What is the source of your understanding that it's interest on a US obligation not taxable by the state?  I would agree with that if it were OID, but "market discount" means the client was buying these Treasury notes on the secondary market.  That's ordinary income (or at least, STCG).  Adding it to interest on Schedule B is a convenience to avoid Schedule D, but it's not really federal interest.  Cough up the 2.5% and be glad it's not California.