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Public schools are funded by taxpayer dollars. School tuition vouchers allow taxpayer dollars to fund private education by paying for private school tuition. Tuition tax credits work in a similar fashion, by allowing a credit for donations to private school voucher funds. In this article, the Institute on Taxation and Economic Policy's Carl Davis, discusses how state and federal tuition tax credits can be profitable to a donor.
By Carl Davis
Carl Davis is the research director at the Institute on Taxation and Economic Policy. The Institute on Taxation and Economic Policy is a non-profit and non-partisan research group that works on federal, state, and local tax issues.
Proponents of private K-12 education, such as Education Secretary Betsy DeVos, have long sought to steer public dollars into private schools. Traditionally, this has been done with taxpayer-funded vouchers that parents can use to pay their child's tuition bill at a private school. More recently, however, state lawmakers have found that the same goal can be pursued in an almost identical fashion via the tax code, under what are known as tuition tax credits, or TTCs.
Rather than directly funding private schools, TTCs provide a lucrative incentive intended to spur high-income taxpayers to fund vouchers (or “scholarships”) to those schools on the state's behalf. Seventeen states currently offer TTCs that offset at least half the cost of donating to private school voucher funds. Charitable donations to other causes, by contrast, are rewarded by state governments with tax deductions that typically offset 10 percent, or less, of the cost associated with donating (the exact percentage depends on the taxpayer's state tax rate).
States such as Alabama, Arizona, Georgia, and South Carolina offer TTCs that reimburse taxpayers for 100 percent of the amount they donate, up to certain limits. In these states, so-called “donations” are entirely costless to the donor and are instead funded, in whole, out of state revenue streams. This thin veneer of philanthropy, where “donors” do not make any personal financial sacrifice, is starkly different from the way that charitable giving tax incentives typically work. But the arrangement is even more problematic when interacting federal tax laws are considered.
As the Institute on Taxation and Economic Policy (ITEP) revealed late last year, some high-income taxpayers donating to K-12 private schools are not merely being reimbursed for their donations. Instead, they are being rewarded with state and federal tax cuts larger than the amounts they actually donated. For these taxpayers, what may appear to be a charitable gift has been twisted, through overly generous tax subsidies, into a scheme in which the donor is able to realize a personal financial gain.
There are a variety of techniques that donors are using to turn a profit with TTCs, but the most common involves claiming both a state TTC and a federal charitable deduction on a single donation. In South Carolina, for instance, a taxpayer donating $20,000 to fund private school vouchers receives not just a $20,000 state tax cut via the state's TTC, but also a $20,000 federal charitable tax deduction. If that donor happens to fall under the federal Alternative Minimum Tax (AMT), that $20,000 federal deduction can save them up to $7,000 on their federal tax bill. The result is $27,000 in tax cuts in return for donating just $20,000. That amounts to a risk-free profit of $7,000, or 35 percent above and beyond the amount donated.
These profits are possible in part because the federal tax code lacks a mechanism for accurately determining whether a charitable donation was truly “charitable” in nature. In the above example, a taxpayer donating $20,000 only to later receive a full reimbursement for that donation with a state tax credit has clearly not engaged in genuine charitable giving. It is therefore highly problematic that this taxpayer is eligible to receive a federal charitable tax deduction. But a 2011 IRS memo makes clear that this is allowed. The IRS refuses to consider a taxpayer's state tax benefits when deciding whether a contribution qualifies for the charitable deduction.
In its memo, the IRS conceded that “there may be unusual circumstances” where it would reconsider its treatment of these sorts of donations. Since it has yet to identify any of those unusual circumstances, however, private schools are aggressively marketing TTCs as tools to help donors “make money.”
And there are strong indications that these money-making schemes could grow larger in the years to come. Lawmakers in states such as Arkansas, Idaho, Kentucky, Minnesota, and Nebraska all gave serious consideration to enacting new TTCs this year, for example.
Even more ominously, there are signs that a nationwide TTC with similar flaws may be on the horizon. As detailed in a report that ITEP coauthored with AASA, the School Superintendents Association, federal TTC legislation proposed by Sen. Marco Rubio and Rep. Todd Rokita would open up at least two new voucher tax shelters that would allow investors, corporations, and high-income taxpayers to turn a profit by making so-called “donations” to fund private school vouchers.
Whether a TTC could pass Congress is unclear, but proponents believe that their best chance involves inserting such a credit into broader federal tax reform legislation that will be debated in the months ahead.
The tax code has long been used to incentivize taxpayers to be generous with their own money. K-12 private school proponents, however, have decided that their cause is worthy of tax incentives far more generous than those afforded to other nonprofits. In fact, the incentives sought, and attained, by private school backers in some states are so lucrative that they have turned the entire idea of charitable giving on its head. Rather than requiring a personal financial sacrifice, some high-income donors are finding that giving to private school voucher funds is a way to turn a risk-free profit. This reality should be unsettling to everyone who values a fair and efficient tax code. Given the current trajectory of state and federal policy debates, however, there is a strong likelihood that this problem could grow worse in the years ahead.
Copyright © 2017 Tax Management Inc. All Rights Reserved.
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