CHICAGO -- Michigan will appeal a July 28 federal court decision that found the state's prepaid college tuition program is not exempt from federal taxation, state Treasurer Doug Roberts said yesterday.

The Michigan Education Trust board voted yesterday to appeal the decision by the U.S. District Court for the Western District of Michigan, said Mr. Roberts, the board's chairman. The next stop for the case is the U.S. Court of Appeals in Cincinnati.

He said he believed Michigan's case was the first to challenge federal taxation of state-run prepaid tuition programs, adding that the case was being watched closely by other states that have instituted similar programs.

Under Michigan's program, administered by the Michigan Education Trust, people can buy contracts from the trust to cover their children's future college education costs. 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.

Sabrina Keeley, executive director of the trust, said the trust filed the suit in May 1990 after receiving a letter ruling from the Internal Revenue Service that found the trust was subject to federal taxation. The trust began selling the contracts in 1988.

In its decision, the U.S. district court ruled that the program "is not an integral part of the state of Michigan," and is subject to the IRS Code. Additionally, the court 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."

The court found the program does not qualify as a 501(c)(3) tax-exempt organization under the IRS Code "because its purpose of providing the tuition guaranteeing service constitutes a substantial private benefit that destroys the exemption."

The court rejected the state's argument that the program was constitutionally protected from federal taxation. In its opinion, the court found no cause for the program's immunity from taxation under the doctrine of intergovernmental immunity. It also found that federal taxation of the program did not discriminate against Michigan.

Mr. Roberts said that if the state loses the case, the trust would not be harmed financially because it has been paying federal taxes.

According to Ms. Keeley, the trust has paid a total of about $29 million in federal taxes. The trust currently has 55,000 contracts outstanding and $450 million of assets, she added.

Peter A. Roberts, the chairman of the College Savings Bank, a private entity that competes with state-sponsored college savings plans, said the decision in the Michigan case "will have a chilling effect" on the state programs because the payment of federal taxes would narrow the spread between the programs' investment income and their liabilities.

But William Montjoy, executive director of Florida's Prepaid Postsecondary Education Expense program, said the impact of the Michigan case on other states' programs will depend on how those other programs are structured. According to Mr. Montjoy, six states besides Michigan have prepaid tuition programs.

He said Michigan's case would have no impact on Florida, which considers its program to be tax-exempt The Florida program is an integral part of the state government, he said, because it is a state agency with a budget funded by state appropriations.

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