Suit threatens tax incentives for 529 plans

Jun 25, 2007 @ 12:01 am

By Charles Paikert

NEW YORK — The college savings plan industry is closely tracking a class action filed in Illinois last month that could help open the legal floodgates for states that use tax incentives to induce residents to invest in their own Section 529 programs. The case, Maryam Ahmad v. Illinois Department of Revenue, challenges the constitutionality of the Illinois law that provides tax breaks for residents who invest in the state’s 529 college savings program but none for residents who invest in those of other states. “It’s a very significant case that the industry is clearly monitoring,” said Peter Mazareas, chief executive of Nahant, Mass.-based Strategic Advancement Group Inc. and treasurer of the College Savings Foundation, a Washington-based industry trade group. “State to state, we’re hearing a lot of dissatisfaction with tax treatment [of 529 plans], and we’re anticipating other cases might be brought around the country, as well.” The Ahmad case “could well be the first of many filed against states that use tax incentives to induce their residents to participate in the state’s own 529 program versus other states’ programs,” confirmed 529 legal expert Len Weiser-Varon, a partner in Boston law firm Mintz Levin Cohn Ferris Glovsky & Popeo PC. Ahmad v. Illinois, which was filed in the Circuit Court of Cook County, is viewed widely as being closely tied to another tax parity case, Davis v. Department of Revenue of Kentucky, which will be heard by the Supreme Court in the fall. Davis centers on a Kentucky statute that gives residents a tax break on municipal bonds issued by that state but not on those from other states. Section 529 plans are considered municipal offerings. The Kentucky statute was ruled unconstitutional last year by the state’s appellate court, and Kentucky is asking the Supreme Court to reverse the decision. If, however, the decision is upheld, states may be forced into allowing tax parity for the college savings plans, meaning either every resident who invests in any 529 plan in the country gets a tax break or no one does.

Noting the “incredible parallels” between the Ahmad and Davis cases, Matthew Hurst, a partner in Chicago law firm Susman Heffner & Hurst LLP, said it is likely that the Supreme Court’s ruling in Davis “could either decide the [Ahmad case] issue or cloud it further.”

His firm represents Maryam Ahmad; Arthur Susman, an attorney in Susman Heffner, was a partner in Susman Walker & Wiley, also of Chicago, which filed the Davis case.

Susman Heffner & Hurst will be added as counsel for Davis in its defense in the Supreme Court, according to Mr. Hurst.

In addition, the College Savings Foundation is considering filing an amicus curiae, or “friend of the court,” brief on the Davis case, according to CSF board member Bruce Harrington, who also is vice president and director of product management of 529 savings plans at Boston-based MFS Investment Management Inc. An amicus brief, which is a voluntary action taken by someone not a party to the case to assist the court in deciding the matter, may not be admitted by the court.

All or nothing

According to the lawsuit, Ms. Ahmad, an Illinois resident, has invested in Indiana’s CollegeChoice 529 plan since 2002, because it offers lower fees than either of Illinois’ college saving programs, Bright Start or Bright Directions.

Mr. Hurst said that his firm and Ms. Ahmad, an attorney with whom Mr. Hurst previously had worked, felt that the Illinois tax law was “worth challenging … to allow [529 college savings plan] participants to make rational economic decisions based on the cost of the plan.”

In addition to asking the court to declare unconstitutional Illinois’ current tax law favoring state residents’ investing in Illinois 529 plans, the lawsuit contends that Ms. Ahmad and other members of the class action are entitled to the tax refunds they would have received had they invested in an Illinois 529 plan.

A favorable ruling for Ms. Ahmad, according to 529 plan observers, could mean the 27 states that currently offer 529 tax breaks only to participants in in-state plans may have to choose between expanding deductions to state residents participating in out-of-state plans or withdrawing the 529 tax breaks altogether.

“States would have to make that decision on public policy reality and in the context of the fiscal impact on the state,” said Jackie Williams, executive director of the Columbus-based Ohio Tuition Trust Authority and chairwoman of the Lexington, Ky.-based College Savings Plans Network, the trade group for state administrators of 529 programs.

States that forecast a negative fiscal impact might well rescind all 529 tax deductions, she said.

The CSF, which comprises financial services companies that serve as the program managers for 529 plans, has been a staunch supporter of tax parity for 529 plans, which currently exists only in Pennsylvania, Maine and Kansas.

“We are all for states’ providing incentives for people to save for college,” said David Pearlman, CSF chairman, and senior vice president and deputy general counsel for Boston-based Fidelity Investments. “We hope they do it for all programs.”

The CSF, Mr. Pearlman said, “continues to work on selected tax parity statutory initiatives,” most recently in Arizona, where a bill including 529 tax parity was passed by the Legislature last week and is expected to be signed by the governor.

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