New proposed rules from the Internal Revenue Service (IRS) mark a turning point in how the federal government views state tax credits. If implemented, the new rules will have a significant impact on tax-credit scholarship programs in several states.
Previously, taxpayers could donate to charities, receive a state tax credit, and claim a federal charitable deduction for the contribution. In some cases, this mechanism could result in donors lowering their overall tax bill by more than the amount contributed.
Changes to the tax code via the Tax Cuts and Jobs Act (TCJA), which passed in December of 2017, brought new attention to this practice.
On August 23, 2018, the IRS proposed new rules to address these workarounds. The rules require taxpayers to subtract the value of any state and local tax credits from their charitable deductions. In other words, if a $1,000 donation results in a credit that lowers state taxes by $1,000, a donor may not claim any of the $1,000 donation as a federal charitable deduction. If the $1,000 results in a $750 state income tax credit, only the remaining $250 can be deducted as a federal charitable contribution, and so forth.
The intent of the rule is to ensure that no charitable contribution results in a benefit larger than the amount of the contribution. This “quid pro quo” rule places state tax credits in the same legal position as gifts that one might receive for donating to a charity—such as subtracting the value of a four-course dinner from the donation at a charity gala, subtracting the fair market value of a DVD box set you may receive for a $100 donation to your local PBS affiliate, etc.
So, where do we go from here?
We believe a short-term delaying of the rules for existing organizations to adjust to the new context, while fully accepting the new rules as good and sound policy, is the best path forward.
No tax-credit scholarship program was designed to help donors save on their tax bill. Instead, they were designed by state lawmakers to allow taxpayers to direct some portion of their tax bill toward a cause they believe in – increasing school options to meet student needs. Just like no school choice supporter would advocate for a 130 percent state tax credit, neither should we push to preserve a loophole in the federal tax code that allows donors to turn a $1,000 donation into $1,300 in lower taxes.
While this rule may cause some short-term transition issues, we believe that these programs can rise to the challenge by focusing their fundraising efforts on donors who believe in the cause. This should be easiest in states with 100 percent credits, where donors feel no financial pain for directing to this worthy cause. States with lower credit amounts—perhaps set low to prevent the very action that the IRS is fixing—have an opportunity to consider raising their credits to 100 percent to ensure that students are not left without scholarships as a result of higher tax burdens for donors.
A new analysis describes the issue, the potential impact on tax-credit scholarship programs, what some potential next steps could look like, and ExcelinEd’s position on the guidance.
The demand for quality options in education remains strong. Given the strong mission of tax-credit scholarship programs, we are hopeful that the impact of this rule change on student scholarships will be minimal.
Listen to Adam Peshek discuss whether new IRS regulations will harm tax credit scholarship programs with Michael Petrilli and David Griffith on the Fordham Institute’s Gadfly podcast.
About the author
Adam Peshek @AdamPeshek
Adam Peshek is Managing Director of Opportunity Policy at ExcelinEd, where he provides strategic support to state leaders interested in developing, adopting, and implementing policies that increase educational options for children. He has provided expert testimony in more than a dozen state legislatures and is a frequent commentator on ESAs, school choice, and education policy across the country. He is also the is the co-editor of the first published volume on ESAs, Education Savings Accounts: The New Frontier in School Choice. Adam currently resides in Atlanta, Georgia and is a Senior Fellow with the Beacon Center of Tennessee.