Kerr v. Killian

• Court: Arizona Supreme Court
• Writing for the Court: HURWITZ, Justice.
• Citation: Kerr v. Killian, 84 P.3d 446, 207 Ariz. 181 (Ariz. 2004)
• Decision Date: 13 February 2004
• Docket Number: No. CV-03-0110-PR.,CV-03-0110-PR.
• Parties: Clark J. KERR and Billie Sue Kerr, husband and wife, Susan Moran, Steve Allen and John Udall, individually and as representatives of the class comprised of federal employees who paid Arizona income taxes on federal retirement contributions during one or more of the years 1984 to date, Plaintiffs-Appellees, Cross-Appellants, v. Mark J. KILLIAN, in his capacity as Director of the Arizona Department of Revenue, the Arizona Department of Revenue of the State of Arizona, Defendants-Appellants, Cross-Appellees. State of Arizona ex rel., the Arizona Department of Revenue, Plaintiff-Appellant, Cross-Appellee, v. Clark J. Kerr and Billie Sue Kerr, husband and wife, Defendants-Appellees, Cross-Appellants. Clark J. Kerr and Billie Sue Kerr, husband and wife; and their Attorneys, Bonn, Luscher, Padden & Wilkins, Chartered and O'Neil, Cannon & Hollman, S.C., Counterclaimants-Appellees, Cross-Appellants, v. State of Arizona ex rel., the Arizona Department of Revenue, Counterdefendant-Appellant, Cross-Appellee.

84 P.3d 446

207 Ariz. 181

Clark J. KERR and Billie Sue Kerr, husband and wife, Susan Moran, Steve Allen and John Udall, individually and as representatives of the class comprised of federal employees who paid Arizona income taxes on federal retirement contributions during one or more of the years 1984 to date, Plaintiffs-Appellees, Cross-Appellants, v. Mark J. KILLIAN, in his capacity as Director of the Arizona Department of Revenue, the Arizona Department of Revenue of the State of Arizona, Defendants-Appellants, Cross-Appellees.

State of Arizona ex rel., the Arizona Department of Revenue, Plaintiff-Appellant, Cross-Appellee, v. Clark J. Kerr and Billie Sue Kerr, husband and wife, Defendants-Appellees, Cross-Appellants.

Clark J. Kerr and Billie Sue Kerr, husband and wife; and their Attorneys, Bonn, Luscher, Padden & Wilkins, Chartered and O'Neil, Cannon & Hollman, S.C., Counterclaimants-Appellees, Cross-Appellants, v. State of Arizona ex rel., the Arizona Department of Revenue, Counterdefendant-Appellant, Cross-Appellee.

No. CV-03-0110-PR.

Supreme Court of Arizona, En Banc.

February 13, 2004.

Bonn & Wilkins, Chartered by Paul V. Bonn, Randall D. Wilkins, D. Michael Hall, Brian A. Luscher, Phoenix and O'Neil, Cannon & Hollman, S.C., by Eugene O. Duffy, Milwaukee, WI, Attorneys for Appellees, Cross-Appellants.

Terry Goddard, Attorney General, by Michael P. Worley, Phoenix, Attorneys for Appellant, Cross-Appellee.

OPINION

HURWITZ, Justice.

¶ 1 The question in this case is whether Arizona's income tax scheme violates the intergovernmental tax immunity doctrine because it effectively subjects federal employees' mandatory retirement contributions to current taxation, while deferring taxation of similar contributions by state and local employees. We conclude that the state income tax code does not discriminate against federal employees because of the source of their pay or compensation, and thus does not violate the intergovernmental tax immunity doctrine, codified in 4 U.S.C. § 111(a) (2000).

I.

¶ 2 This case has a long and complicated procedural and substantive history. This litigation commenced in 1989 and has been the subject of five prior reported appellate opinions.¹ We begin with a review of the "long strange trip"² that brought this case here.

A. The Federal Tax Code

¶ 3 This controversy has its origins in several arcane provisions of the federal tax code. Under various sections of the Internal Revenue Code, including I.R.C. §§ 401 and 403, governmental employers may choose to establish "contributory" retirement plans. A typical plan requires employees to contribute a portion of their income to the plan (the "employee's contribution") and the employer then contributes additional funds (the "employer's contribution").

¶ 4 In the abstract, both the employee's and employer's contributions would seem to be current taxable income to the employee; the former comes out of the employee's salary, while the latter is plainly a benefit conferred by the employer as a result of the employee's labor. See generally I.R.C. § 61 (defining gross income as "all income from whatever source derived"). But, in what has aptly been termed "one example of the dominance of form over substance in the tax code," Howell v. United States, 775 F.2d 887, 887 (7th Cir.1985), federal tax law distinguishes between the employee's and the employer's contributions. An employer's contribution to a retirement plan "qualified" under I.R.C. §§ 401(a) and 403(a) is not treated as taxable income for the employee until the plan pays benefits to the employee. See Howell, 775 F.2d at 887. An employee's contribution to a retirement plan, however, is generally treated as current taxable income to the employee, even if the employee is mandated to make the contributions out of his current pay. See generally United States v. Basye, 410 U.S. 441, 449-50, 93 S.Ct. 1080, 35 L.Ed.2d 412 (1973) (treating contributions to retirement plan as "anticipatory assignments of income"). The employee is not taxed, however, on the eventual distributions from the plan corresponding to his taxable contributions. See I.R.C. § 72.

¶ 5 In 1974, Congress complicated the situation further by enacting Pub.L. No. 93-406, 88 Stat. 825 (1974), codified at I.R.C. § 414(h)(2). Section 414(h)(2) provides that if a state or local governmental employer "picks up" employee contributions to a plan qualified under §§ 401(a) or 403(a), "the contributions so picked up shall be treated as employer contributions," and thus not subjected to current income tax. The Internal Revenue Service has established two criteria that must be met before a state or local government can "pick up" employee contributions:

First, the employer must specify that the contributions, although designated as employee contributions, are being paid by the employer in lieu of contributions by the employee. Second, the employee must not have the option of choosing to receive the contributed amounts directly instead of having them paid by the employer to the pension plan.

Rev. Rul. 81-35, 1981-1 C.B. 255.

B. Arizona's Income Tax Scheme

¶ 6 In 1979, Arizona adopted federal adjusted gross income ("AGI") as the starting point for computing Arizona taxable income. 1978 Ariz. Sess. Laws, ch. 213, § 2 (codified as amended at Arizona Revised Statutes ("A.R.S.") § 43-1001(2) (Supp.2003) ("`Arizona gross income' of a resident individual means the individuals federal adjusted gross income for the taxable year, computed pursuant to the internal revenue code.")). The income tax statutes list a series of items Arizona taxpayers must add to, or may subtract from, federal AGI to reach their Arizona taxable income. See A.R.S. § 43-1021 (Supp.2003) (listing twenty-seven additions); id. § 43-1022 (listing twenty-nine subtractions).

¶ 7 At the same time that the legislature adopted federal AGI as the starting point for calculating Arizona taxable income, it also amended the state tax code to allow state and local employees to subtract their mandatory retirement contributions from Arizona gross income. 1978 Ariz. Sess. Laws, ch. 213, § 2 (codified at A.R.S. § 43-1022(2) (Supp.1978)). Under the version of § 43-1022(2) adopted in 1978, "[c]ontributions made to the state retirement system, the judges' retirement fund, the public safety personnel retirement system or a county or city retirement plan" could be subtracted from the employee's Arizona gross income.³ In 1982, the legislature added mandatory contributions to the elected officials' retirement plan ("EORP") to the list of subtractions. 1982 Ariz. Sess. Laws, ch. 126, § 2 (codified at A.R.S. § 43-1022(2) (Supp.1982)). In 1986, contributions to the corrections officer retirement plan ("CORP") were added to the list. 1986 Ariz. Sess. Laws, ch. 325, § 3 (codified at A.R.S. § 43-1022(2) (Supp.1986)).⁴

¶ 8 In addition to allowing subtractions from Arizona taxable income of employee contributions to the various retirement plans, Arizona law also provided until 1989 that all benefits paid to employees under those plans could likewise be subtracted. See A.R.S. § 43-1022(3) (Supp.1988). Thus, state and local employees could avoid Arizona taxation altogether on retirement benefits, regardless of whether these benefits derived from employers' contributions or employees' contributions. In 1989, however, Davis v. Michigan Department of Treasury, 489 U.S. 803, 109 S.Ct. 1500, 103 L.Ed.2d 891 (1989), held that a similar Michigan statute violated principles of intergovernmental tax immunity, by favoring retired state and local governmental employees over federal employees, who were not allowed to deduct retirement benefits from their taxable Michigan income.

¶ 9 The Arizona legislature promptly reacted to Davis by amending A.R.S. § 43-1022(3) to eliminate benefits received from state and local retirement plans from the list of permitted subtractions from Arizona gross taxable income.⁵ 1989 Ariz. Sess. Laws, ch. 312, § 12. The same statute also removed from the list of statutory subtractions contributions to ASRS, EORP, and county or city retirement plans. Id. In 1991, the legislature removed mandatory contributions to CORP and PSPRS from its list of subtractions from Arizona gross income. 1991 Ariz. Sess. Laws, ch. 155, § 8 (retroactively effective to January 1, 1991).

¶ 10 Thus, for tax years after 1990, Arizona law has not provided for subtraction from gross income for mandatory employee contributions to any state or local retirement plans and it has treated benefits received from federal, state or local plans similarly. This did not mean, however, that all employee contributions were immediately subjected to current Arizona tax.

¶ 11 Beginning in 1985, the legislature had enacted statutes authorizing certain state retirement plans to "pick up" employee contributions pursuant to I.R.C. § 414(h)(2). 1985 Ariz. Sess. Laws, ch. 294, § 4 (now codified at A.R.S. § 38-736(B) (2001) (authorizing ASRS pick up)); 1985 Ariz. Sess. Laws, ch. 309, § 4 (now codified at A.R.S. § 38-810(E) (2001) (authorizing EORP pick up)); 1986 Ariz. Sess. Laws, ch. 325, § 1 (now codified at A.R.S. § 38-892 (2001) (authorizing CORP pick up)). Prior to 1989, ASRS and EORP had already opted to pick up employee contributions pursuant to § 414(h)(2); these contributions were therefore not included in federal AGI, and thus not subject to current Arizona tax, notwithstanding the elimination of the previous subtractions in 1989.⁶

¶ 12 Although CORP had received legislative authorization to pick up employee contributions in 1986, it did not elect to do so immediately; its pick up was first effective on July 1, 2000. PSPRS did not receive legislative authorization to pick up employee contributions until 1999, 1999 Ariz. Sess. Laws, ch. 50, § 4; 1999 Ariz. Sess. Laws, ch. 327, § 22 (now codified at A.R.S. § 38-843.01 (2001)), and its election was effective at the same time as CORP's.⁷ Thus, throughout the period from 1...