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

• Author: Graeb, James T.
• Position: Taxationissues

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.

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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...