Litigation over the constitutionality of state tax benefits that began with the municipal bond sector has spread to Section 529 college savings plans. A class action lawsuit filed in Illinois on May 15, 2007 threatens the tax incentives used to induce residents to invest in a state’s own Section 529 college savings plan versus out-of-state 529 plans. The case, Maryam Ahmad v. Illinois Department of Revenue, challenges the constitutionality of the Illinois law that provides a deduction from adjusted gross income of up to $10,000 for residents who invest in the state’s 529 college savings plan, but none for residents who invest in the college savings plans of other states.
According to the lawsuit, Ms.Ahmad, an Illinois resident, has invested in Indiana’s College Choice 529 plan since 2002, because it offers lower fees than either of Illinois’ college saving plans. In addition to asking the court to declare unconstitutional Illinois’ current tax law favoring state residents’ investing in an Illinois529 plan, the lawsuit contends that Ms. Ahmad and other members of the class action are entitled to the tax refunds they would have received had they invested in an Illinois 529 plan. A favorable ruling for Ms. Ahmad could mean that states that currently offer 529 tax breaks only to participants in in-state plans may have to choose between expanding deductions to state residents participating in out-of-state plans or withdrawing 529 tax breaks altogether.
The Ahmad class action was filed a week before the U.S. Supreme Court decided to review a Kentucky case, Davis v. Department of Revenue of Kentucky, in which a Kentucky appellate court held that Kentucky’s practice of exempting from state income taxation interest on municipal bonds issued in Kentucky while taxing interest on municipal bonds issued in other states violates the Commerce Clause of the U.S. Constitution. Kentucky is asking the U.S. Supreme Court to reverse the decision of the Kentucky appellate court. Because there are differences between municipal bonds and Section 529 plans, the eventual U.S.Supreme Court decision in the Davis case will not necessarily be dispositive of the 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. Supreme Court in Davis and/or other courts faced with Ahmad-type litigation decide that non-parity statutes are unconstitutional.
Litigation Threatens Tax Incentives
December 12, 2008
By: Marjorie L. Fox, JD, CFP®,AIF®
Litigation over the constitutionality of state tax benefits that began with the municipal bond sector has spread to Section 529 college savings plans. A class action lawsuit filed in Illinois on May 15, 2007 threatens the tax incentives used to induce residents to invest in a state’s own Section 529 college savings plan versus out-of-state 529 plans. The case, Maryam Ahmad v. Illinois Department of Revenue, challenges the constitutionality of the Illinois law that provides a deduction from adjusted gross income of up to $10,000 for residents who invest in the state’s 529 college savings plan, but none for residents who invest in the college savings plans of other states.
According to the lawsuit, Ms.Ahmad, an Illinois resident, has invested in Indiana’s College Choice 529 plan since 2002, because it offers lower fees than either of Illinois’ college saving plans. In addition to asking the court to declare unconstitutional Illinois’ current tax law favoring state residents’ investing in an Illinois529 plan, the lawsuit contends that Ms. Ahmad and other members of the class action are entitled to the tax refunds they would have received had they invested in an Illinois 529 plan. A favorable ruling for Ms. Ahmad could mean that states that currently offer 529 tax breaks only to participants in in-state plans may have to choose between expanding deductions to state residents participating in out-of-state plans or withdrawing 529 tax breaks altogether.
The Ahmad class action was filed a week before the U.S. Supreme Court decided to review a Kentucky case, Davis v. Department of Revenue of Kentucky, in which a Kentucky appellate court held that Kentucky’s practice of exempting from state income taxation interest on municipal bonds issued in Kentucky while taxing interest on municipal bonds issued in other states violates the Commerce Clause of the U.S. Constitution. Kentucky is asking the U.S. Supreme Court to reverse the decision of the Kentucky appellate court. Because there are differences between municipal bonds and Section 529 plans, the eventual U.S.Supreme Court decision in the Davis case will not necessarily be dispositive of the 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. Supreme Court in Davis and/or other courts faced with Ahmad-type litigation decide that non-parity statutes are unconstitutional.