WASHINGTON -- The Supreme Court ruled yesterday that Georgia must pay refunds to federal retirees who were illegally taxed, but the justices left it up to the state to decide how.

Justice Sandra Day O'Connor wrote for a unanimous court in Reich v. Collins that Georgia had improperly used a "bait and switch" technique by changing its statutory tax refund scheme in the course of litigation, thereby depriving the taxpayers of due process.

The court directed Georgia, which may have to refund up to $200 million, to provide "meaningful backward-looking relief" to the retirees.

The dispute between federal retiree Charles Reich and Marcus Collins, head of the state Department of Revenue, arose from a line of cases beginning with a March 1989 Supreme Court decision in Davis v. Michigan. The high court found in Davis that state laws providing for taxation of federal retirement benefits, but not state benefits, violated constitutional principles of intergovernmental tax immunity.

Reich and other retirees paid the unconstitutional taxes during the 1980s and sought refunds, but the Georgia Supreme Court said the retirees should have sought a remedy before they paid the taxes and affirmed the state's denial of refunds.

Reich had sought a refund under a Georgia law providing for such refunds to taxpayers who paid illegal taxes. But Georgia, during the course of the litigation, declared that after the retirees paid the disputed taxes, the state refund law did not apply to them because the law that had assessed the taxes in the first place was unconstitutional.

The high court said states have flexibility to set up schemes for providing remedies to taxpayers who are illegally taxed. States may provide remedies that apply before taxpayers pay disputed taxes, and/or apply remedies after taxes are paid, the court said.

"But what a state may not do, and what Georgia did here, is to reconfigure its scheme, unfairly, in mid-course -- to 'bait and switch,' as some have described it," the high court said. While Georgia had properly set up a scheme under which taxpayers could seek remedies either before or after paying taxes, the state's later declaration that refunds were not available to the retirees was illegal, the court said.

The court found "significant" a general preference by states to have taxpayers pursue remedies only after they pay taxes. "This preference is significant in that it would seem especially unfair to penalize taxpayers who may have ignored the possibility of pursuing predeprivation [before-the-fact] remedies out of respect for that preference," the court said.

States may rely exclusively on before-the-fact remedies, as Georgia sought to do in midstream, but only as long as the remedial scheme is "clear and certain," the court said in a restatement of a 1993 ruling in Harper v. Virginia Department of Taxation.

States and state interests participating in the case had hoped that the court would clarify what it meant by "clear and certain."

But yesterday's opinion did not address that "murky" standard, said Charles Rothfeld, an attorney with the firm of Mayer, Brown & Platt in Washington. Rothfeld filed a friend-of-the-court brief in support of Georgia on behalf of a group of state interests led by the National Governors' Association. The ruling should be narrowly construed as applying only to the facts of the Georgia case, he said.

But Kevin Fowler, an attorney with Frieden, Haynes & Forbes in Topeka, Kan., who filed a friend-of-the-court brief in support of the retirees, called the decision "significant."

"The court makes very clear that if a state holds out alternative remedies that appear to be available to reasonable taxpayers, and when a taxpayer chooses to take advantage of one of those ... remedies, the state cannot extinguish that after the fact," said Fowler, who represents retirees who settled a similar case with Kansas.

Most states affected by the Davis line of rulings have settled with federal retirees, said Timothy McCormally, general counsel and director of tax affairs for Tax Executives Institute Inc., an association of corporate tax executives in North America. About 16 states had taxed federal retirement benefits while exempting state benefits.

The institute filed a friend-of-the-court brief in support of Reich out of concern that many states are not providing retroactive remedies in business cases in which institute members have been subjected to illegal state taxes.

While the Reich decision may appear to be limited by the facts of Georgia's situation, "that's never the case with Supreme Court decisions," McCormally said. The decision is "evidence of the court's growing frustration with states' efforts to skirt compliance with [the high court's] earlier decisions," he said.

Carlton Henson, the attorney representing Reich, said questions remain on how Reich and other retirees will obtain refunds.

Henson, who is with the firm McAlpin, Henson & Kearns in Atlanta, said the high court specified that taxpayers such as Reich who filed for refunds should "not now be put in any worse position" for having failed to pursue before-the-fact remedies.

About 45,000 retirees filed for refunds in Georgia, and a tentative settlement had been reached with the state that is subject to approval by the state legislature. The settlement provides for payment in four equal annual installments of the full refunds sought plus 7% interest, which totals in the range of $100 million to $110 million, Henson said.

"We have still to sort out how the opinion affects those terms and whether we think we are better off continuing in court," but the state has indicated a willingness to pursue the settlement, Henson said.

In addition to the taxpayers who filed for refunds, about 50,000 retirees did not file for refunds, which could bring the state's total liability to $200 million or more, Henson said. How those taxpayers would be affected by the ruling is unclear, he said.

Dan Formby, an assistant attorney general for Georgia, had little comment on the decision, other than to say that the next step will be to schedule the remanded proceedings at the Georgia Supreme Court.

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