Litigation Threatens Tax Incentives
By: Marjorie L. Fox, JD, CFP®,AIF®
Litigation over theconstitutionality of state tax benefits that began with the municipal bondsector has spread to Section 529 college savings plans. A class actionlawsuit filed in Illinois on May 15, 2007 threatens the tax incentives used toinduce residents to invest in a state's own Section 529 college savings planversus out-of-state 529 plans. The case, Maryam Ahmad v. IllinoisDepartment of Revenue, challenges the constitutionality of the Illinois lawthat provides a deduction from adjusted gross income of up to $10,000 forresidents who invest in the state's 529 college savings plan, but none forresidents who invest in the college savings plans of other states.
According to the lawsuit, Ms.Ahmad, an Illinois resident, has invested in Indiana's CollegeChoice 529 plansince 2002, because it offers lower fees than either of Illinois' collegesaving plans. In addition to asking the court to declare unconstitutionalIllinois' current tax law favoring state residents' investing in an Illinois529 plan, the lawsuit contends that Ms. Ahmad and other members of the classaction are entitled to the tax refunds they would have received had theyinvested in an Illinois 529 plan. A favorable ruling for Ms. Ahmad couldmean that states that currently offer 529 tax breaks only to participants inin-state plans may have to choose between expanding deductions to stateresidents participating in out-of-state plans or withdrawing 529 tax breaksaltogether.
TheAhmad class action was filed a week before the U.S. Supreme Court decided toreview a Kentucky case, Davis v. Department of Revenue of Kentucky, in which aKentucky appellate court held that Kentucky's practice of exempting from stateincome taxation interest on municipal bonds issued in Kentucky while taxinginterest on municipal bonds issued in other states violates the Commerce Clauseof the U.S. Constitution. Kentucky is asking the U.S. Supreme Court toreverse the decision of the Kentucky appellate court. Because there aredifferences between municipal bonds and Section 529 plans, the eventual U.S.Supreme Court decision in the Davis case will not necessarily be dispositive ofthe constitutionality of non-parity tax treatment of out-of-state Section 529plans. However,since tax parity for 529 plans exists only in Pennsylvania, Maine and Kansas,our clients in Virginia, Maryland, et al. will be impacted if the U.S. SupremeCourt in Davis and/or other courts faced with Ahmad-type litigation decide thatnon-parity statutes are unconstitutional.