Private Schools Could Take Unintended Hit From IRS Donation Regs

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 Emma Beyer

Proposed IRS regulations cracking down on state workarounds to the deduction cap for state and local taxes (SALT) may end up shattering private school donation programs, including those in red Southern states with low taxes.

“Treasury has really cut off the whole arm when it really just needed to amputate a finger,” Rick Reames III, member of Nexsen Pruet LLC, told Bloomberg Tax.

The fear is that the proposed regulations, which target workarounds in high-tax states that use charitable contributions, could also apply to long-standing programs across the country.

“It will be significantly more difficult to solicit and secure contributions from individuals and businesses who, otherwise, would not have as their philanthropic focus the needs of low- and middle-income parents seeking alternative educational choices for their children,” according to one of the 2,973 comments submitted to the IRS since it released proposed regulations in August.

But it’s unlikely the IRS will create a carve-out for existing scholarship programs, many in southern, Republican-leaning states that haven’t joined the charge to avoid the SALT cap led by New York and New Jersey.

Dan Rosen, a partner in Baker & McKenzie LLP’s North America Tax Practice Group in New York, said “the IRS has to apply the same rule to all exemptions, or they’re opening up for more lawsuits.”

And private schools are scrambling to figure out what to do if they lose millions of dollars in donations due to the proposed regulations.

In May, the IRS announced that it would address state attempts to use charitable contributions to sidestep the $10,000 cap on the SALT deduction imposed by the 2017 federal tax law (Pub. L. No. 115-97). The IRS aimed proposed regulations at workaround programs in high-tax states like New York, New Jersey, California, and Connecticut in an attempt to prevent residents from avoiding the new cap. Under these proposed regulations, donors who receive a state or local tax credit would have to reduce any federal deduction for that contribution by the amount of the state tax credit.

However, the proposed regulations could have an unintended target: mostly southern, Republican-leaning states with “pre-existing state credit programs.” Some southern states, including Louisiana, Georgia, and South Carolina have had long-standing programs that allow individuals to donate money to qualifying private schools in exchange for up to a 100 percent tax credit.

The IRS has set a deadline of Oct. 11 for comments before a hearing scheduled for Nov. 5. This short timeline suggests the group is serious about making these regulations final, Rosen said. “We’re working under the assumption that regulations will be finalized.”

Tax Shelter or Philanthropic Effort?

In 2018, there were 22 tax credit scholarship programs authorized across 18 states. These programs provide state tax credits for individual and business donations that fund scholarships for students to attend private elementary and secondary schools, a September report from the U.S. Government Accountability Office found.

Half of these programs allow eligible donors to claim 100 percent of their donations as state tax credits, “meaning that for each dollar donated, state taxes owed are reduced by a dollar, up to any maximum set by the state,” the report said. Alabama, Arizona, Florida, Georgia, Louisiana, Montana, Nevada, and South Carolina allow a 100 percent credit, according to the GAO.

In states with these credits, donors gave more than $856 million in scholarships to primary and secondary students during the 2016-17 school year, the report found. These donations are used in part for scholarships and vouchers to private schools for low-income families.

This is where controversy sets in. In addition to reducing their state tax liabilities, donors may also be able to reduce their federal income tax liabilities through a federal tax deduction for charitable contributions.

Currently, the reduction is based on specific circumstances, such as whether the taxpayer itemizes or takes the standard deduction, the federal rates at which their income is taxed, and the amount of federal deductions they take for state and local tax.

Changes Under Proposed Regulations

Under the IRS’ proposed regulations, donors could no longer receive the federal deduction for school donations if they receive a state tax credit for that donation. Donors could still receive credits at the state level, David Trimner, a principal at wealth advisory and tax consulting company CliftonLarsonAllen LLP, told Bloomberg Tax.

Under the former system in a state with a 100 percent tax credit program, Donor A would be eligible for a reduction in state and federal tax liability if the donor has state taxes greater than $10,000. If the donor gives $1,000 to a private school charity, they would receive a $1,000 state tax credit. This donor could then deduct this $1,000 donation from their federal tax liability to receive a discounted tax bill based on their tax rate.

Under the proposed regulations in the same 100 percent tax credit state, Donor B wouldn’t be able to reduce both their state and federal tax liabilities if they paid less than $10,000 in state and local taxes. If Donor B makes a $1,000 charitable contribution, the donor would still receive a $1,000 credit against their state taxes. But they wouldn’t be eligible to deduct $1,000 from their federal tax bill; that savings would be offset by the amount of their state tax credit.

“A charitable contribution should be a gift,” Trimner said. “Now, donors are paying for a tax credit.”

Alabama Braces for Loss

Without the federal tax deduction, some education officials believe taxpayers will lose their incentive to donate, ultimately leading to fewer dollars for private schools.

The proposed regulations have real implications for students and families, Lesley Searcy, executive director of the Alabama Opportunity Scholarship Fund, an organization that provides scholarships to low-income students through the state’s tax liability program, told Bloomberg Tax.

“It’s the parents and kids that are worried,” Searcy said. “It’s their scholarship.”

Alabama enacted its tax liability program in 2013, “well before the workarounds that being discussed now,” Searcy said.

Alabama’s program provides $30 million a year to the Alabama Opportunity Scholarship Fund and serves more than 4,000 students whose families earn below $26,000 a year, Searcy said. “That’s what’s at risk.”

“It’s a long standing, highly successful program,” she said. The Alabama Opportunity Scholarship Fund is hoping the IRS will carve out exceptions for it and other tax credit scholarship programs. In the meantime, they’re urging individuals to submit comments to the IRS.

Bad Timing for South Carolina

The timing of Treasury’s action is especially bad for South Carolina, where tax credit programs have really gained traction in recent years, Rick Reames III, former South Carolina Department of Revenue director and current member of Nexsen Pruet LLC, told Bloomberg Tax.

South Carolina credits became permanent law July 1 with the start of South Carolina’s new fiscal year. Prior to that, the credit program had been renewed by an annual budget provison. “The program was just starting to take off,” Reames said.

“I don’t think most tax advisers or donors are fully aware of the potential impact to tax credit scholarship programs,” Reames said. “The Treasury Department acted to preserve the new federal tax reform act’s state and local tax deduction cap. However, this may unintentionally strip away some of the tax benefits to the scholarship programs.”

Wait-and-See Approach

At least two would-be-affected states are taking an interest in how others may deal with the regulations.

Louisiana—a state with a significant private and charter school movement—offers a nonrefundable income tax credit with a three-year carryforward to taxpayers making donations to organizations that provide scholarships to students to attend qualified schools under a 2017 law (Act 377). The law, effective Jan. 1, requires Louisiana taxpayers to file a state income tax return to qualify for the credit and doesn’t allow them to receive any other state tax benefit for the donation if the credit is taken.

“For individual income taxpayers, the limitation on the federal deduction for charitable contributions may decrease the Louisiana deduction for the excess federal itemized personal deductions and increase the Louisiana deduction for federal income tax liability,” the Louisiana Department of Revenue said in recent guidance.

“We’ll wait to see what the IRS does before we issue any other guidance,” Louisiana DOR Secretary Kimberly Robinson told Bloomberg Tax. She said Louisiana will also be looking at what other states are doing in response to the proposed rules.

The Arizona Department of Revenue is also monitoring the legislation and its possible impacts, Spokesman Ed Greenberg told Bloomberg Tax. “We’ll watch this situation and see how it proceeds.”

Linda Zell, executive director of the Jewish Tuition Organization, had a similar take. The organization uses the tax credit money to award scholarships for private Jewish schools in the Phoenix area.

The potential for change isn’t affecting how the organization operates, Zell said.

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