SCOTUS to Decide if Tax Breaks for State and Local Government Retirees are Unlawful

In Dawson v. Steager the Supreme Court will decide whether states may give some retired state and local government employees a bigger tax break on retirement benefits than retired federal employees.

West Virginia taxes the government-provided retirement income of most local, state, and federal employees. While retired federal employees and most state and local government employees may exempt up to $2,000 of retirement benefits from their taxable income, certain state and local police officers, sheriffs, and firefighters can exempt all of their benefits. This group comprises about two percent of all state government retirees.

James Dawson, a former U.S. Marshal, sued West Virginia alleging that preferential treatment for state and local law enforcement officials violates 4 U.S.C. § 111. This federal statute allows states to tax federal retirement benefits only “if the taxation does not discriminate . . . because of the source of the pay or compensation.”

In Davis v. Michigan Department of Treasury (1989), the Supreme Court held that Michigan’s tax scheme where all state retirement benefits were exempt from state taxation while all federal retirement benefits were taxed violated 4 U.S.C. § 111.

The West Virginia Supreme Court of Appeals held that West Virginia’s law doesn’t discriminate against federal retirees. The court distinguished this case from Davis on the grounds that the West Virginia tax exemption was not a blanket exemption for all state employees, but was “intended to give a benefit to a very narrow class of former state and local employees.” The court also reasoned that federal retirees receive a tax benefit identical to the majority of state retirees and a better benefit than non-state retirees, so there was no intent to discriminate against federal employees.

It is unclear how much of an impact this case will have on other states. The United States notes that Massachusetts and New Mexico state courts have upheld state and local employee retirement-benefit exemptions similar to West Virginia’s while courts in Missouri, Arkansas, and Colorado have struck them down. But it appears that as of 2015 only West Virginia and Connecticut (see Table 2) disfavor federal government employees versus state employees in exempting taxing retirement benefits.

It may be that state legislatures have rejected providing more favorable tax treatment to state and local retirees than federal retirees for policy reasons. It is also possible state legislatures not done so because of uncertainty in the law. Either way states will have a better idea of what is lawful following the Supreme Court’s decision in this case.