TAX-EXEMPT TAXATION

LOUIS AND MARY BOLI, a retired couple from Santa Barbara, Calif., are suing the federal government in U.S. Claims Court, Washington, D.C., for the refund of $548 in federal income taxes. The outcome could have an important bearing on the continued ability of port authorities and other state and local government agencies to finance their operations.

The Bolis are challenging the constitutionality of an act of Congress they claim imposes, for the first time, a federal income tax on the interest income of tax-exempt bonds issued by state and local governments.The law is the 1983 Social Security Act, known as Section 86 of the Internal Revenue Code. It requires taxpayers to pay income tax on Social Security benefits if their total income exceeds certain amounts. One of the income items that must be included is interest income from municipal bonds.

Mr. and Mrs. Boli would not have had to pay any 1984 federal income tax had they not owned municipal bonds.

Through their lawyer, Harry D. Shapiro of the Baltimore firm of Venable, Baaetjer and Howard, the Bolis offer two arguments:

* That the inclusion of tax-exempt interest in the formula for taxation of Social Security benefits constitutes a tax on municipal bond interest.

* That such a tax is unconstitutional.

The Bolis hold that the framers of the Constitution recognized, as Alexander Hamilton put it, "that the individual states should possess an independent and uncontrollable authority to raise their own revenues for the supply of their own wants." So did the federal governments.

Two Supreme Court decisions affirmed the right of both levels of government not to be taxed by the other. In 1819, in McCulloch vs. Maryland, it ruled that Maryland could not tax the U.S. National Bank since "the power to tax is the power to destroy." In 1895, in Pollock vs. Farmers Loan and Trust Co., it held that neither could the U.S. government tax the property or instrumentalities of the states.

The Bolis contend, in documents filed with the court, that these decisions have not been overruled and have, in fact, been sustained by subsequent Supreme Court decisions.

The Justice Department, countering these arguments, argues that the 1983 act does not constitute a tax on municipal bonds. Also, on the constitutional issue, that a series of recent cases, none of which refer specifically to municipal bond interest, make the Pollock decision obsolete.

The Public Securities Association, which speaks for the investment banking community on this matter, notes that while one arm of the Justice Department is arguing that federalism no longer applies when it comes to the borrowing powers of state and local governments, another has been busy reaffirming the need for an arm's length relationship between the two levels of government.

In August 1985, it notes, the White House Domestic Policy Council created a working group to develop a strategy to ensure that federal laws and regulations are rooted in "basic constitutional federalism principles." That group, headed by Charles J. Cooper, assistant U.S. attorney general, reported in November.

It cited many examples that the executive, legislative and judicial branches have repeatedly and consistently intruded into the sovereign powers of the states over the past 50 years. The report argued: "Government litigators should recognize - and advocate in appropriate cases - the protection of state sovereignty provided by the constitutional structure of specifically enumerated national powers and generally reserved state powers, as expressly recognized in the Tenth Amendment."

That, say the Bolis, is what their case is all about.

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