US Supreme Court Leaves Interest Alone
This update is for any who deal with non-taxable interest from governments
and the potential that those rules were changing. The US Supreme Court
(May 19, 2008) decided to leave the rules as they have been.
Most states provide that interest earned from bonds sold by governments within
the state is exempt from (state) income taxes. The reason for this is to assist
local governments in raising money for public benefit by structuring the tax
code such that they can pay below-market rates in interest. Since that
interest is exempt from state taxes, the net after-tax benefit for the investor
is the same as
for investments in private (corporate) bonds that are paying market rates.
The issue is that most states do not permit this favorable tax treatment
for interest earned from government bonds issued by governments outside
the state. A 2003 law suit suggested that this unequal treatment was
In the suit the Circuit Court for Jefferson County ruled in favor of the
Kentucky Department of Revenue, but the Davises appealed.
The Kentucky Court of Appeals reversed that and ruled the state law as
The Kentucky Department of Revenue appealed to the Kentucky Supreme Court
but was denied a hearing. The Kentucky Department of Revenue then appealed
to the US Supreme Court which did hear the case.
The US Supreme Court ruled that such inequitable treatment is acceptable. The
basis for the decision appears to be that cities are an extension of the
state government. It does not make sense for a government to tax the money
it pays out. So exclusion is logical.
Because cities in a different state are not an extension of the local state
the taxation of the income does make sense.
Of course the opinion is much longer, and there was not only a dissenting
opinion of those judges who voted contrary, but a separate opinion for the
reasoning of the majority view. Those particularly interested may want
to read all three perspectives.