Tax Law

6 States Sue To Block Student Loan Forgiveness Plan Because Their Governments Really Need The Interest Income

The gatekeeper here is whether the plaintiff states have standing to sue.

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The student loan lawsuits continue. Six states — Arkansas, Iowa, Kansas, Missouri, Nebraska, and South Carolina — have jointly filed a lawsuit to block President Joe Biden’s student loan forgiveness program.

As with the other lawsuits, the plaintiffs argue that the president does not have the unilateral authority to forgive student loans on a mass scale. They point out that Speaker Nancy Pelosi said that only Congress has the power to do so. In addition, two legislative bills that would forgive student loans failed to pass in Congress. Thus, the president is trying to sidestep the legislative process and by doing so violate the constitutional separation of powers.

The gatekeeper here is whether the plaintiff states have standing to sue, meaning whether they suffered a harm that a court can address. They claim that they are harmed in one of two ways. First, they will lose tax revenue because the forgiveness will be excluded from taxable income. Second, they will lose interest income if the federal government allows holders of Federal Family Education Loans (FFEL) to transfer their loans to the Federal Direct Loan Program (FDLP) in order to qualify for loan forgiveness. Each will be examined in turn.

Regarding taxes, five of the six plaintiff states do not include forgiven student loan as taxable income because they conform with the federal tax laws which also do not tax such income. The only exception is Arkansas.

The question here is whether the plaintiff attorneys general for these states can show an addressable harm if their legislatures are able to remedy it. The legislature can update their tax laws so that cancellation of debt income is taxable income for state income tax purposes. If this issue is so important, then surely the legislators in these states would have passed or at least proposed such a bill by now. But chances are they will not do this as it will be unpopular. If this is the case, then it would appear that the harm is due to lack of interest from the state legislature.

Next, the plaintiffs turn to FFELs, a subset of federal loans that are mostly managed by third-party entities, although some are held by the federal government. The extent of the federal government’s involvement is that they will guarantee the loan in case the borrower defaults on repayment. FFELs were discontinued in 2010 but still exist for repayment purposes.

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Missouri, Arkansas, and Nebraska own entities that manage and service FFELs. Their argument is that the president’s forgiveness plan has motivated eligible FFEL holders to convert their loans to the FDLP, and many have done so. As a result, these states will lose out on substantial interest income if their customers basically refinance with the federal government and get their money back earlier than anticipated.

Whether there is harm in this case is also questionable. While they may lose out on future interest payments as a result of mass consolidation applications, were the plaintiffs entitled to the interest income at all? This is a loan, not an annuity or some other kind of guaranteed income stream. It is not uncommon to refinance these loans, and there is no penalty for early repayment. Generally for loans with no collateral, it is preferable to be paid as agreed earlier rather than risk a default in the future. In sum, it will be hard to show harm if the borrowers abided by the loan contracts, although not quite in the way the plaintiffs wanted.

Interestingly, the plaintiffs argue that the loss of interest income will negatively affect things like the state pension fund, the ability to issue bonds, the ability to issue new loans, paying interest on bonds, and funding reserves, to name a few. In other words, student loan interest is funding government activities. There is nothing wrong with that per se, but it does give these governments an incentive to make sure that borrowers pay as much interest as possible.

Unfortunately, on September 29, in response to this lawsuit, the federal government quietly announced that FFELs held by third parties would no longer be eligible to claim loan forgiveness unless they applied for consolidation before its announcement. The belief is that making FFELs ineligible will weaken the plaintiffs’ argument, although it appears that the damage has already been done as many had already applied for consolidation before the announcement.

Ironically, this sudden reversal might give standing to FFEL holders who were denied eligibility because they did not consolidate on time. For example, someone could have stopped payments on their loans relying on the announcement (FFELs were not eligible for the moratorium on payment and interest accrual). They were harmed because they were put in forbearance or collections and their interest rate could have increased as a result. Also, these people were not able to consolidate immediately because they may have been unable to consolidate online because of heavy website traffic. And of course, the ineligibility announcement came without warning.

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While six states along with their attorneys general are respected and credible plaintiffs, their standing claims are not bulletproof. Loans paid earlier than expected and as agreed should not establish harm. And their income tax revenue worries can be remedied by the state legislature. But the lawsuit inadvertently shows that these loans are also in effect a second, secret tax on the young.

Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at stevenchungatl@gmail.com. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.

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