An intended class-action lawsuit filed in Illinois in mid-May has the potential to challenge how all state Treasury offices apply tax deductions for contributions to in-state, versus out-of-state, 529 college savings plans.

At the center of the lawsuit are the tax incentives that many states extend to residents allowing them a tax deduction for each year's contribution to a 529 plan sponsored by their home state's Treasury. However, tax deductions for similar contributions made to 529 plans operated by other states are generally not allowed. That policy of providing favorable tax incentives for in-state contributions over contributions to out-of-state plans is unconstitutional, charges the Illinois lawsuit, and could spark major changes to all state plans.

On May 15, the Chicago law firm of Susman Heffner & Hurst filed the lawsuit in Cook County, Ill., Circuit Court on behalf of Maryam Ahmad. Ahmad is a resident of Illinois and a practicing attorney with the Cook County Public Defender's office.

According to the complaint, filed against the Illinois Department of Revenue and its director, Brian Hamel, despite being a resident of Illinois, Ahmad has been contributing since 2002 to the Indiana CollegeChoice 529 college savings plan for her son. Ahmad decided to allocate her contributions to Indiana's plan, in part, because of the higher plan fees and expenses in the Illinois plan. Indiana's plan charges a fraction of the fees levied under the Illinois plans.

Ahmad's plan contributions, however, were not deductible from her Illinois resident income taxes because Illinois does not recognize out-of-state 529 plan contributions.

That unequal tax treatment is discriminatory and makes other states' plans "less desirable, from a tax perspective," the lawsuit charges. "As a result, decisions by Illinois taxpayers regarding which section 529 plan to invest in are not made on a tax-neutral basis," the lawsuit added.

It continued: "Preferential tax treatment of contributions to its own section 529 plan constitutes an unlawful burden on interstate commerce and discriminates against interstate commerce in violation of the U.S. Constitution."

"This lawsuit makes sure that people can make rational decisions based upon the true cost of the 529 program rather than tax incentives offered," said Matt Hurst, a partner with Susman Heffner & Hurst and the plaintiff's attorney. "This is really a case of trying to make sure the economic playing field is restored to help people make the right decision. We are looking at this from both a Constitutional and economic perspective." Ahmad is seeking tax refunds on the non-deductible contributions she made to Indiana's plan.

A representative with the Illinois governor's office had not returned a call seeking comment.

This lawsuit challenges a provision of the Constitution called the "Commerce Clause," which prohibits states from favoring in-state economic interests. This same provision was challenged in 1994 in Ohio (predating the IRS section that allowed for the creation of college savings plans) under different circumstances surrounding the tax treatment of municipal bond income. The issue rose again in 2006 in a Kentucky court relating to in-state versus out-of-state muni bond income. But the two state courts' rulings opposed each other. A similar case is now pending in North Carolina.

This past May, the U.S. Supreme Court agreed to hear the facts of the Kentucky case this coming September, and is expected to render a decision by June 2008. That ruling could usurp any state court decisions and have far-reaching implications for the future tax incentives offered on 529 plans.

"This is a dynamic, developmental industry. We're in an evolutionary state in this business," said Jackie Williams, executive director of the Ohio Tuition Trust Authority and chairman of the College Savings Plan Network. She concedes that as the industry has grown, changes are being made by state officials, who have residents' best interests in mind and want to provide incentives for all residents to save for college. The original intent when plans were first developed was never to be unfair or discriminatory, she said.

"There may be the necessity for states to make changes," Williams said. Depending on the eventual court decisions, states may abolish the tax deductions for contributions altogether or allow deductions for any state's 529 plan investments, just as states have been signing new contracts with firms, reassessing their 529 plans' viability, changing administrators, cutting fees and considering different investment choices.

"I'd personally like to see a state tax deduction for contributions to any plan, but there's not a consensus on this within the 529 plan industry," said Burt Baker, president of 1693 Analytics, a financial advisory firm in Williamsburg, Va.

Pennsylvania offers the most progressive plan. Under a July 2006 change to the state's college savings plan, Pennsylvania allows residents to take tax deductions for contributions made to any state-sponsored 529 plan. However, a handful of states, including Kentucky, offer no tax deductions at all.

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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