Taxable Talk

The Supreme Court ruled today in Dept. of Revenue v. Davis that states can give preferential treatment to their own municipal bonds (over those of other states). Thus, the practice of paying state income tax on out-of-state municipal bonds will continue. The Supreme Court ruling was fractured, with Justice Souter's opinion, four concurring opinions, and two dissenting opinions.

The main impact of this decision is that municipal bonds will tend to be purchased by individuals who reside in that state, so that they can obtain the largest tax impact. The decision is good news for California, as a decision that would have invalidated preferential treatment would have likely cost the state millions of dollars in additional interest.


Link to previous coverage of this case on Taxable Talk

As I noted, yesterday the Supreme Court heard oral arguments in Kentucky Department of Revenue v. Davis. Today, the TaxProf Blog has the views of Professors Gregory Germain of Syracuse University and Bradley Joondeph of the University of Santa Clara. They both believe that Kentucky will prevail.

You can read their opinions here.

The Supreme Court heard arguments in Kentucky Department of Revenue v. Davis today. The Scotusblog has a good discussion of the arguments that were made today.

The case, as I've mentioned before, is on whether or not states can favor their own municipal bonds and grant them tax-exempt status while not granting tax-exempt status for out-of-state municipal bonds.

A decision will likely not be announced until early in 2008.

As I mentioned previously, the Supreme Court will hear Department of Revenue v. Davis this Fall. If the Supreme Court rules for the Kentucky Department of Revenue (overturning the Kentucky Court of Appeals), then nothing will change, and states will be able to continue discriminate in favor of their own municipal bond interest for tax deductions. However, if the Court upholds the decision, then states will have to choose between taxing no municipal bond interest and taxing all municipal bond interest.

California allows taxpayers to file protective claims on issues that have not been decided. This is one such issue. I hadn't advised clients to file such claims yet because the Franchise Tax Board wasn't ready. Indeed, the FTB denied such claims. If you filed such a claim, and it was denied and the status is final, you must appeal to the State Board of Equalization or you will lose your claim.

The FTB is no longer denying such claims, and is now accepting protective claims. If you are impacted by this issue, and wish to file such a protective claim, you can do so by mailing such claims to:

FRANCHISE TAX BOARD
PO BOX 942867
SACRAMENTO CA 94267-2222

Make sure you note that you are filing a protective claim on the "Department of Revenue v. Davis" decision. Any client who feels that they are impacted by this should contact our office so we can advise them on this issue.

As I mentioned in May, the Supreme Court will be looking at the taxing of municipal bonds later this year (Department of Revenue v. Davis). There's an interesting article that I found that analyzes what the Supreme Court will likely do; "Muni Bonds and the Commerce Clause After United Haulers."

The law professors who wrote this article, Ethan Yale and Brian Galle, conclude that the Supreme Court will not overturn the Kentucky Court of Appeals ruling that taxing out-of-state municipal bonds while not taxing in-state municipal bonds is unconstitutional. The article is quite interesting; those with an interest in the case should read it.

Of course there's a huge caveat—trying to guess what the Supreme Court will do is very difficult.

The Supreme Court doesn't decide many tax cases. They're usually not that interesting, and it's rare to see a split among the different circuits in a tax issue. However, a very important tax case will be decided in the next Supreme Court term (beginning in October): Department of Revenue v. Davis.

In 2006 the Kentucky Court of Appeals (the Kentucky Supreme Court declined to hear the case) held that, "...[W]e find that Kentucky’s tax on the income derived from bonds issued outside Kentucky violates the Commerce Clause of the United States Constitution, we vacate and remand."

Why is this important? If you live in a state with a state income tax, and you own municipal bonds issued by your state, you do not pay income tax on those bonds. However, if you own bonds issued by another state you almost certainly do pay income tax on those bonds. The Kentucky ruling says that's illegal—it violates the dormant commerce clause of the U.S. Constitution.

To no one's surprise, the National Association of State Treasurers doesn't like this ruling; they will be filing an amicus brief on the case. The Kentucky Department of Revenue doesn't like the ruling; it will cost the state money. Indeed, high tax states (and Kentucky is not one of those) like this ruling even less. If the Court of Appeals ruling is upheld, bonds issued by high tax states (such as California) will need to pay a higher interest rate, costing the states money.

The case will be heard late this year; a decision isn't likely to be announced until early 2008. If you own municipal bonds from a state other than your own, pay attention to the decision. If you paid enough tax from these bonds and the ruling is upheld by the Supreme Court, you may be able to amend your state tax return seeking a refund of tax.

The TaxProfBlog has more on this case, and you can find news stories at Bloomberg and elsewhere.

Hat Tip: TaxProfBlog