Court Upholds Tax on Pension Income; Strikes Down Phaseout of Exemptions
Late last week, the Michigan Supreme Court upheld the constitutionality of the vast majority of the tax reform plan to implement a new business Corporate Income Tax and modify Michigan's Individual Income Tax. The tax reform plan included replacing the Michigan Business Tax with a simple Corporate Income Tax as well as attempting to treat all retirement income, regardless of whether it is from public resources or private, the same.
In Re Request for Advisory Opinion Regarding Constitutionality of 2011 PA 38, Michigan Supreme Court, Docket No. 143157, November 18, 2011, the Michigan Supreme Court has held that:
(1) reducing or eliminating the personal income tax statutory exemption for public pension income does not impair accrued financial benefits of a pension plan or retirement system of Michigan or its political subdivisions under the state constitution;
(2) reducing or eliminating the statutory exemption for pension income does not impair a contract obligation in violation of the federal or state constitutions;
(3) determining eligibility for exemptions on the basis of date of birth does not violate equal protection under the federal or state constitutions; and
(4) determining eligibility for exemptions on the basis of total household resources does create a graduated income tax in violation of the state constitution. Even though the portion of the statute that determined eligibility for exemptions was unconstitutional because it created a graduated income tax, the court determined that it could be severed from the remainder of the Act.
The opinions were issued in response to a request from Governor Rick Snyder. The governor requested the opinion so that the constitutionality of several of the personal income tax changes enacted earlier in the year could be determined before the law took effect on January 1, 2012.
Accrued Financial Benefits
Under the Michigan state constitution, the accrued financial benefits of each pension plan and retirement system of the state is a contracted obligation that cannot be diminished or impaired. This means that public pensions are treated as contractual obligations that, once earned, cannot be diminished. The court noted that this section of the constitution does not contain any limitations on the Legislature's authority to tax pensions. In fact, if the ratifiers of the constitution had intended to limit the Legislature's authority to tax pensions, specific limiting language would have been included.
A tax exemption is not an "accrued financial benefit" of the pension plan. "Accrue" means to increase or grow over time; an exemption does not grow. An exemption does not even vest until the employee begins to collect pension benefits. The exemption is a post-distribution effect of the benefits otherwise paid in full. The constitution protects deferred compensation and not tax exemptions.
Under the federal and state constitutions, no law impairing the obligation of contract can be enacted. Here, the obligation of contract consists of pension income, not the tax exemption of that income. Thus, the reduction or elimination of the exemption does not affect or impair the obligation of contract.
In general, statutes do not create contractual rights, but, rather, represent policies to be pursued. Policies, unlike contracts, are inherently subject to revision and repeal. Before a statute, especially a tax one, is held to be irrepealable or not subject to amendment, an intent not to repeal or amend must be clearly stated within the statute so that there is no doubt. Here, there are no terms used that are typically associated with contractual relationships. The tax exemption laws at issue do not create contractual rights that cannot be altered by the Legislature. Taxpayers do not have a vested right in tax statutes.
Under the federal and state constitutions, no person can be denied the equal protection of the law. However, classifications are not forbidden. Under the rational basis test, the classification must rationally further a legitimate state interest. As age is at issue here, a suspect class is not involved. The person challenging the constitutionality of the law has the burden of proof to show that the legislation is arbitrary. Perfection is not possible nor necessary.
The court reasoned that it is a rational distinction to provide an exemption for older persons as they are less able to earn additional income to offset the loss of the exemption. Also, recognizing that older individuals may have decreased earning capacity is a legitimate reason to base the eligibility for the pension exemption on age.
Graduated Income Tax
Under the state constitution, no income tax graduation as to rate or base can be imposed by the state. A graduated income tax generally is a tax on income that imposes a proportionately greater tax burden on higher-income taxpayers than on lower-income taxpayers. Here, it is uncontested that the base consists of net taxable income and that exemptions and deductions decrease the base by decreasing the amount of the taxpayer's income subject to tax. If the taxpayer is entitled to the exemption or deduction, the base is decreased; on the other hand, if the taxpayer is not entitled to the exemption or deduction, then the base is not decreased. The income-based exemption or deduction can result in an income tax that is graduated as to base, even if a flat rate is applied. Here, an income tax graduated as to base is created because entitlement to the exemption (and the extent of such entitlement, which reduces the taxpayer's base) is entirely dependent on the taxpayer's income level. This violates the state constitution.
The unconstitutional portions of the statute can be severed from the remainder of the Act. Thus, the rest of the Act can be given effect without the invalid portions.