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Following Kentucky? Kentucky court decision May revolutionize state bond taxation.

the Kentucky Court of Appeals issued an opinion Jan. 6, 2006, that sent shock waves through the CPA and tax adviser professional communities, the municipal bond industry and state finance departments.

Kentucky, like all states with a state income lax, imposes a state income lax upon all municipal bonds, with two exceptions: federal bonds (per the Supremacy Clause in the U.S. Constitution) and bonds issued by Kentucky.

George & Catherine Davis v. Kentucky Department of Revenue it at Docket No. 2004-CA-00 I940-MR) challenged that system. In the case, the Davises sued the Kentucky Department of Revenue on the grounds that it was a violation of the "Commerce Clause" in the U.S. Constitution for Kentucky to exempt its own state bonds while taxing those of other states.

Surprisingly, the Kentucky Court of Appeals agreed, ruling that such a system was indeed "unconstitutional" and that the system was unjust.

While the court's decision is only effective in Kentucky the case has moved to the U.S. Supreme Court and may have national repercussions that could alter the way CPAs and tax advisers handle their clients' financial planning. Before discussing that aspect, some background can shed light on the importance of this issue.

Different States, Same Tune

In each stale that imposes a state income tax. CPAs and tax advisers base their tax planning upon whether a given municipal bond (or bond fund.' holds bonds issued in the same state as the taxpayer or from another state. State finances are affected by the tax scheme in that a state does not lax its own bonds, it can offer its own bonds at a reduced interest rate, taking into account the lax savings of "tax-free" bonds.

The state's income tax rate is usually inversely proportional to the interest rate offered on their own bonds.

For example. New York and California have fairly high tax rates and therefore sell their bonds at much lower interest rates (saving billions of dollars in interest expense; since their residents will buy them based on the after-tax yield.


Some states do not have a state income tax(.and its corresponding "own state bond" exemption) and generally pay a much higher interest rate since they don't have a ready market that will buy their bonds at a lower yield.

Depending upon how high the slate income tax rate is, states ran offer same state bonds at lower interest rates and still compete effectively against bonds from other states, since the specialists that price Lionels take into account the amount of interest "saved'" from the state lax exemption and reduce the gross interest rate they must pay on their stale bonds to offer buyers the same "net" after tax income as other bonds.

Then there is the mutual fund industry.

There are roughly 1,300 different municipal bond funds in the United States specializing in bonds from each slate that doesn't tax their own bonds. Special funds are set up to combine revenue bonds with municipal bonds, state guaranteed bonds with income bonds, etc. Funds and sub funds have developed into a multi billion-dollar industry based on this common system.

Interest on all state bonds is exempt from federal taxation by IRC Sec. 103. The federal government is not required to bestow this "exemption benefit" and it is not a constitutional right. Rather, it is a benefit that serves the purposes of the Congress. Every state with a state income tax follows suit and exempts its own bonds. Again, this "benefit" is granted for reasons of state finance, but has always been deemed a revocable exemption. Therefore, all GPAs, tax planners, financial advisers and slate finance directors took advantage of this general rule that municipal bond income from one's home state is usually tax-free.

CPAs and other tax advisers have used this tax-exempt characteristic to assist clients and have encouraged taxpayer investors to place investment dollars in special "tax-exempt" funds. CPAs and other tax planners also rely heavily upon using municipal bonds for tax advice and strategies regarding estate planning.

Estate planning vehicles like charitable remainder trusts rely heavily upon a "tiered" income system to pass the tax-exempt interest income through to the income beneficiary, while recommending investment in taxable growth securities for the remainder beneficiaries.

However, the Kentucky court's decision may change all the above.


In Davis, the Kentucky Court of Appeals held that the constitutionality test in Kentucky was that something needed only a "rational basis" to be constitutional. Only matters that, are "arbitrary or unreasonable" (See Opinion Section III. B) should be stricken as unconstitutional.

Surprisingly, the court found it. suspicious that out-of-state bonds were taxed differently than Kentucky's state bonds even though this had been going on for about 75 years. The court agreed with the Davises and ruled that limiting the exemption on municipal bond taxation to only Kentucky bonds was "unconstitutional."

While courts have long upheld, modified or struck down tax laws, they almost inevitable do so on grounds oilier than "unconstitutionality" It is the "unconstitutional" basis of this ruling that makes it so unusual and raises so many red flags for CPAs, tax advisers and others; unconstitutional means the decision has the ability to affect the entire United States.

The law in Kentucky today is that all municipal bonds, from whatever state, are not subject to Kentucky's income tax. At minimum, Kentucky is now the first "municipal bond tax haven state."

The change in Kentucky's municipal bond taxation is also a forewarning to (ax clients and others.

If the Davis case is left standing, other stales may be forced to compete in some manner by exempting or lowering that lax rate on interest income from other bonds. To compete they may need to amend their (ax laws to preserve the home state's financial resources and avoid permanently allowing Kentucky to become a municipal bond "tax haven" state.

Repercussions for Rest of Nation?

This remains to be seen. The U.S. Supreme Court heard oral arguments on [his case Nov. 5. At press time, no ruling had been issued. To follow the progress of the case, search for docket number 06-666 at

James T. Graeb, CPA, MBA, JD, L.LM (Taxation) was a senior tax manager at San Francisco-based Bertorelli, Gandi, Won & Behti. You can reach him at

While the court's decision is only effective in Kentucky, it may have national repercussions.
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Title Annotation:taxationissues
Author:Graeb, James T.
Publication:California CPA
Date:May 1, 2008
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