CHICAGO -- The Internal Revenue Service this week asked for a rehearing before a federal appellate court that last month found Michigan's prepaid tuition program to be tax-exempt.

An attorney for the Justice Department said yesterday that the petition for a rehearing before the entire court was sent Tuesday to the U.S. Court of Appeals for the Sixth Circuit in Cincinnati.

The court ruled against the IRS on Nov. 8 by reversing a district court decision on the tax status of the Michigan Education Trust. The appellate court also granted the trust a tax refund of $57.4 million plus interest.

In a 2-to-1 decision, the appellate court reversed a July 1992 district court ruling that supported the IRS' decision not to exempt the trust from federal taxation. The lower court found that the trust is not an "integral part of the state of Michigan" and is subject to the IRS code. The court also ruled that the program's income was not exempt from taxation "because the income does not accrue to the state of Michigan or one of its political subdivisions."

In its reversal, the appellate court agreed with Michigan's characterization of the education trust as an integral part of state government and similar to other state agencies that have not been subject to federal taxation.

The court found that the trust "is a public agency explicitly authorized to exercise contracting powers on behalf of the state for a purpose that the legislature has declared public."

Michigan filed the lawsuit in May 1990 after receiving a letter ruling from the IRS denying the trust a tax exemption. State officials said the lawsuit was probably the first to challenge federal taxation of state-run prepaid tuition programs.

John Collins, a lawyer with Miller, Canfield, Paddock & Stone who serves as a special attorney general for Michigan in the case, said yesterday that the petition for a rehearing was not unexpected.

"At this point, we're awaiting the court's direction whether or not there will be a rehearing," he said.

Under Michigan's six-year-old program, people can buy contracts from the trust to cover the cost of their children's college education. The trust invests the money in preferred stocks and corporate bonds, and guarantees the tuition cost of the contract's beneficiary at a state-run college or university.

Michigan stopped selling the contracts in 1991. As of last month, the trust had 54,200 contracts and assets of $502 million.

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