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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.

Background

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 unconstitutional.

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 unconstitutional. 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.

Ruling

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.

"Tax software is no substitute for tax knowledge."

Any views expressed herein are based on our best information. The content of this web site was written as general information without specific individual information and thus may not apply in all situations. This material was not written, and cannot be used by the taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer.

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Janelle Ogg, EA
Richard Ogg, EA