plans established pursuant to sections 401(k) and 457 of the Internal Revenue Code, respectively. These two are the only § 401(k) and § 457 plans whose benefits are recoverable under the settlement and are exempt from future taxes.

The Department has received several inquiries about whether the special separation allowance provided to qualified retired law enforcement officers is a qualified State or local retirement system pursuant to Bailey. The special separation allowance is paid pursuant to Chapter 143, Article 12D of the General Statutes. The statutes providing for the special separation allowance have never afforded an exemption from tax for the allowance. Therefore, the allowance is not a qualified State or local retirement system.

"Vesting" Period for Qualifying Federal Retirement Systems

Directive PD-99-1 identifies the Thrift Savings Plan (Plan) as a qualified federal retirement system and explains that the 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 contribute voluntarily 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. At the time the Directive was issued, the Court had not resolved issues about when an employee is vested under either employer component. It also had not decided how the settlement and future income tax exclusion apply to retirement benefits received from the Plan if the retiree is vested in the employee component but not the employer fixed percentage component.

The Court addressed these issues in its Order Supplementing Order Regarding Class Definition With Respect to the Federal Thrift Savings Plan, which was signed by Judge Thompson on March 26, 1999. The Court ruled that an employee who is vested in the employee component of the plan is also vested in the employer component for matching contributions. The Court further ruled that an employee is vested in the employer fixed percentage component only if the employee had three years of service (two years of service for certain highly ranked employees) as of August 12, 1989. The only exception to the three-year (or two-year) rule is that an employee who died prior to completing the mandatory three years (or two years) is still considered vested if the date of death was on or before August 12, 1989.

It is possible for a participant in the Plan to be vested in the employee component but not in the employer fixed percentage component as of August 12, 1989. The annual tax information statement (Form 1099-R) sent by the Plan to every benefit recipient under the Plan does not distinguish between the various components when reporting the amount distributed during the year. Therefore, a recipient who is vested in one component but not both cannot readily determine the amount to exclude from North Carolina income tax. A recipient can use Form TSP-8, Thrift Savings Plan Participant Statement, to determine how much to exclude each year. When a participant in the Plan ceases employment, the recipient is provided a Form TSP-8. The Form identifies the cash balances in the various components. To determine the proper amount to exclude, the recipient should multiply the annual distribution by a fraction, the numerator of which is the balance of the components in which the recipient is vested as of August 12, 1989, and the denominator of which is the total cash balance of all components. That same fraction is to be used for each year the recipient receives distributions from the Plan.

Settlement Extinguishes the State's Liability

The Consent Order signed by Judge Thompson on June 10, 1998, provides that 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 their retirement benefits from 1989 through 1997. The Department of Revenue has received amended returns for those years from taxpayers who did not claim the $4,000 retirement benefits deduction allowed under G.S. 105-134.6(b)(6). It is the Department's position that, for taxpayers who are members of the class under the settlement, the Department cannot issue refunds based on those amended returns because those claims arise from the taxation of State, local, and federal retirement benefits.Amended returns claiming a $4,000 deduction filed by retirees who are not part of the settlement will be processed. This group of retirees consists of those who were not vested as of August 12, 1989, or receive retirement benefits from a plan that is not a qualifying State, local, or federal retirement plan.