The tax-free provisions of college savings plans and other state programs could be significantly curtailed if the Supreme Court decides to review a Kentucky court ruling that found it unconstitutional for Kentucky to tax municipal bonds issued in other states, while not taxing those issued in-state, a lawyer stated this week.

Speaking at a federal outlook session during the National Association of State Treasurers’ annual legislative conference, Richard Sigal, a partner at Hawkins, Delafield & Wood, said college savings plans, state programs to exempt students’ tuition fees from state taxes, and even city and state programs that hire in-state contractors could all be affected by a high court review of the ruling in Kentucky v. Davis.

Sigal later said the case could impact a broad range of state programs that offer tax or other preferences for in-state versus out-of-state entities or individuals.

College savings plans, which every state has established under Section 529 of the Internal Revenue Code, allow adults to save money in special accounts that will be free from federal income tax when used to pay for the “qualified higher education expenses” of their children or other beneficiaries. Many states try to lure residents to their in-state programs by offering them a deduction on personal income tax returns for contributions to these plans.

If the Supreme Court decides to review Kentucky v. Davis and sides with the state appeals court ruling that it is unconstitutional to tax out-of-state but not in-state issued bonds, the same reasoning could be applied to 529 plans and could wipe out the state tax advantages that many states offer, Sigal said.

Kentucky asked the Supreme Court last November to review the appeals court ruling, which the state’s high court declined to review and let stand. George W. Davis and Catherine V. Davis, who sued the state over the issue, owned a lot of bonds issued by other states and were protesting having to pay taxes on those bonds, but not the bonds issued in-state.

The municipal market has been waiting for weeks to see whether the Supreme Court will take up the case. At least 38 states refrain from taxing bonds issued instate, Sigal said. But other states have different policies. Utah has a reciprocal program under which it exempts taxes on bonds issued by states that exempt taxes on bonds issued by Utah and its authorities. Indiana exempts taxes on all municipal bonds regardless of where they are issued, he said.

Meanwhile, Ken Roberts, another partner at Hawkins who spoke at the same session, said the University of Kentucky is trying to see if it can create a model that can be used to study how eliminating state taxes on muni bonds would affect various states.

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.