SALT Blawg – State and Local Tax Blog
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Chamberlain Hrdlicka Blawgs
Business and International Tax Blog
by Stewart Weintraub and Jennifer Weidler
This past week, Michigan senior citizens packed into the Michigan Supreme Court to hear oral arguments over the legality of a proposed change that would impose a tax upon their public pensions. Notably, this is not the first time that Michigan was involved with litigation concerning its taxation of pension plans. During the late 1980s, the U.S. Supreme Court decided a case involving the Michigan Income Tax Act ("Act"). The Act provided an exemption from taxation for all retirement benefits paid by the State or its political subdivisions, but subjected to tax retirement benefits paid by other employers, including the Federal government. See Davis v. Michigan Department of Treasury, 489 U.S. 803 (1989). The Court concluded that the Act violated the principles of intergovernmental tax immunity by favoring retired state and local government employees but not retired federal employees.
In dicta, the Court noted that: "A tax exemption truly intended to account for differences in retirement benefits would not discriminate on the basis of the source of those benefits, as Michigan's statute does; rather, it would discriminate on the basis of the amount of benefits received by individual retirees." The Michigan Legislature appears to have grasped onto this idea, revamping its state business and income tax system and adopting 2011 PA 38 ("Amendment"). Subsequent to the decision in Davis, all pension income for public retirees was exempt from income tax. As a result of the Amendment, the previous exemption for state pension income would be limited based upon age and household resources. With regard to age, the amendment creates three (3) classes of pension recipient taxpayers:
- Class 1: Taxpayers 67 years of age or older during 2012. These individual's public pension distributions will remain completely exempt. Their private pension exemptions will be capped at $45,120/$92,240 (single filer/joint filer).
- Class 2: Taxpayers age 60 through 66 during 2012. For these taxpayers, their public and private pension exemptions will be capped at $20,000/$40,000 (single filer/joint filer). Upon a taxpayer's attainment of age 67, the pension exemption for this Class becomes a general income exemption and no pension or income exemption will be granted if the taxpayer's total household income exceeds $75,000/$150,000 (single filer/joint filer).
- Class 3: Taxpayers age 59 or younger during 2012. Initially these taxpayers will receive no pension exemption. Upon attainment of age 67, this Class will receive an income exemption subject to the same cap as Class 2 taxpayers.
Additionally, the Amendment creates personal exemption phaseouts based upon total household resources. There is a phaseout of the exemption where total household resources exceed $75,000/$150,000 (single filer/joint filer). Furthermore, personal exemptions are completely disallowed where total household resources exceed $100,000/$200,000 (single filer/joint filer).
In order to obtain an advisory opinion addressing the legality of the Amendment, Michigan Governor Rick Snyder invoked Article III, section 8 of the Michigan Constitution, requesting that the Michigan Supreme Court issue an opinion regarding the constitutionality of the Amendment. During June the court granted the request, but issued the following four (4) questions to the parties for response:
- Whether reducing the statutory exemption for public pension income violates the constitutional provision stipulating that the "accrued financial benefits of each pension plan and retirement system of the state and its political subdivisions…shall not be diminished or impaired";
- Whether eliminating the statutory tax exemptions for pension income results in the impairment of contractual obligation in violation of the Michigan and U.S. constitutions;
- Whether using total household resources as a measure for phasing out exemptions creates a graduated income tax in violation of Michigan Constitution Article IX, section 7; and
- Whether basing eligibility for exemptions on a taxpayer's date of birth violates the equal protection clauses of the Michigan and U.S. constitutions.
Proponents of the Amendment argue that the state constitution did not create a permanent tax exemption from public pension income nor did it create a contractual right to a perpetual tax exemption. Furthermore, proponents argue that the provisions relating to a graduated income tax were solely meant to prohibit the state from adopting a federal-like graduated income tax; as long as the rate of taxation on taxable income is constant, there is no violation. Finally, proponents claim that the Amendment should be upheld because there is a rational basis for the birth date classifications in that younger people are better able to adjust to and absorb changes that may negatively affect their income stream in retirement.
Opponents of the Amendment argue that the Amendment would reduce the pension income that public sector employees have already earned, violating the state constitution. Furthermore, opponents claim that the Amendment would violate public worker's constitutional right not to have their contracts impaired. Additionally, opponents argue that the Amendment creates a graduated income tax by taxing retirees differently based on income level in violation of the constitution. Finally, opponents argue that the applicable standard for evaluating the Amendment is strict scrutiny, not rational basis, and that the Amendment violates the equal protection clause because it attaches the right of Michigan taxpayers to receive an exemption to their date of birth and marital status. Conversely, opponents claim that there is no rational basis for the distinction.
This past week, the seven Michigan Supreme Court justices debated the issues with attorneys from both sides during oral arguments, which lasted for over an hour. However, the line of questioning and arguments focused on the question of whether the Amendment creates an unconstitutional graduated income tax. While proponent's claim that there is no violation of the prohibition against a graduated income as long as the rate of taxation on taxable income is constant, this proposition stands in direct contradiction to established Pennsylvania case law examining an analogous issue. First, in Kelley v. Kalodner, 320 Pa. 180 (1935), the statute in question established a graduated income tax in which the court scrutinized the use of exemptions from tax based upon income. The court held that:
There can be no doubt that these exemptions were inserted for the purpose of putting the burden of the tax upon those most able to bear it, but it results in taxing those whose incomes arise above a stated figure merely because the legislature believes their incomes are sufficiently great to be taxed. It is obvious that the application of the tax is not uniform.
For the next 36 years Pennsylvania did not impose an income tax. Then during 1971, the Pennsylvania General Assembly enacted a new income tax. As enacted, the tax was imposed at a flat rate of tax upon taxpayers based upon Federal adjusted gross income as modified for Pennsylvania adjustments. Enactment of the tax was immediately challenged. The Pennsylvania Supreme Court found that although the Tax Reform Code of 1971 purported to impose a flat 3.5% tax upon “taxable income,” the concept of “taxable income” already reflected the federal personal exemptions for the taxpayer and his/her qualified dependents. Thus, the court found that the same elements of nonuniformity were built-in to the Tax Reform Code of 1971 as existed in Kelley, and therefore violated uniformity even though a uniform rate was imposed. Thus, Pennsylvania case law appears to be in contradiction to the arguments advanced by proponents of the Amendment with regard to the graduated tax. See Amidon v. Kane, 279 A2d 53 (Pa. 1971).
The Amendment is expected to generate approximately $225 million during 2012 and $343 million during 2013. Thus, if the tax is struck down, the state's budget will have a gaping hole. Not surprisingly, the Michigan Chamber of Commerce and the business community, which would benefit from a $1.8 billion tax cut the pension tax helps to provide, are some of the proponents of the Amendment. If the Court upholds the constitutionality of the Amendment, it would go into effect on January 1, 2012.
Stewart Weintraub’s practice has centered on taxation for more than 40 years. He helps clients plan and structure transactions so that all state and local tax obligations are minimized. He represents clients in all aspects of ...