States Must Pay Refunds for Illegal Taxes, Court Says

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Washington--In two rulings that could have a major impact on state treasuries and separate cases involving public employees' retirement benefits, the U.S. Supreme Court decided last week that states must, in many instances, pay refunds or make other adjustments when a state tax has been declared unconstitutional.

The Supreme Court ruled last year, in Davis v. Michigan Department of the Treasury, that federal law bars states from taxing federal pensions if the states exempt state and local retirees, such as teachers. But the ruling did not address the question of whether federal retirees are entitled to refunds of any illegal taxes they had paid. (See Education Week, April 26, 1989.)

Refund suits are pending against most of the 24 states that at some point have treated state and local retirees more favorably than federal pensioners, according to the National Conference of State Legislatures. The decisions issued last week could lead to the resolution of those disputes.

Over all, requiring states to make retroactive amends in tax cases could cost as much as $6.5 billion, causing a financial pinch in 30 states where courts have declared some taxes unconstitutional, the State and Local Tax Center, an organization of state officials, said in briefs it filed in the tax cases.

Florida and Arkansas Cases

In McKesson Corporation v. Division of Alcoholic Beverages and Tobacco (Case No. 88-192), which involves a Florida liquor tax, the Court ruled unanimously last week that states must make amends for the effect of unconstitutional taxes when they violate established legal principles, such as federal law or legal precedent.

State officials should have known that the liquor tax at issue in the case was illegal, because it was "indistinguishable" from a similar Hawaii levy that had been voided, according to the opinion written by Justice William J. Brennan.

Therefore, the Court decided, Florida must either make refunds or assess back taxes against the tax who benefited from the unconstitutional law.

In the second case, American Trucking Associations v. Smith (No. 88-325), a 5-to-4 majority decided that states that assessed a type of highway tax voided by the High Court in 1987 did not have to refund taxes levied before that ruling.

Justice Sandra Day O'Connor, joined by three other Justices, held in a plurality opinion that states are not liable for retroactive refunds when a tax is voided by a Court ruling that breaks new legal ground, as the 1987 decision did.

However, Justice Antonin Scalia, who provided the fifth vote in favor of the state of Arkansas in the Smith case, agreed with the four dissenters that the court's rulings should almost always be retroactive.

In a concurring opinion, Justice Scalia said he voted not to compel the refunds in this instance because he thought the truck tax was constitutional, and was thus valid until the 1987 decision, which he believes to be incorrect.

Implications for Pensions?

The only dissenter in last year's Davis ruling was Justice John Paul Stevens, who also wrote the dissenting opinion in Smith.

If Justice Scalia were to join the Smith dissenters in an eventual ruling on the retroactivity of the Court's pension decision, it could force the 24 affected states to pay as much as $2.5 billion in refunds, according to the Federation of Tax Administrators--or to retroactively tax the retirement benefits of teachers and other state and local retirees.

"We consider this to be a big plus," said Dennis Harrington, a spokesman for the National Association of Retired Federal Employees.

However, Attorney General Mary Sue Terry of Virginia--whose state has many federal retirees and faces liability for $370 million in refunds--issued a statement declaring the Smith ruling "good news for Virginia taxpayers."

Benna Solomon, chief counsel for the State and Local Legal Center, said that, while last week's rulings "are obviously not very favorable for the states," the pension issue could be resolved differently.

"It's clear from the Court's opinion in the trucking case that they will go through a case-by-case analysis with each case that is brought to them and say, 'Should this be retroactive?"' she explained.

State Responses

Since the Davis ruling, 20 of the 24 affected states have altered their tax codes to comply with it, and action is pending in Montana and Oregon, according to an n.c.s.l. survey published May 28.

The states that have not acted because officials contend that they are already in compliance are Kansas, where only military retirees are disadvantaged, and Arkansas, which passed legislation in 1985 to equalize treatment of public pensions beginning this year.

Of the 22 states where action to comply with Davis has been taken or is pending, 8 reduced tax preferences for state and local pensioners, while 8 increased preferences for federal retirees. Georgia and Oklahoma did both. Iowa reduced preferences for both groups and made them equal. New Mexico, Utah, and Virginia replaced exclusions for pension income with an age-linked exemption.

Five states have raised benefits for state and local retirees to compensate for new, less favorable tax treatment. States that do not do this, observers noted, could be faced with challenges from retirees who contend that they were promised favorable tax treatment of pensions as part of their employment contract.

Missouri is the only state that has acted to provide refunds to federal retirees, temporarily raising taxes to comply with an order from the state's highest court. (See Education Week, June 7, 1989.)

Other states are waiting for the outcome of further litigation, which observers say is virtually certain to end at the U.S. Supreme Court.

Lower-court rulings thus far have been contradictory. Virginia, for example, was not required to pay refunds, while Arizona and South Carolina were ordered to pay them for certain years.

Observers noted that the High Court might have to rule on the applicability of state laws governing tax refunds, as well as on the retroactivity of Davis.

Other Action

In other action last week, the Supreme Court:

Declined to hear a challenge to a Virginia law forbidding elected school boards.

Black residents argued in Irby v. Virginia State Board of Elections (No. 89-1612) that the state's appointment system was designed to exclude blacks.

But lower courts ruled that, while the system was maintained for discriminatory reasons in the past, it had more recently been retained for other purposes, such as insulating school boards from political pressure. (See Education Week, Dec. 6, 1989.)

In Virginia, the only state that prohibits elected school boards, members are appointed by other local officials or by commissions named by judges.

Declined to hear a suit challenging the way a Michigan teachers' union assesses fees on non-members.

In James Linsey v. Ferris Faculty Association (No. 89-1415), a group of instructors at Ferris State College argued that an auditor should be required to certify that non-members are charged only for legitimate expenses, rather than merely ensuring that the funds were spent as reported. The instructors also argued that it was inequitable for the union to unilaterally designate the American Arbitration Association to select a mediator for disputes over the charges.

Set aside a law adopted by a Maryland county banning adult bookstores within 1,000 feet of a school or church.

In 11126 Baltimore Blvd. Inc. v. Prince George's County (No. 89-1177), a federal appeals court had ordered that a store in Hyattsville, Md., be shut down for violating a 1975 county zoning law. The Justices ordered the appeals court to review the case based on the High Court's January decision striking down a licensing requirement for sexually oriented businesses in Dallas.

Vol. 09, Issue 38

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