Directive PD-00-1 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 Number: PD-00-1 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 tax. The following rules determine when the distributions received by an ORP participant are recoverable under the settlement and excludable from future North Carolina income tax: 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 benefits. (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.