ATLANTA - Ending a legal battle that has clouded South Carolina's finances for almost five years, state officials have agreed to an $85 million settlement of a lawsuit filed by retirees who had claimed unfair taxation of their federal pensions.

The settlement, reached on Tuesday, calls for repayment of state taxes collected on the pensions between 1985 and 1988. The agreement now must be approved by the state's 15th Circuit Court in Horry County, where the lawsuit was originally filed in April 1989.

The payout figure is an estimate of reimbursement to retirees who filed for the refund by April 15, 1992. It includes 3% interest on payment due.

An official at the circuit court said a hearing on the lawsuit has been set for Dec. 28, but was unable to provide further information.

State officials had been apprehensive that they faced repayment of more than $200 million had a higher interest rate been ordered by the court, or the filing period extended.

"Putting this issue behind us is a big step for the state and is part of a pattern of good news for South Carolina over the last year," state Treasurer Grady Patterson Jr. said in an interview.

Patterson said the agreement reached between the retirees and the state's five-member Budget Control Board, on which he serves, calls for repayment in up to three installments. He said $30 million will be paid by June 1, with the remaining $55 million divided between payments sent by Oct. 10, 1994, and, if necessary, June 30, 1995.

The treasurer said that he expects the $30 million to be appropriated by the state legislature during the upcoming regular session, which begins in January. He said legislative leaders have agreed to back a plan to cover the $30 million with the state's fiscal 1993 surplus, which he said has recently been pegged at 100 million. The 1993 fiscal year ended June 30.

Patterson said the remaining $55 million will come from a similar legislative appropriation of the expected surplus for fiscal 1994. Based on current revenue collections, officials expect the 1994 surplus to total at least $75 million.

Tucker Eskew, Gov. Carroll A Campbell Jr.'s press secretary, said yesterday that the governor "was very pleased that a settlement has occurred."

Eskew said that in presenting his $3.96 billion general fund budget for fiscal 1995, Campbell yesterday pledged to cover settlement of the retirees' lawsuit. He said Campbell would ask for total appropriations of $70 million for the settlement, including $30 million from the fiscal 1993 surplus and $40 million from the expected fiscal 1995 surplus. He said he would ask for $15 million more if the repayment figure reached $85 million.

"The $85 million was a top figure for the settlement; we don't realistically expect the final number to go above $70 million," Eskew said.

Patterson hailed the settlement of the lawsuit and the emergence of the surplus as part of an "amazing turn-around" in the state's financial condition in the past year and a half

During 1993, he noted, the state replenished its rainy-day reserve fund, which now stands at $167 million; changed its revenue estimating procedure for the annual budget; and agreed to reduce income tax withholding.

He also said that the state revenue collections are running "comfortably ahead of projections" in 1993 following lower-than-expected revenues in 1992.

All of these factors, Patterson said, should encourage Standard & Poor's Corp. to re-evaluate its downgrade in January 1993 of the state's general obligation debt to AA plus from AAA.

"We ask that they recognize this dramatic change in our financial position, all of which has been accomplished without a tax increase," he said.

At the time, Standard & Poor's said it lowered the rating because of the state's weakened financial position over the previous four years. In particular, analysts pointed to a $255 million deficit in the state's accumulated balance on a budgetary basis.

Standard & Poor's director Richard Marino said yesterday that the settlement of the lawsuit was a "positive step" for South Carolina.

Addressing Patterson's contention that the state has considerably improved its fiscal status and should be considered for an upgrade, Marino said. "South Carolina has made some progress, but we would like to see a longer track record."

"In coming to a decision on a change in rating, we are not going to rely on projections but on results," he said.

Moody's Investors Service and Fitch Investors Service rate the state's GOs at triple-A.

The South Carolina retirees' lawsuit followed a 1989 U.S. Supreme Court ruling, Davis v. Michigan Department of Revenue, that found Michigan had discriminated against a federal retiree by taxing his pension while exempting state employees' pensions from taxation. Following the ruling, similar lawsuits were filed in a number of states.

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