In a decision Oct. 17, the N.C. Court of Appeals rejected an attempt by North Carolina to prohibit a class-action lawsuit challenging the constitutionality of taxes. The ruling comes in an as-yet undecided case about the legality of state income taxes on out-of-state but not in-state issued bonds.
In November 2003, Lessie J. Dunn and Erwin W. Cook, Jr. asked North Carolina to refund to them income taxes they had paid on interest from state and municipal bonds they held that were issued outside North Carolina. When the state refused, Dunn and Cook sued, contending that the preferential tax treatment for bonds issued in-state violated the Constitution’s Commerce Clause.
The courts have not addressed whether there is indeed a Commerce Clause violation. North Carolina, however, is not contesting just the constitutionality of the tax. It is also seeking to prevent Dunn and Cook’s challenge from proceeding as a class-action lawsuit, a single challenge to the tax for all taxpayers who had paid the tax, regardless of whether they had previously contested the tax. If the state’s challenge is successful, it would greatly reduce the state’s financial exposure if the tax were ultimately found to be unconstitutional, as those who had not taken the time, effort, and expense to contest the tax payments within the three-year deadline would not be entitled to a refund.
Without class-action status, the small out-of-pocket benefit to individual taxpayers of eliminating an unconstitutional tax compared to the expense of suing makes it much less likely that the tax will be challenged in court.
After the case was certified as a class action by Superior Court Judge Lindsay Davis, the state appealed to the state’s second highest court, the N.C. Court of Appeals. Court of Appeals rulings are binding legal precedent on questions of North Carolina law unless the decision is reviewed and overturned by the N.C. Supreme Court. Whatever determinations the Court of Appeals made regarding the procedures for challenging the constitutionality of a state tax in this case will likely be the rules in force for any future challenges as well.
On appeal, the state contended that each person affected by the allegedly unconstitutional tax was required to individually object, or, in other words, that a class-action suit to recover money challenging the tax was not allowed under state law.
This same issue has arisen previously. In 1998, the N.C. Supreme Court, in a case called Bailey II, held that the “purpose underlying the requirements of section 105-267 is to put the State on notice that a tax, or a particular application thereof, is being challenged as improper so that the State might properly budget or plan for the potential that certain revenues derived from such tax have to be refunded.” (Emphasis in original ruling.)
From this, the high court reasoned that it was unjust to limit recover only to those that had filed a claim objecting to the tax.
Applying this precedent, the Court of Appeals would (and did) have little trouble in finding that those individual taxpayers who didn’t challenge the tax might be included in a class-action lawsuit against the state.
The state, however, argued that the Supreme Court’s holding Bailey II should not be applied in this case because the underlying facts were different. These differences, the government argued, included the uncertainty of the total amount the state might be liable for if the tax were declared unconstitutional and the recent changes in state law giving taxpayers much longer to protest a tax.
The appeals court, however, found that the underlying rational in Bailey II to still apply — that the state was being placed upon notice that by a lawsuit being filed that the constitutionality of a tax was being questioned.
“Once notice is received, the burden is on the State to determine its potential exposure and to plan accordingly,” Judge Linda Stephens wrote for the Court of Appeals.
The state also argued that the Bailey IIdecision is distinguishable because the General Assembly has since changed the period to challenge a tax from 30 days to three years. The Court of Appeals was not swayed by this argument.
“Had the General Assembly wanted to modify the notice requirements of N.C. Gen. Stat. § 105-267 and thus weaken the Bailey II decision, we believe it would have specifically and directly done so, rather than leaving it to litigants and Courts to speculate that, by increasing a taxpayer’s protest period, the Legislature also changed the statutory notice requirement as defined by our Supreme Court,” Stephens wrote. “Other than argument, Defendants offer no evidence that this is what the Legislature intended, and we decline to make this leap.”
The state also argued that if a class action were certified, it should not extend to include corporations, estates, and trust. The Court of Appeals rejected this argument.
“Most significantly, however, although individuals, estates and trusts, and corporations pay tax under different statutory provisions, in this litigation, each group is contesting the adjustment to taxable income under N.C. Gen. Stat. § 105-134.6(b)(1)b and N.C. Gen. Stat. § 134.6(c)(1), that is, each group is alleging that the same law… is unconstitutional,” Stephens wrote.
“Therefore, the named Plaintiffs have more than a technical or official interest in the subject matter of this lawsuit affecting corporations or estates and trusts; their interest is personal. Accordingly, once the named Plaintiffs established standing to proceed on the individual claims, they were entitled, under Rule 23, to represent not only other individuals, but also non-individual taxpayers, specifically, estates and trusts, and corporations.”
Because the decision by the three-judge panel of the Court of Appeals was unanimous, the N.C. Supreme Court is not required to take the case even if the state further appeals.
The case is Dunn v. State, (05-1178).
Michael Lowrey is an associate editor of Carolina Journal.