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03/31/87 Stephen J. Andras Et Al., v. the Department of Revenue

March 31, 1987

STEPHEN J. ANDRAS ET AL., PLAINTIFFS-APPELLANTS

v.

THE DEPARTMENT OF REVENUE ET AL., DEFENDANTS-APPELLEES



APPELLATE COURT OF ILLINOIS, SECOND DISTRICT

506 N.E.2d 439, 154 Ill. App. 3d 37, 106 Ill. Dec. 732 1987.IL.410

Appeal from the Circuit Court of Kane County; the Hon. Marvin D. Dunn, Judge, presiding.

APPELLATE Judges:

JUSTICE UNVERZAGT delivered the opinion of the court. INGLIS and REINHARD, JJ., concur.

DECISION OF THE COURT DELIVERED BY THE HONORABLE JUDGE UNVERZAGT

Plaintiffs, Stephen and Betty Andras (hereinafter referred to as the taxpayers), appeal from a judgment of the circuit court of Kane County which affirmed the decision of the Illinois Department of Revenue concluding that they could not deduct from their gross income for Illinois income tax purposes distributions received by them from the Trust for Short-Term U.S. Government Securities (the Trust). The Trust is also a plaintiff in this appeal.

The facts are not disputed. The Trust was established as a Massachusetts business trust and operates as a regulated investment company, as defined in section 851(a) of the Internal Revenue Code (26 U.S.C. sec. 851(a) (1982)), and commonly known as a mutual fund. Investors buy shares in the Trust through a distributor and receive dividends on those shares on a monthly basis. With the exception of its expenses, the Trust pays out all of its net income to its shareholders in dividends. The Trust invests exclusively in short-term United States government securities, the interest on which is exempted from State taxation by Federal law. (31 U.S.C. sec. 742 (1976)).1 The Illinois Department of Revenue (hereinafter referred to as the Department) refused to apply the exemption to taxpayers' dividend income, however, finding that the Trust is taxable under Illinois law as a corporation and is therefore a distinct taxable entity which cannot pass its exemptions through to its shareholders unless the pass-through is specifically authorized by statute. In addition, the Department found that certain repurchase agreements involving government securities were in fact loans by the Trust to the sellers and that the interest on them was therefore ordinary rather than tax-exempt income.

There are two issues presented for appeal: (1) whether section 742 of title 31 requires States to exempt from State income taxation dividend income paid to shareholders of mutual funds which pay out their entire net income in dividends on a regular basis, and (2) whether income from the Trust's repurchase agreements involving government securities is tax-exempt. I

Section 742 (31 U.S.C. sec. 742 (1976)) exempts United States government securities and the interest received on them from State taxation. Plaintiffs argue that, in its decision in American Bank & Trust Co. v. Dallas County (1983), 463 U.S. 855, 77 L. Ed. 2d 1072, 103 S. Ct. 3369, the United States Supreme Court held that there are no implied exceptions to section 742 -- not even the historical distinction between a corporation and its shareholders on which the Department relies.

We will review the history of section 742 and some earlier Supreme Court cases before discussing the American Bank & Trust decision. Two landmark decisions of the Supreme Court established that the constitution necessarily immunizes the Federal government (McCulloch v. Maryland (1819), 17 U.S. (4 Wheat.) 316, 4 L. Ed. 579) and obligations of the Federal government from State taxation (Weston v. City Council (1829), 27 U.S. (2 Pet.) 449, 7 L. Ed. 481). Section 742 is the most recent in a succession of statutes which codified that constitutional rule. (See First National Bank v. Bartow County Board of Tax Assessors (1985), 470 U.S. 583, 592-93, 84 L. Ed. 2d 535, 543, 105 S. Ct. 1516, 1522; Memphis Bank & Trust Co. v. Garner (1983), 459 U.S. 392, 397, 74 L. Ed. 2d 562, 567, 103 S. Ct. 692, 695; Society for Savings v. Bowers (1954), 349 U.S. 143, 144, 99 L. Ed. 950, 955, 75 S. Ct. 607, 608.) The Illinois Supreme Court has acknowledged this as the purpose of section 742. Rockford Life Insurance Co. v. Department of Revenue (1986), 112 Ill. 2d 174, 178-79.

In 1866, the Supreme Court decided Van Allen v. Assessors (1866), 70 U.S. (3 Wall.) 573, 18 L. Ed. 229, in which taxpayers challenged State taxes imposed on shareholders' interests in several national banks, claiming that the property should be immune from State taxation under the earliest predecessor of section 742. The court stated that a shareholder's interest in a corporation is a "distinct, independent interest or property" not equivalent to the corporation's interest in its assets and concluded that, in any event, the National Bank Act affirmatively authorized States to tax shareholders of national banks. (70 U.S. (3 Wall.) 573, 584-86, 18 L. Ed. 229, 234-35.) In Cleveland Trust Co. v. Lander (1902), 184 U.S. 111, 46 L. Ed. 456, 22 S. Ct. 394, the same immunity argument was raised by taxpayers who, like the plaintiffs here, were shareholders in a trust company which had invested in United States government securities. The court again rejected the argument, relying on Van Allen, and held that granting the shareholders immunity from State taxation would destroy the distinction between the trust company and its shareholders (184 U.S. 111, 114-15, 46 L. Ed. 456, 458, 22 S. Ct. 394, 395-96) and that applying the immunity rule would put shareholders of a trust in a more advantageous position than shareholders of a national bank (184 U.S. 111, 113, 46 L. Ed. 456, 458, 22 S. Ct. 394, 395.) The Van Allen rule was more recently applied in Society for Savings v. Bowers (1955), 349 U.S. 143, 147, 99 L. Ed. 950, 957, 75 S. Ct. 607, 609-610, in which the court again concluded that a stockholder's interest was a property interest distinct from the corporation's assets.

Each of the above decisions, however, was decided prior to the 1959 amendment of section 742. Until 1959, the section provided: "[a]ll stocks, bonds, Treasury notes, and other obligations of the United States, shall be exempt from taxation by or under State or municipal or local authority." (31 U.S.C. sec. 742 (1976).) It was amended in 1959 by the addition of the following language:

"This exemption extends to every form of taxation that would require that either the obligations or the interest thereon, or both, be considered, directly or indirectly, in the computation of the tax, except nondiscriminatory franchise or other nonproperty taxes in lieu thereof imposed on corporations and except estate taxes or inheritance taxes." 31 U.S.C. sec. 742 (1976).2

In American Bank & Trust Co. v. Dallas County (1983), 463 U.S. 855, 77 L. Ed. 2d 1072, 103 S. Ct. 3369, the Supreme Court considered the effect of the additional language on the distinction recognized since Van Allen between a State property tax imposed directly on a national bank and one imposed only on its shareholders' interests. The court noted that in addition to the change to the language of section 742, there is no longer any affirmative statutory authorization for a State to tax shareholders' interests in a national bank. (463 U.S. 855, 868, 77 L. Ed. 2d 1072, 1082-83, 103 S. Ct. 3369, 3378.) The court invalidated the tax, holding that the amendment "abolished the formalistic inquiry whether the tax is on a distinct interest and replaced it with the inquiry whether 'computation of the tax' requires consideration of federal obligations." (463 U.S. 855, 867, 77 L. Ed. 2d 1072, 1082, 103 S. Ct. 3369, 3377.) The court stated that the new language indicated a congressional intent "to sweep away formal distinctions and to invalidate all taxes measured directly or indirectly by the value of federal obligations, except those specified in the amendment." (463 U.S. 855, 867, 77 L. Ed. 2d 1072, 1082, 103 S. Ct. 3369, 3377.) In discussing Van Allen, Cleveland Trust, and Society for Savings, the court stated that the prior version of section 742 permitted taxing the ...


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