A Kentucky lawsuit decided in early 2006, and a similar tax case now being tried in North Carolina, could spell the demise of single-state municipal bond funds as we know them.

Moreover, if these cases are successful in their bids to equalize the tax treatment of municipal bond income from state-to-state, industry participants worry that in-state deductions for 529 college savings plan contributions as well as the tax-free earnings on these plans could subsequently be targeted.

The closely watched Davis v. the Kentucky Department of Revenue lawsuit was decided in January 2006 in favor of the plaintiff, who balked at the inequity of the tax treatment of municipals bond income. For Kentucky residents, as is the case for residents of about 40 other states, the income derived from muni bonds issued by the Commonwealth of Kentucky is exempt from state taxes. But income from other states' municipal bonds is subject to state tax. (Muni bond income from all states is federally tax-exempt.)

Plaintiffs' lawyers claimed the practice violated the Commerce Clause, a U.S. Constitutional law giving Congress the power to regulate commerce between states and prohibiting states from favoring in-state economic interests. The Kentucky Court of Appeals ruled that providing favorable tax status to in-state muni bond income was, in fact, in violation.

In August 2006, the Kentucky Supreme Court declined to hear the lower court's appeal. In November, the U.S. Supreme Court was petitioned, but has yet to hear and decide this case.

If the high court affirms the previous decision or declines to hear the case, Kentucky's court decision would stand, and Kentucky officials would then be faced with an all-or-nothing decision: levy taxes on all municipal bond income for residents or make all muni bond income uniformly tax-exempt.

"If the Supreme Court doesn't take the case, Kentucky could become the basis for other court cases," said Walter St. Onge, a partner in the Boston office of Edwards, Angell Palmer & Dodge. "It's too premature to ask Congress to do anything, but Congress could regulate that the status quo is permissible."

If the U.S. Supreme Court were to rule that the Kentucky court decision was sound due to a violation of Constitutional law, all states would be impacted. Once a court has made a determination based on a set of facts, "lower courts will adhere to that principle and apply it to all future cases [so that] its application would be effective nationwide," said Caryl Stephens Johnson, an associate with Kaufman & Canoles of Norfolk, Va., and a member of the American Bar Association's public finance committee, state and local section.

The decision could potentially eliminate Kentucky and other single-state muni funds, which would then have little tax savings appeal and potentially force fund advisors to merge them into national muni bond funds, experts predict.

According to Morningstar of Chicago, there are nine Kentucky-only muni bond funds with a collective $1.9 billion in assets; less than 6% of the entire $34 billion held in all single-state muni funds. Kentucky-fund advisors include Aquila Management, BB&T, BlackRock, Eaton Vance, Franklin Templeton, JPMorgan, Nuveen and Dupree.

"I do not think this will spell the end of single-state muni funds," said Diana Herrmann, vice chairman and CEO of Aquila Management, the advisor to the $271 million Churchill Tax-Free Trust of Kentucky. "There is always going to be a need for municipal bonds as a safe and secure place for people to invest," she said.

State tax exemptions aren't the only reason investors flock to muni funds. Florida, for example has no state tax, yet there are several Florida tax-exempt municipal funds available. "I still think there will be a desire for people to invest locally," she added.

The Kentucky case isn't the first of its kind. A 1994 case in Ohio, Shaper v. Tracy, challenged the Ohio state revenue department on similar issues. But the Ohio appeals court ruled that Ohio taxpayers were not entitled to tax relief on out-of-state muni bond income and filed an opinion opposite to that of the Kentucky court.

The U.S. Supreme Court might agree to hear the case because of the conflict between the Kentucky and Ohio decisions, said Merl Hackbart, a professor of finance at the Martin School of Public Policy and Administration at the University of Kentucky in Lexington.

A similar case is now being heard in North Carolina, Dunn vs. North Carolina Department of Revenue, and others are in the works, insiders note.

"Even if you're in the highest 30% Federal tax bracket, in North Carolina, the highest state tax bracket is 7%," said Eugene Schlaman, state and local tax executive director in the Charlotte, N.C., office of accounting firm Grant Thornton. "I still think we'll have these municipals regardless as to what happens."

Since college savings plans are regulated like municipal securities and many offer their own in-state residents deductions for plan contributions and tax-free earnings, could 529s also be challenged?

"It's not really a concern of ours right now, but we have lawyers watching this," said David Lawhorn, program advisor for the Kentucky Higher Educational Assistance Authority, which runs the $98 million Kentucky 529 plan. "We do not have a state tax incentive for the deduction of contributions," he added.

"The Davis case could at some point affect 529s, if someone challenges 529 plans and how they are taxed and not taxed," explained Jackie Williams, executive director of the Ohio Tuition Trust Authority and chairperson of the College Savings Plan Network.

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

http://www.mmexecutive.com http://www.sourcemedia.com

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.