Request By:
Mr. Vic Hellard, Jr.
Director, Legislative Research Commission
Room 300, State Capitol
Frankfort, Kentucky 40601
Opinion
Opinion By: Frederic J. Cowan, Attorney General; Nathan Goldman, Assistant Attorney General
In your letter to the Attorney General you have asked us for an opinion on the effect of Davis v. Michigan Department of the Treasury on Kentucky's current taxation policy as it relates to military retirement benefits.
The Davis Case
The Davis case was decided by the U.S. Supreme Court March 28, 1989 (Docket No. 87-1020). In that case, the Court considered the issue of whether Michigan's taxation of retirement benefits paid by the federal government violated federal law.
Michigan levied its income tax on retirement benefits received, including federal retirement benefits, pursuant to Michigan Comp. Laws Ann. § 206.30(1)(f). That statute states:
"Taxable income", for a person other than a corporation, estate, or trust, means adjusted gross income as defined in the internal revenue code subject to the following adjustments: . . .
(f) Deduct to the extent included in adjusted gross income:
(i) Retirement or pension benefits received from a public retirement system of or created by this state or a political subdivision of this state.
(ii) Any retirement or pension benefits received from a public retirement system of or created by another state or any of its political subdivisions if the income tax laws of the other state permit a similar deduction or exemption or a reciprocal deduction or exemption of a retirement or pension benefit received from a public retirement system of or created by this state or any of the political subdivisions of this state.
(iii) Social security benefits as defined in section 86 of the internal revenue code.
(iv) Retirement or pension benefits from any other retirement or pension system as follows:
(A) For a single return, the sum of not more than $ 7,500.00.
(B) For a joint return, the sum of not more than $ 10,000.00. . . .
As you can see, state retirement benefits were completely exempt from income tax while federal retirement benefits were exempt for only up to $ 7,500 or $ 10,000.
The Court held that this scheme of taxation violated the Public Salary Tax Act of 1939, 4 U.S.C. § 111, and the doctrine of intergovernmental tax immunity. The statute states, in relevant part:
The United States consents to the taxation of pay or compensation for personal service as an officer or employee of the United States . . . by a duly constituted taxing authority having jurisdiction, if the taxation does not discriminate against the officer or employee because of the source of the pay or compensation.
The Court found this provision to be a codification of the nondiscrimination component of the constitutional immunity doctrine first announced in
McCulloch v. Maryland, 4 Wheat. 316 (1819). This is also referred to as the doctrine of intergovernmental tax immunity. A state may not levy a tax which discriminates against retired federal employees and in favor of retired state employees.
The Court held that Michigan's tax statutes did, in fact, violate the principles of intergovernmental tax immunity and that the appellant was entitled to the refund he sought. He had also asked for prospective relief. The Court, in addressing this issue, stated, at page 13 of the Slip Opinion:
While invalidation of Michigan's income tax law in its entirety obviously would eliminate the constitutional violation, the Constitution does not require such a drastic solution. We have recognized, in cases involving invalid classifications in the distribution of government benefits, that the appropriate remedy 'is a mandate of equal treatment, a result that can be accomplished by withdrawal of benefits from the favored class as well as by extension of benefits to the excluded class'. . . . In this case, appellant's claim could be resolved either by extending the tax exemption to retired federal employees (or to all retired employees), or by eliminating the exemption for retired state and local government employees.
The Court remanded the case to the Michigan courts to determine the best remedy.
Kentucky Law
According to 103 KAR 17:080, Section 2, the following retirement income is specifically exempt by Kentucky law which established the retirement systems: (1) Kentucky teachers retirement income, (2) Kentucky state employees and county employees retirement income, (3) Kentucky judicial retirement income, (4) Kentucky legislative retirement income, and (5) Kentucky state supported institutions of higher education retirement income. See KRS 6.525 (legislative retirement) , KRS 21.470 (judicial retirement) , KRS 61.690 (state and county retirement) , KRS 164.2871 (state supported institutions of higher education retirement) , and KRS 161.700 (teachers retirement) .
Federal retirement benefits are partially exempted subject to certain limitations -- there is a $ 4,000 maximum retirement exclusion based on earned income from other sources. See KRS 141.021 and 103 KAR 17:080, § 3.
Conclusion
The effect of the present Kentucky law dealing with the taxation of state and federal retirement benefits is to completely exempt state benefits and, for the most part, tax federal benefits. Consequently, based on the reasoning of the Davis case, Kentucky's method of taxation violates federal law. Kentucky would then find itself in the same position as Michigan as regards the way to remedy this situation.
We have been in touch with the Michigan Attorney General's Office and they inform us that the case has been remanded to the Michigan Court of Appeals and the parties are briefing the question of whether to extend the exemption to federal retirees or to strike down as unconstitutional that portion of the statute exempting state retirees.
Recently a class action lawsuit was filed in court in Kentucky on behalf of federal retirees in the state challenging state taxation of their retirement benefits. While this lawsuit will definitely have an impact on the situation, we believe that the General Assembly could act on the issue itself. The General Assembly could take one of the following courses of action: (1) exempt federal benefits; (2) tax state benefits; or (3) partially tax and partially exempt federal and state benefits equally.
As always, if our office can be of any assistance to you and the legislature on this matter, please do not hesitate to call on us.