Court Finds Fed Worker Pension Contributions Illegally Taxed by Arizona

In a decision published last Friday, the Arizona Court of Appeals noted that Arizona law is structured so that while state and local workers pay no income tax on the portion they are required to contribute to government retirement plans, federal workers – some 40,000 of them – have not been accorded the same favorable treatment, according to the Arizona Tribune.

And if the request for class action is approved, the state could be looking at repayments of about $100 million, covering taxes paid since 1990.  

When state and local government workers make mandatory contributions to their retirement systems, those contributions are made on a pre-tax basis, much as most 401(k) salary deferrals are handled.   However, there is no similar system for most other workers in Arizona, according to the report.

Case History

According to the Arizona Department of Revenue, in 1994 the Arizona Court of Appeals held that the state’s statutory scheme was unconstitutional because it violated the intergovernmental tax immunity doctrine, which bars states from discriminating in how they tax federal employees.   In response, the DOR offered federal workers in the state the option to subtract those contributions from Arizona taxable income, but warned that if the DOR prevailed in its action, they could be subject to potential audit (see http://www.revenue.state.az.us/taxnews/0303news.pdf ).

However, in the recent ruling, Judge Cecil Patterson Jr. wrote for a unanimous court in noting, “Arizona has chosen to design its individual income taxing scheme in a way that includes federal employees’ mandatory retirement contributions in their Arizona gross incomes, but excludes from Arizona gross income the corresponding mandatory retirement contributions of state and local employees.”