Corporate Law Blog

KY Supreme Court Approves Plugging Holes with Others' Piggy Banks

Budget drafting is one of the most challenging, yet essential, functions of state governments. Unlike the federal government, which has the ability to run large deficits and print its own currency, almost every state - Kentucky included - has a statutory or Constitutional framework requiring a balanced budget. Every two years, the Commonwealth's budget drafters utilize familiar methods to balance the ledger: debt restructuring, adjusting tax rates and spending levels, infusing federal funds and taxing new revenue sources. Another option, less understood by the public but increasingly utilized by Kentucky policy makers, is "sweeping" restricted funds. This controversial task has just been made easier thanks to a recent decision by the Kentucky Supreme Court. In a 5-2 opinion, the practice of sweeping regulatory accounts was declared lawful, meaning that lawmakers may continue to transfer fees and fines collected by state regulatory agencies to the General Fund without violating the Kentucky Constitution. The legality of sweeping funds that are generated by a statutory tax (rather than fines and fees) was not directly addressed by the Court, leaving open the possibility that the sweeping of such funds may yet be deemed unconstitutional.

As background, state regulatory agencies have the power to police certain occupations and activities in order to protect the health, welfare, and safety of the public. The cost of administering such regulation is borne by those in that occupation, who pay state-imposed fees and/or fines. Regulatory fees can only be levied to compensate an agency for issuing a license and playing a supervisory role over the profession; they cannot be used to generate state general fund revenue.The statutes that govern state agencies contain anti-lapse provisions that allow monies collected in one fiscal year to remain in the agency's account for the next year. Further, Section 180 of the Kentucky Constitution provides that taxes must be levied with a specific, distinct purpose and cannot be devoted to any other purpose after collected.

Although the practice is not new, the genesis of this case was the passage of the 2008-2010 biennial budget in 2008. Pursuant to an Executive Order by Governor Beshear that year, and in response to a General Fund budget shortfall of hundreds of millions of dollars, anti-lapse provisions were suspended, and funds in certain agency accounts were transferred to the General Fund. Subsequently, two separate set of appellants brought suit, arguing that regulatory fees may only be used by the collecting agency for regulatory purposes, and that their transfer to the General Fund for general revenue purposes, in effect, converts them to taxes, in violation of the Kentucky Constitution.

The two cases made their way through the trial court and Court of Appeals and were then certified for discretionary review at the Kentucky Supreme Court. Because they presented similar issues, the Court consolidated their review and issued a single opinion.

At issue before the Supreme Court was the transfer of $700,000 from the Department of Charitable Gaming ("DCG") and the transfer of $10 million from various funds created within the Department of Housing, Buildings and Construction ("DHBC"). DCG and DHBC both rely upon licensing, permit and inspection fees and fines (for example, for building code violations or illegal gaming) to carry out their regulatory responsibilities.

According to the Court, "it is not unlawful for the General Assembly to provide in a budget bill for the suspension of anti-lapse provisions in agency enabling statutes and for the transfer to the General Fund of surpluses incidentally existing in agency accounts." The only requirement is that the fees collected bear a "reasonable relation" to the regulatory expense so that a revenue-raising intent does not appear. In addition, though the funds come solely from private sources, the agencies' supervisory actions (e.g., building codes and gaming regulations) benefit the public at large; thus, they are considered public funds and subject to budget-bill transfer.

The dissent, authored by Judge Venters and joined by Judge Scott, disagrees with the majority that the amounts transferred from the agencies were genuinely "surplus." There is a clear distinction, as the dissent sees it, between a true surplus left over when a project is complete (such as the construction of a court house or the building of a road) versus the cases at hand where the money could have been used to pay for ongoing regulatory functions. Transferring funds, Venters wrote, results in higher fees on future participants, along with less agency service and protection.

While neither DCG nor DHBC generated funds through statutory taxation, some state agencies do, and these agencies are having substantial portions of their account balances transferred as well. For example, $9 million was swept from the Tourism Marketing Fund in order to balance the 2014-2016 budget. This fund is generated by a 1% tax on hotel rooms in Kentucky, which was passed overwhelmingly by the General Assembly in a 2005 omnibus tax bill. The Supreme Court only gives passing reference, in a footnote, to the important distinction between taxes and regulatory fees in this decision, but does little more to address the constitutionality of sweeping revenues generated through taxes, which is a clear violation of Section 180.[1] The 2014-16 budget calls for agency transfers totaling about $300 million.

Although the practice of transferring funds was commonplace long before this court ruling, it did not take long for policymakers to cite it as justification for subsequent sweeps. Kentucky's biennial budget bills often include a "General Fund Budget Reduction Plan" which authorizes the governor to cut the budget at the margins in the event of a shortfall, without calling the legislature back to redraft and pass another budget. A one-percent reduction in estimated revenue left a $90.9 million hole that needed to be filled before closing the books on the 2014 fiscal year. Less than one month after the ruling, Governor Beshear transferred almost $50 million from a range of agency funds, including the Board of Nursing, another transfer from Housing, Buildings and Construction, various environmental protection funds, among dozens of others. "The use of fund transfers is a valuable tool in how we manage and balance the overall budget of the Commonwealth, and one that keeps us from making deeper cuts to state agencies," Governor Beshear said. "The recent ruling by the Kentucky Supreme Court again affirms the constitutionality of this practice, thus ensuring much needed flexibility for the executive and legislative branches."

For now, it appears that all branches of state government are content with addressing budget shortfalls with money from agency pockets. The Supreme Court was clear that the transfer of regulatory fees does not constitute a hidden tax, but because they remained silent on the issue of the constitutionality of sweeping funds accrued from an express tax, further litigation or legislation may be required before agencies can stop the raid of taxes from their funds.

Stephen G. Amato, Member of McBrayer, has practiced law throughout Kentucky since his graduation from the University of Kentucky College of Law in 1990. His practice is diverse, focusing on civil litigation and administrative law. Mr. Amato's administrative practice focuses extensively in the area of alcoholic beverage regulation, primarily representing the interests of alcoholic beverage retailers and distributors in connection with licensing and enforcement issues at both the state and local levels. He can be reached at samato@mcbrayerfirm.com or (859) 231-8780, ext. 1104.

James Higdon is located at MML&K Government Solutions. He is a registered lobbyist for clients in the pharmaceutical, charitable gaming and information technology industries. In addition to his role as a lobbyist, he continues to perform a wealth of research and client communications for the firm - an essential function given the depth and breadth of information needed for effective client advocacy. Mr. Higdon can be reached at jhigdon@mmlk.com or (502) 875-1176.

This article is intended as a summary of federal and state law and does not constitute legal advice.

[1]See Footnote 6, "In a broad sense, perhaps, any monetary exaction by a governmental entity could be thought a tax, but a 'tax' in the strict sense of monies levied to meet the general expenses of government has been distinguished in a variety of contexts from more particularized exactions, such as fines, user fees - tolls, for example - infrastructure assessments, or regulatory fees, such as those at issue here...[T]he classic 'tax' is 'imposed by a legislature upon many, or all, citizens. It raises money, contributed to a general fund, and spent for the benefit of the entire community...[T]he classic 'regulatory fee' is imposed by an agency upon those subject to its regulation...[I]t may serve regulatory purposes directly by, for example, deliberately discouraging particular conduct by making it more expensive...[O]r, it may serve such purposes indirectly by, for example, raising money placed in a special fund to help defray the agency's regulation-related expenses.'" (citing San-Juan Cellular Tel. Co. v. Pub. Serv. Comm's of Puerto Rico, 967 F.2d 683, 685 (1st Cir. 1992)(citations omitted).