Does anyone have thoughts on if being a state government employee ("STATE OF XXXXXX") has any bearing on this?

In addition to my previous information maybe I should have noted I also filled out an "Employee Action Request" form STD. 686. It appears to be the state version of the W-4. Payroll asked for this after I submitted the W-4 (not 12 USC 411). If I recall correctly I received a IRS 3175C letter (no fine) many months later.

Here is a link to a STD. 686 I found on the internet: http://hr.sdsu.edu/pdf/Payroll/EAR.pdf

This is on page 2:

"IF YOU ARE EXEMPT FROM EITHER FEDERAL OR STATE WITHHOLDING, but not exempt from both, contact your personnel office for special instructions."

I am thinking lawful money would be exempt for both.