‘Fix’ for Federal Cap on State Tax Deduction? K-12 Tax Credits

Daily Tax Report: State provides authoritative coverage of state and local tax developments across the 50 U.S. states and the District of Columbia, tracking legislative and regulatory updates,...

By Christopher Brown

The IRS should target existing tax credit programs for private K-12 schools to protect the integrity of the new federal state and local tax deduction cap—and not just target new workaround credits enacted in New York and other states, a new report said.

Critics of the new workaround credits say they are a shameless attempt by high-taxing states to undercut the $10,000 cap on state and local tax payments, which was enacted as part of the 2017 federal tax act (Pub. L. No. 115-97).

But the very same charge can be made against the tax credit programs for private K-12 schools, the Institute on Taxation and Economic Policy said in its report. These programs are now being openly promoted by tax advisers and accountants as a way to sidestep or circumvent the SALT deduction cap, according to ITEP.

“In Alabama, Arizona, Georgia, Louisiana, and Pennsylvania, these tax credits are being publicly marketed to potential donors as ways to ‘convert’ or ‘exchange’ capped SALT deductions for uncapped and more lucrative charitable deductions,” the ITEP report said.

Many donors who act on this advice are able to come out ahead on the deal, receiving more back in the form of state credits and federal charitable deductions than they donate, the report said.

“In other words, these tax credits are being used by taxpayers to generate federal charitable deductions for behavior that meets virtually nobody’s definition of genuine charity,” it said.

IRS Review

Carl Davis, ITEP’s research director, told Bloomberg Tax that the IRS has been reviewing the workaround tax credit programs, which typically offer state tax credits in return for donations made on behalf of public services. The question before the IRS is whether those donations should be treated as charitable donations for the purposes of the federal charitable deduction, which wasn’t capped under the new federal tax law.

The IRS is expected to issue new regulations addressing the issue sometime this summer, Davis said.

Davis said it’s hard to see why the IRS should treat donations to tax credit programs that turn out to be a financial winner for the donor as charitable. “That’s not what we ordinarily mean by charity,” he said.

It’s also difficult to justify treating donations to private charity differently from those to state or local governments for public purposes, he said.

“State tax payments and charitable gifts are often directed to the same kinds of activities: education, health care, social services,” Davis said. “All kinds of areas of the economy are funded both by tax dollars and by charitable giving. And this would seem to make it questionable to treat the donations differently under the tax code.”

If the IRS does end up favoring private donations over those to governments, it may end up doing little more than stimulating the capacity for creative policy making among lawmakers, he said.

“The distinction between private and public isn’t a clear as some people seem to think,” he said. “There are a lot of options out there to run state services through the private sector, and a lot of ways to game the rules.”

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